Chapter 25
Short-Term Business Decisions
Review Questions
1. List the four steps in short-term decision making. At which step are managerial accountants most
involved?
The four steps in short-term decision making are: (1) Define business goals; (2) Identify alternative
2. What makes information relevant to decision making?
3. What makes information irrelevant to decision making?
4. What are sunk costs? Give an example.
5. When is nonfinancial information relevant?
6. What is differential analysis?
7. What are the two keys in short-term decision making?
The two keys in short-term decision making are (1) focusing on relevant revenues, costs, and profits,
8. What questions should managers answer when setting regular prices?
The three questions managers should answer when setting regular prices are:
9. Explain the difference between price-takers and price-setters.
A company is a price-taker when it has little control over the prices of its products and services
10. What is target pricing? Who uses it?
11. What does the target full product cost include?
12. What is cost-plus pricing? Who uses it?
13. What questions should managers answer when considering special pricing orders?
Managers should answer the following three questions when considering special pricing orders:
14. When completing a differential analysis, when are the differences shown as positive amounts? As
negative amounts?
15. When should special pricing orders be accepted?
16. What questions should managers answer when considering dropping a product or segment?
Some of the questions managers must consider when deciding whether to drop a product or a
business segment, include the following:
• Does the product or segment provide a positive contribution margin?
• Will fixed costs continue to exist, even if the company drops the product or segment?
17. Explain why a segment with an operating loss can cause the company to have a decrease in total
operating income if the segment is dropped.
18. What is a constraint?
19. What questions should managers answer when facing constraints?
Managers should answer the following questions when facing constraints:
20. What is the decision rule concerning products to emphasize when facing a constraint?
21. What is the most common constraint faced by merchandisers?
22. What is outsourcing?
23. What questions should managers answer when considering outsourcing?
24. What questions should managers answer when considering selling a product as is or processing
further?
25. What are joint costs? How do they affect the sell or process further decision?
26. What is the decision rule for selling a product as is or processing it further?
Short Exercises
S25-1 Describing and identifying information relevant to business decisions
Learning Objective 1
You are trying to decide whether to trade in your inkjet printer for a more recent model. Your usage
pattern will remain unchanged, but the old and new printers use different ink cartridges.
Indicate if the following items are relevant or irrelevant to your decision:
a. The price of the new printer
b. The price paid for the old printer
c. The trade-in value of the old printer
d. Paper cost
e. The difference between ink cartridges’ costs
SOLUTION
(a)
relevant
(b)
irrelevant
(c)
relevant
(d)
irrelevant
(e)
relevant
S25-2 Making pricing decisions
Learning Objective 2
Mountain Run operates a Rocky Mountain ski resort. The company is planning its lift ticket pricing for
the coming ski season. Investors would like to earn a 12% return on investment on the company’s
$111,000,000 of assets. The company primarily incurs fixed costs to groom the runs and operate the
lifts. Mountain Run projects fixed costs to be $37,000,000 for the ski season. The resort serves about
680,000 skiers and snowboarders each season. Variable costs are about $8 per guest. Currently, the
resort has such a favorable reputation among skiers and snowboarders that it has some control over the
lift ticket prices.
Requirements
1. Would Mountain Run emphasize target pricing or cost-plus pricing? Why?
2. If other resorts in the area charge $80 per day, what price should Mountain Run charge?
SOLUTION
Requirement 1
Mountain Run would emphasize cost-plus pricing because it is a price-setter. Mountain Run would be
Requirement 2
Current variable costs
($8 per guest × 680,000 guests)
$ 5,440,000
Plus: Fixed costs
37,000,000
Full product cost
42,440,000
Plus: Desired profit
(12% × $111,000,000 assets)
13,320,000
Target revenue
$ 55,760,000
Divided by number of guests
Cost-plus price per guest
Note: Short Exercise S25-2 must be completed before attempting Short Exercise S25-3.
S25-3 Making pricing decisions
Learning Objective 2
Refer to details about Mountain Run from Short Exercise S25-2. Assume that Mountain Run’s
reputation has diminished and other resorts in the vicinity are charging only $80 per lift ticket. Mountain
Run has become a price-taker and will not be able to charge more than its competitors. At the market
price, Mountain Run managers believe they will still serve 680,000 skiers and snowboarders each
season.
Requirements
1. If Mountain Run cannot reduce its costs, what profit will it earn? State your answer in dollars and as
a percent of assets. Will investors be happy with the profit level?
2. Assume Mountain Run has found ways to cut its fixed costs to $36,320,000. What is its new target
variable cost per skier/snowboarder?
SOLUTION
Requirement 1
(680,000 guests @ $80 per lift ticket)
$ 54,400,000
[37,000,000 + ($8 per guest × 680,000 guests)]
42,440,000
11,960,000
111,000,000
Requirement 2
Revenue at market price
(calculated above)
$ 54,400,000
Less: Desired profit
(12% × $111,000,000 assets)
13,320,000
Target full product cost
41,080,000
Less: Fixed costs
36,320,000
Variable costs
Divided by guests
Target variable cost per guest
S25-4 Making dropping a product or segment decisions
Learning Objective 3
Gila Fashions operates three departments: Men’s, Women’s, and Accessories. Departmental operating
income data for the third quarter of 2016 are as follows:
Assume that the fixed costs assigned to each department include only direct fixed costs of the
department:
• Salary of the department’s manager
• Cost of advertising directly related to that department
If Gila Fashions drops a department, it will not incur these fixed costs. Under these circumstances,
should Gila Fashions drop any of the departments? Give your reasoning.
SOLUTION
Accessories Department:
Expected decrease in revenue
$ (97,000)
Expected decrease in total variable costs
$ 94,000
Expected decrease in fixed costs
Expected decrease in total costs
Expected increase in operating income
S25-5 Making product mix decisions
Learning Objective 3
ContainAll produces plastic storage bins for household storage needs. The company makes two sizes of
bins: large (50 gallon) and regular (35 gallon). Demand for the products is so high that ContainAll can
sell as many of each size as it can produce. The company uses the same machinery to produce both
sizes. The machinery can be run for only 2,800 hours per period. ContainAll can produce 11 large bins
every hour, whereas it can produce 17 regular bins in the same amount of time. Fixed costs amount to
$130,000 per period. Sales prices and variable costs are as follows:
Requirements
1. Which product should ContainAll emphasize? Why?
2. To maximize profits, how many of each size bin should ContainAll produce?
3. Given this product mix, what will the company’s operating income be?
SOLUTION
Requirement 1
Contribution Margin per Product:
Regular
Bin
Large
Bin
Sales price per bin
$ 8.90
$ 10.80
Variable cost per bin
Contribution margin per bin
$ 5.20
Contribution Margin per Machine Hour:
Regular
Bin
Large
Bin
(1) Bins produced per hour
17
11
(2) Contribution margin per bin (calculated above)
$ 6.70
Contribution margin per machine hour [(1) × (2)]
$ 73.70
When facing a constraint concerning which products to emphasize, the decision rule is to emphasize the
Requirement 2
Requirement 3
Regular
Bins
Sales Revenue
(47,600 bins × $8.90 per bin)
$ 423,640
Variable Costs
(47,600 bins × $3.70 per bin)
Contribution Margin
(47,600 bins × $5.20 per bin)
Fixed Costs
Operating Income
$ 117,520
S25-6 Making outsourcing decisions
Learning Objective 4
Suppose Brady House restaurant is considering whether to (1) bake bread for its restaurant in-house or
(2) buy the bread from a local bakery. The chef estimates that variable costs of making each loaf include
$0.54 of ingredients, $0.25 of variable overhead (electricity to run the oven), and $0.72 of direct labor
for kneading and forming the loaves. Allocating fixed overhead (depreciation on the kitchen equipment
and building) based on direct labor, Brady House assigns $1.05 of fixed overhead per loaf. None of the
fixed costs are avoidable. The local bakery would charge $1.70 per loaf.
Requirements
1. What is the full product unit cost of making the bread in-house?
2. Should Brady House bake the bread in-house or buy from the local bakery? Why?
3. In addition to the financial analysis, what else should Brady House consider when making this
decision?
SOLUTION
Requirement 1
Direct materials
$ 0.54
Direct labor
0.72
Variable manufacturing overhead
0.25
Fixed manufacturing overhead
1.05
Cost per loaf of bread
Requirement 2
Bread Costs
Make
Outsource
Difference
(Make – Outsource)
Variable costs:
Direct materials
$ 0.54
$ 0.54
Direct labor
0.72
Variable manufacturing overhead
0.25
Purchase cost
Total differential cost per loaf
$ 1.51
Requirement 3
In addition to the financial analysis, Brady House should consider what else it could do with the freed
S25-7 Making outsourcing decisions
Learning Objective 4
Delila Nailey manages a fleet of 325 delivery trucks for Yankee Corporation. Nailey must decide
whether the company should outsource the fleet management function. If she outsources to Fleet
Management Services (FMS), FMS will be responsible for maintenance and scheduling activities. This
alternative would require Nailey to lay off her five employees. However, her own job would be secure;
she would be Yankee’s liaison with FMS. If she continues to manage the fleet, she will need fleet-
management software that costs $10,000 per year to lease. FMS offers to manage this fleet for an annual
fee of $265,000. Nailey performed the following analysis:
Requirements
1. Which alternative will maximize Yankee’s short-term operating income?
2. What qualitative factors should Yankee consider before making a final decision?
SOLUTION
Requirement 1
The decision rule on outsourcing states that if the differential cost of making the product exceeds the
Requirement 2
S25-8 Making sell or process further decisions
Learning Objective 4
Chocolicious processes cocoa beans into cocoa powder at a processing cost of $10,300 per batch.
Chocolicious can sell the cocoa powder as is, or it can process the cocoa powder further into either
chocolate syrup or boxed assorted chocolates. Once processed, each batch of cocoa beans would result
in the following sales revenue:
The cost of transforming the cocoa powder into chocolate syrup would be $67,000. Likewise, the
company would incur a cost of $179,000 to transform the cocoa powder into boxed assorted chocolates.
The company president has decided to make boxed assorted chocolates due to their high sales value and
to the fact that the cocoa bean processing cost of $10,300 eats up most of the cocoa powder profits.
Has the president made the right or wrong decision? Explain your answer. Be sure to include the
correct financial analysis in your response.
SOLUTION
Process into boxed assorted chocolates:
Costs
Sell
Process
Further
Difference
Expected revenue per batch
$ 14,500
$ 196,000
$ 181,500
Additional costs of processing
Total net revenue
$ 14,500
$ 2,500
Process into chocolate syrup:
Costs
Sell
Process
Further
Difference
Expected revenue per batch
$ 14,500
$ 104,000
$ 89,500
Additional costs of processing
Total net revenue
$ 14,500
$ 22,500
The President of Chocolicious has not made the best decision. The best decision would be to process the
cocoa powder into chocolate syrup to sell. It is important to look at costs, as well as expected revenue,
Exercises
E25-9 Describing and identifying information relevant to business decisions
Learning Objective 1
Dan Jacobs, production manager for GreenLife, invested in computer-controlled production machinery
last year. He purchased the machinery from Superior Design at a cost of $3,000,000. A representative
from Superior Design has recently contacted Dan because the company has designed an even more
efficient piece of machinery. The new design would double the production output of the year-old
machinery but would cost GreenLife another $4,500,000. Jacobs is afraid to bring this new equipment
to the company president’s attention because he convinced the president to invest $3,000,000 in the
machinery last year.
Explain what is relevant and irrelevant to Jacobs’s dilemma. What should he do?
SOLUTION
The cost and doubled production output of the new machine would be relevant information. The
E25-10 Making special pricing decisions
Learning Objective 2
1. $2,750
Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hungry-Cardz with a
special order. The Hall of Fame wishes to purchase 55,000 baseball card packs for a special promotional
campaign and offers $0.33 per pack, a total of $18,150. Hungry-Cardz’s total production cost is $0.53
per pack, as follows:
Hungry-Cardz has enough excess capacity to handle the special order.
Requirements
1. Prepare a differential analysis to determine whether Hungry-Cardz should accept the special sales
order.
2. Now assume that the Hall of Fame wants special hologram baseball cards. Hungry- Cardz will spend
$5,000 to develop this hologram, which will be useless after the special order is completed. Should
Hungry-Cardz accept the special order under these circumstances, assuming no change in the special
pricing of $0.33 per pack?
SOLUTION
Requirement 1
Expected increase in revenue
(55,000 packs × $0.33 per pack)
$ 18,150
Expected increase in variable manufacturing costs
(55,000 packs × $0.28 per pack)
Expected increase in operating income
Requirement 2
Expected increase in revenue
(55,000 packs × $0.33 per pack)
$ 18,150
Expected increase in variable manufacturing costs
(55,000 packs × $0.28 per pack)
Expected increase in fixed manufacturing costs
Expected decrease in operating income
E25-11 Making special pricing decisions
Learning Objective 2
1. $475,000
Tolman Sunglasses sell for about $154 per pair. Suppose that the company incurs the following average
costs per pair:
*$2,250,000 Total fixed manufacturing overhead / 90,000 Pairs of sunglasses
Tolman has enough idle capacity to accept a one-time-only special order from Alaska Shades for 25,000
pairs of sunglasses at $83 per pair. Tolman will not incur any variable selling expenses for the order.
Requirements
1. How would accepting the order affect Tolman’s operating income? In addition to the special order’s
effect on profits, what other (longer-term qualitative) factors should Tolman’s managers consider in
deciding whether to accept the order?
2. Tolman’s marketing manager, Peter Kyler, argues against accepting the special order because the
offer price of $83 is less than Tolman’s $92 cost to make the sunglasses. Kyler asks you, as one of
Tolman’s staff accountants, to explain whether his analysis is correct. What would you say?
SOLUTION
Requirement 1
Relevant variable costs:
Direct materials
$ 39
Direct labor
16
Variable manufacturing overhead
Total relevant variable costs
$ 64
Expected increase in revenue
(25,000 pairs × $83 per pair)
Expected increase in variable manufacturing costs
(25,000 pairs × $64 per pair)
Expected increase in operating income
(25,000 pairs × $19 per pair)
Requirement 2
As a staff accountant you need to explain that Peter Kyler’s analysis is not correct. The $92
E25-12 Making pricing decisions
Learning Objective 2
3. Desired profit $32,480
Rouse Builders builds 1,500-square-foot starter tract homes in the fast-growing suburbs of Atlanta. Land
and labor are cheap, and competition among developers is fierce. The homes are a standard model, with
any upgrades added by the buyer after the sale. Rouse Builders’s costs per developed sublot are as
follows:
Rouse Builders would like to earn a profit of 16% of the variable cost of each home sold. Similar homes
offered by competing builders sell for $202,000 each. Assume the company has no fixed costs.
Requirements
1. Which approach to pricing should Rouse Builders emphasize? Why?
2. Will Rouse Builders be able to achieve its target profit levels?
3. Bathrooms and kitchens are typically the most important selling features of a home. Rouse Builders
could differentiate the homes by upgrading the bathrooms and kitchens. The upgrades would cost
$22,000 per home but would enable Rouse Builders to increase the selling prices by $38,500 per
home. (Kitchen and bathroom upgrades typically add about 175% of their cost to the value of any
home.) If Rouse Builders makes the upgrades, what will the new cost-plus price per home be?
Should the company differentiate its product in this manner?
SOLUTION
Requirement 1
Requirement 2
Relevant variable costs:
Land
$ 51,000
Construction
121,000
Landscaping
Variable selling costs
Total relevant variable costs
$ 181,000
Revenue per home
$ 202,000
Less: Desired profit
(16% × $181,000 variable cost per home)
Requirement 3
Upgraded variable costs per home
($181,000 original + $22,000 upgrades)
$ 203,000
Plus: Fixed costs
0
Full product cost
Plus: Desired profit
(16% × $203,000 variable cost per home)
Cost-plus price per home
$ 235,480
Upgraded home selling price:
$ 202,000 original + $ 38,500 upgrades =
E25-13 Making dropping a product decisions
Learning Objective 3
1. $(33,000)
(Requirement 1 only)
Top managers of Best Video are alarmed by their operating losses. They are considering dropping the
DVD product line. Company accountants have prepared the following analysis to help make this
decision:
Total fixed costs will not change if the company stops selling DVDs.
Requirements
1. Prepare a differential analysis to show whether Best Video should drop the DVD product line.
2. Will dropping DVDs add $43,000 to operating income? Explain.
SOLUTION
Requirement 1
Expected decrease in revenue
$ (123,000)
Expected decrease in total variable costs
Expected decrease in operating income
$ (33,000)
Requirement 2
Dropping the DVD product line will not add $43,000 to operating income. Dropping the DVD product
Note: Exercise E25-13 must be completed before attempting Exercise E25-14.
E25-14 Making dropping a product decisions
Learning Objective 3
1. $12,000
Refer to Exercise E25-13. Assume that Best Video can avoid $45,000 of fixed costs by dropping the
DVD product line (these costs are direct fixed costs of the DVD product line).
Prepare a differential analysis to show whether Best Video should stop selling DVDs.
SOLUTION
Expected decrease in revenue
$ (123,000)
Expected decrease in total variable costs
$ 90,000
Expected decrease in fixed costs
Expected decrease in total costs
Expected increase in operating income
$ 12,000