E26-4 Use incremental analysis for make-or-buy decision
Pottery Ranch Inc. has been manufacturing its own finials for its curtain rods. The company is currently operating at 100% of capacity, and
variable manufacturing overhead is charged to production at the rate of 70% of direct labor cost. The direct materials and direct labor cost per
unit to make a pair of finials are $4 and $5, respectively. Normal production is 30,000 curtain rods per year.
A supplier offers to make a pair of finials at a price of $12.95 per unit. If Pottery Ranch accepts the supplier’s offer, all variable manufacturing
costs will be eliminated, but the $45,000 of fixed manufacturing overhead currently being charged to the finials will have to be absorbed by
other products.
Instructions
(a) Prepare the incremental analysis for the decision to make or buy the finials.
(b) Should Pottery Ranch buy the finials?
(c ) Would your answer be different in (b) if the productive capacity released by not making the finials could be used to produce income
of $20,000?
NOTE: Enter a number in cells requesting a value; enter either a number or a formula in cells with a “?” .
(a) Prepare the incremental analysis for the decision to make or buy the finials.
Make Buy
Net income
Increase
(Decrease)
Direct materials ? Value Value
Direct labor ? Value Value
Variable overhead costs ? Value Value
Fixed manufacturing costs Value Value Value
Purchase price ? Value Value
Total annual costs ? ? ?
(b) Should Pottery Ranch buy the finials?
(c ) Would your answer be different in (b) if the productive capacity released by not making
the finials could be used to produce income of $20,000?
Make Buy
Net income
Increase
(Decrease)
Total annual cost (above) Value Value Value
Opportunity cost Value Value
Total cost ? ? ?
After you have completed E26-4, consider the following additional question.
1. Assume that the direct materials and direct labor cost per unit to make the finials are $4.75 and $5.50, respectively.
What impact do these changes on your analysis and the decision to make-or-buy the finials?
E26-4 Solution
(a) Prepare the incremental analysis for the decision to make or buy the finials.
Make Buy
Net income
Increase
(Decrease)
Direct materials(30,000 x $4.00) $120,000 $0 $120,000
Direct labor (30,000 x $5.00) 150,000 0 $150,000
Variable overhead costs ($150,000 x 70%) 105,000 0 $105,000
(b) Should Pottery Ranch buy the finials?
(c ) Would your answer be different in (b) if the productive capacity released by not making the
finials could be used to produce income of $20,000?
Make Buy
Net income
Increase
E26-4 Solution to additional question
1. Assume that the direct materials and direct labor cost per unit to make the finials are $4.75 and $5.50, respectively.
What impact do these changes on your analysis and the decision to make-or-buy the finials?
(a)
Make Buy
Direct materials(30,000 x $4.75) $142,500 $0 $142,500
Direct labor (30,000 x $5.50) 165,000 0165,000
(b) Should Pottery Ranch buy the finials?
(c ) Would your answer be different in (b) if the productive capacity released by not making the
finials could be used to produce income of $20,000?
Make Buy
Yes. By purchasing the finials, a total cost saving of $54,500 will result as shown
below.
E26-7 Use incremental analysis concerning elimination of division.
Veronica Mars, a recent graduate of Bell’s accounting program, evaluated the operating performance
of Dunn Company’s six divisions. Veronica made the following presentation to Dunn’s board of directors
and suggested the Percy Division be eliminated. “If the Percy Division is eliminated,” she said, “our
total profits would increase by $26,000.”
The Other Percy
Five Divisions
Division Total
Sales $1,664,200 $100,000 $1,764,200
Cost of goods sold 978,520 76,000 1,054,520
Gross Profit 685,680 24,000 709,680
Operating expenses 527,940 50,000 577,940
Net income $157,740 ($26,000) $131,740
In the Percy Division, cost of goods sold is $61,000 variable and $15,000 fixed, and operating expenses
are $30,000 variable and $20,000 fixed. None of the Percy Division’s fixed costs will be eliminated if the
division is discontinued.
Instructions
Is Veronica right about eliminating the Percy Division? Prepare a schedule to support your answer.
NOTE: Enter a number in cells requesting a value; enter either a number or a formula in cells with a “?” .
Is Veronica right about eliminating the Percy Division? Prepare a schedule to support your answer.
Continue Eliminate
Net income
Increase
(Decrease)
Sales Value Value Value
Variable costs
Cost of goods sold Value Value Value
Operating expenses Value Value Value
Total variable ? ? ?
Contribution margin ? ? ?
Fixed costs
Cost of goods sold Value Value Value
Operating expenses Value Value Value
Total fixed ? ? ?
Net income (loss) ? ? ?
Response:
After you have completed E26-7, consider the following additional question.
1. Assume that variable cost of goods sold for the Percy Division changed to $68,000 and fixed
operating expenses changed to $27,500. There was no change to variable operating costs or fixed
cost of goods sold. How would these changes impact your answer?
E26-7 Solution
Continue Eliminate
Net income
Increase
(Decrease)
Sales $100,000 $0 ($100,000)
Variable costs
Cost of goods sold 61,000 0 61,000
Operating expenses 30,000 0 30,000
E26-7 Solution to additional question
1. Assume that variable cost of goods sold for the Percy Division changed to $68,000 and fixed
operating expenses changed to $27,500. There was no change to variable operating costs or fixed
cost of goods sold. How would these changes impact your answer?
Continue Eliminate
Net income
Increase
(Decrease)
Sales $100,000 $0 ($100,000)
Variable costs
Cost of goods sold 68,000 068,000
Operating expenses 26,000 0 26,000
E26-9 Compute cash payback period and net present value
Doug’s Custom Construction Company is considering three new projects, each requiring an equipment
investment of $22,000. Each project will last for 3 years and produce the following net annual cash
flows.
Year AA BB CC
1 $7,000 $10,000 $13,000
2 9,000 10,000 12,000
3 12,000 10,000 11,000
Total $28,000 $30,000 $36,000
The equipment’s salvage value is zero, and Doug uses straight-line depreciation. Doug will not
accept any project with a cash payback period over 2 years. Doug’s required rate of return is 12%.
Instructions
(a) Compute each project’s payback period, indicating the most desirable project and the least
desirable project using this method. (Round to two decimals and assume in your computations
that cash flows occur evenly throughout the year.)
(b) Compute the net present value of each project. Does your evaluation change? (Round to
nearest dollar.)
NOTE: Enter a number in cells requesting a value; enter either a number or a formula in cells with a “?” .
(a) Compute each project’s payback period, indicating the most desirable project and the least
desirable project using this method. (Round to two decimals and assume in your computations
that cash flows occur evenly throughout the year.)
Net Annual Cumulative
Year Cash Flow Net Cash Flow
1Value ?
2Value ?
3Value ?
Cash Payback Period:
Cost of capital investment Value
Cumulative net cash flow, year 2 Value
Remaining cost to be recovered (a) ?
Net cash flow, year 3 (b) Value
Payback period, year 3 (a) ÷ (b) Value
Total cash payback period in years ?
Cash Payback Period:
Cost of capital investment (a) Value
Net annual cash flow Value
Total cash payback period in years (a) ÷ (b) ?
Net Annual Cumulative
Year Cash Flow Net Cash Flow
1Value ?
2Value ?
3Value ?
Cash Payback Period:
Cost of capital investment Value
Cumulative net cash flow, year 1 Value
Project AA
Project BB
Project CC
Remaining cost to be recovered (a) ?
Net cash flow, year 2 (b) Value
Payback period, year 2 (a) ÷ (b) Value
Total cash payback period in years ?
(b) Compute the net present value of each project. Does your evaluation change? (Round to
nearest dollar.)
12%
Discount Cash Present Cash Present Cash Present
Year Factor Flow Value Flow Value Flow Value
1 0.89286 Value ?Value ?Value ?
2 0.79719 Value ?Value ?Value ?
3 0.71178 Value ?Value ?Value ?
Total present value ? ? ?
Investment Value Value Value
Net present value ? ? ?
After you have completed the requirements of E26-9, consider these additional questions.
1. Assume that the investment for equipment is $25,000. Recompute for each project’s
payback period and indicate the most desirable and least desirable project.
2. Recompute the net present value for each project. How does this change your evaluation?
Project CC
Project AA
Project BB
Response:
Response:
E26-9 Solution
(a) Compute each project’s payback period, indicating the most desirable project and the least
desirable project using this method. (Round to two decimals and assume in your computations
that cash flows occur evenly throughout the year.)
Net Annual Cumulative
Year Cash Flow Net Cash Flow
1 $7,000 $7,000
2 9,000 16,000
Cash Payback Period:
Cost of capital investment (a) $22,000
Net Annual Cumulative
Year Cash Flow Net Cash Flow
1 $13,000 $13,000
2 12,000 25,000
Project AA
Project BB
Project CC
The most desirable project is CC because it has the shortest payback period. The least
(b) Compute the net present value of each project. Does your evaluation change? (Round to
nearest dollar.)
12%
Discount Cash Present Cash Present Cash Present
Year Factor Flow Value Flow Value Flow Value
1 0.89286 $7,000 $6,250 $10,000 $8,929 $13,000 $11,607
2 0.79719 9,000 7,175 10,000 7,972 12,000 9,566
Project CC
Project AA
Project BB
ccep p y y
E26-9 Solution to additional question
1. Assume that the investment for equipment is $25,000. Recompute for each project’s
payback period and indicate the most desirable and least desirable project. (Round to two decimals
and assume in your computations that cash flows occur evenly throughout the year.)
Net Annual Cumulative
Year Cash Flow Net Cash Flow
1 $7,000 $7,000
Cash Payback Period:
Cost of capital investment $25,000
Cumulative net cash flow, year 2 16,000
Remaining cost to be recovered (a) 9,000
Cash Payback Period:
Cost of capital investment (a) $25,000
Net Annual Cumulative
Year Cash Flow Net Cash Flow
1 $13,000 $13,000
2 12,000 25,000
Project AA
Project BB
Project CC
2. Recompute the net present value for each project. How does this change your evaluation?
12%
Discount Cash Present Cash Present Cash Present
Year Factor Flow Value Flow Value Flow Value
1 0.89286 $7,000 $6,250 $10,000 $8,929 $13,000 $11,607
2 0.79719 9,000 7,175 10,000 7,972 12,000 9,566
Project CC
Project AA
Project BB
P26-4A Prepare incremental analysis concerning elimination of divisions.
Brislin Company has four operating divisions. During the first quarter of 2017, the company reported
aggregate income from operations of $213,000 and the following divisional results.
III III IV
Sales $250,000 $200,000 $500,000 $450,000
Cost of goods sold 200,000 192,000 300,000 250,000
Selling and administrative expenses 75,000 60,000 60,000 50,000
Income (loss) from operations ($25,000) ($52,000) $140,000 $150,000
Analysis reveals the following percentages of variable costs in each division.
III III IV
Cost of good sold 70% 90% 80% 75%
Selling and administrative expenses 40 60 50 60
Discontinuance of any division would save 50% of the fixed costs and expenses for that division. Top management is
very concerned about the unprofitable divisions (I and II). Consensus is that one or both of the divisions should be discontinued.
Instructions
(a) Compute the contribution margin for Division I and II.
(b) Prepare an incremental analysis concerning the possible discontinuance of (1) Division I and
(2) Division II. What course of action do you recommend for each division?
(c ) Prepare a columnar condensed income statement for Brislin Company, assuming Division II
is eliminated. (Use the CVP format.) Division II’s unavoidable fixed costs are allocated equally
to the continuing divisions.
(d) Reconcile the total income from operations ($213,000) with the total income from operations
without Division II.
NOTE: Enter a number in cells requesting a value; enter either a number or a formula in cells with a “?” .
(a) Compute the contribution margin for Division I and II.
Division I Division II
Sales Value Value
Variable costs
Cost of goods sold
Value Value
Selling and administrative
Value Value
Total variable expenses
? ?
Contribution margin
? ?
(b) (1) Prepare an incremental analysis concerning the possible discontinuance of Division I
Net Income
Increase
Continue Eliminate (Decrease)
Contribution margin (above)
Value Value Value
Fixed costs
Cost of goods sold
Value Value Value
Selling and administrative
Value Value Value
Total fixed expenses
? ? ?
Income (loss) from operations
? ? ?
(b) (2) Prepare an incremental analysis concerning the possible discontinuance of Division II.
Net Income
Increase
Continue Eliminate (Decrease)
Contribution margin (above)
Value Value Value
Fixed costs
Cost of goods sold
Value Value Value
Selling and administrative
Value Value Value
Division
Division I
Division II
Total fixed expenses
? ? ?
Income (loss) from operations
? ? ?
What course of action do you recommend for each division?
(c) Prepare a columnar condensed income statement for Brislin Company, assuming Division II
is eliminated. (Use the CVP format.) Division II’s unavoidable fixed costs are allocated equally
to the continuing divisions.
IIII IV Total
Sales
Value Value Value ?
Variable costs
Cost of goods sold
Value Value Value ?
Selling and administrative
Value Value Value ?
Total variable costs
? ? ? ?
Contribution margin
? ? ? ?
Fixed costs
Cost of goods sold
Value Value Value ?
Selling and administrative
Value Value Value ?
Total fixed costs
? ? ? ?
Income (loss) from operations
? ? ? ?
(d) Reconcile the total income from operations ($213,000) with the total income from operations
without Division II.
After you have completed P26-4A, consider the following additional question.
1. Assume that Division II’s cost of goods sold and selling and administrative expenses changed to $180,000
and $75,000 respectively. How do these changes impact the decision to drop or not drop Division II?
Divisions
BRISLIN COMPANY
CVP Income Statement
For the Quarter Ended March 31, 2017
Response:
Response:
P26-4A Solution
(a) Compute the contribution margin for Division I and II.
Division I Division II
Sales $250,000 $200,000
Variable costs
Cost of goods sold
140,000 172,800
(b) (1) Prepare an incremental analysis concerning the possible discontinuance of Division I
Net Income
Increase
Continue Eliminate (Decrease)
Contribution margin (above)
$80,000 $0 ($80,000)
Fixed costs
Cost of goods sold
$60,000 $30,000 $30,000
(b) (2) Prepare an incremental analysis concerning the possible discontinuance of Division II.
Net Income
Increase
Continue Eliminate (Decrease)
Contribution margin (above)
($8,800) $0 $8,800
Fixed costs
What course of action do you recommend for each division?
(c) Prepare a columnar condensed income statement for Brislin Company, assuming Division II
is eliminated. (Use the CVP format.) Division II’s unavoidable fixed costs are allocated equally
to the continuing divisions.
IIII IV Total
Sales
$250,000 $500,000 $450,000 $1,200,000
140,000 240,000 187,500 567,500
Divisions
Division I
Division II
BRISLIN COMPANY
CVP Income Statement
For the Quarter Ended March 31, 2017
Division I should be continued because it is producing positive contribution margin of $80,000.