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4
Fundamentals of Cost Analysis for Decision
Making
Solutions to Review Questions
4-1.
4-2.
4-3.
Strictly speaking, sunk costs can never be differential costs. However, sunk costs can
4-4.
Short-run decisions affect operations within one year (for example, the decision to
4-5.
The full cost of a product is the sum of all fixed and variable costs of manufacturing and
4-6.
4-7.
4-8.
The product life cycle covers the time from initial research and development to the time
4-9.
4-10.
Target cost is the target price minus some desired profit margin. Target price is a price
set by management based on customers’ perceived value for the product and the price
competitors charge. There are four steps to developing target prices and target costs:
1. Develop a product that satisfies the needs of potential customers.
4-11.
Predatory pricing is the practice of a setting a selling price at a low price with the intent
of driving competitors out of the market or of creating a barrier to entry for new
competitors.
4-12.
Dumping is the practice of exporting products to consumers in another country at an
4-13.
Price discrimination is the practice of selling identical goods or services to different
4-14.
Unit gross margins are typically computed with an allocation of fixed costs. Total fixed
costs generally will not change with a change in volume within the relevant range.
4-15.
4-16.
Production constraints mean that managers have to consider the opportunity cost of
4-17.
Common nonfinancial considerations that are important in deciding to drop a product
4-18.
The theory of constraints focuses on these three factors:
Solutions to Critical Analysis and Discussion Questions
4-19.
4-20.
4-21.
Although the variable cost of a passenger is very low, airlines do not usually price
4-22.
4-23.
4-24.
There is a danger that in making pricing decisions, especially in the short term,
4-25.
Variable costs are usually relevant when talking about changes in production volumes.
4-26.
In the short run, sales revenues need only cover the differential costs of production and
4-27.
This is a difficult and complex issue, so the purpose of this question is to stimulate
discussion and have students think about the complexities of using incremental costs as
a basis for decision making.
4-28.
Most likely most and maybe all of the opportunity costs identified are not included in the
accounting records. Although they are important in the decision, they are difficult to
4-29.
The differential costs include:
• Fuel
4-30.
The differential costs include:
• Cost of the car
• Forgone interest income on funds paid for the car
4-31.
This approach will maximize profits only if there are no constraints on production or
4-32.
Fixed costs are relevant anytime they change with the product-mix decision. For
4-33.
4-34.
Profits can be increased by decreasing investments, increasing throughput, and
Solutions to Exercises
4-35. (25 min.) Special Orders: Maria’s Food Service.
a.
Status Quo
3,000 Units
Alternative
3,300 Units
Difference
Sales revenue .......
$ 18,000
$19,050
$1,050
(higher)
Variable costs:
a Variable costs per meal = ($13,500 – $4,500) ÷ 3,000 units
4-36. (25 min.) Special Orders: Alpine Luggage.
Alpine should accept the offer; profit is higher by $80,000.
a.
(All revenues and costs in $000)
Status Quo
80,000 Units
Alternative
85,000 Units
Difference
Sales revenue .......................
$ 12,800
$13,300
$500
(higher)
Variable costs:
4-37. (30 min.) Pricing Decisions: MTA Sandwiches.
a.
Status Quo
6,000 units
Alternative
6,400 units
Difference
Sales revenue ...............
$43,200a
$45,360b
$2,160
(higher)
Less variable costs:
Materials....................
16,200
17,280
1,080
(higher)
4-38. (30 min.) Pricing Decisions: Rutkey Collectibles.
a.
Status Quo
20,000 Cars
Alternative
23,000 Cars
Difference
Sales revenue ...............
$800,000a
$884,000b
$84,000
(higher)
Less variable costs:
c. An important factor to consider would be the effect on the regular business once
4-39. (30 min.) Special Order: Andreasen Corporation.
(All Costs in Thousands of Dollars)
a.
Status Quo
100,000 Units
Alternative
107,500 Units
Difference
Sales revenue ...............
$10,000a
$10,450b
$450
(higher)
Less variable costs:
Materials....................
3,600
3,885c
285
(higher)
Operating profits would be higher with the additional order by $10,000.
4-40. (30 min.) Special Order: Fairmont Travel Gear.
(All Costs in Thousands of Dollars)
a.
Status Quo
45,000 Units
Alternative
48,000 Units
Difference
Sales revenue ...............
$4,050.0a
$4,239.0b
$189
(higher)
Less variable costs:
Materials....................
1,215.0
1,314.0c
99.0
(higher)
c. This question can be answered using the break-even analysis of Chapter 3. The
4-41. (10 min.) Target Costing and Pricing: Sid’s Skins.
Profit
=
(Price – Costs)
=
20% Costs
4-42. (10 min.) Target Costing and Pricing: Domingo Corporation.
Profit
=
(Price – Costs)
=
25% Costs
4-43. (20 min.) Target Costing and Purchasing : Mira Mesa Appliances.
$126.
The target cost for Mira Mesa is calculated as follows:
Profit
=
(Price – Costs)
=
30% Price
4-44. (20 min.) Target Costing: Kearney, Inc.
0.5 hours.
The target cost for Kearney is calculated as follows:
Profit
=
(Price – Costs)
=
20% Costs
4-45. (20 min.) Make-or-Buy Decisions: Mobility Partners.
The $20,000 savings could not be achieved. The cost to make is only $16,000 more
than the cost to purchase from Trailblazers.
Status Quoa
Alternative
Difference
Trailblazers’ offer ................
$ –0–
$440,000
$440,000
(higher)
Materials ...........................
100,000
100,000
(lower)
Alternative presentation.
Differential costs to make:
Direct materials ...................
$ 50
4-46. (15 min.) Make or Buy Decisions: Mel’s Meals 2 Go.
Mel could save $0.10 per cookie ($0.20 per lunch) by making the cookies rather than
buying them.
Status Quo
(Buy)
Alternative
(Make)
Difference
(Buy–Make)
Cost to buy ...............
$0.60
$ 0
$0.60
(higher)
4-47. (10 min.) Make or Buy with Opportunity Costs: Mel’s Meals 2 Go.
In this case, he should continue to buy the cookies. The cost of making 20,000 cookies
4-48. (30 min.) Dropping Product Lines: Cotrone Beverages.
Status Quo
Alternative:
Drop
Strawberry
Difference
(all lower under
the alternative)
Revenue .....................
$253,200
$167,600
$85,600
4-49. (30 min.) Dropping Product Lines: Freeflight Airlines.
Status Quo
Alternative:
Drop
U.S. to Europe
Difference
(all lower under
the alternative)
Revenue .....................
$ 8.80
$6.00
$2.80
4-50. (30 min.) Theory of Constraints: CompDesk, Inc.
b. No. Operating profit would decrease by $11,250 (as shown below).
Differential revenues ($300 150 units) ............
$45,000
Differential costs:
4-51. (30 min.) Theory of Constraints: Playful Pens, Inc.
Solutions to Problems
4-52. (60 min.) Special Order: Unter Components.
a.
Direct labor hours per unit:
Model
Labor
cost per
unit
÷
Wage rate
per
labor-hour
=
Labor-hours per unit
Star100
$60
÷
$40
=
1.5 hours
b. Total hours required for the additional business: 3,500 x 1.5 hours + 3,500 x 2.0
hours = 12,250 hours. The total production time required now is 10,000 hours (for
4-52. (continued)
Star100
Star150
Revenue per unit ..................................
$580
$780
Variable cost per unit ............................
220
270
Star100.
The total contribution margin with the special order:
Star100
Star150
Total
Special order
Contribution margin per unit
(Price – Variable cost)
$180a
$230a
Number of units
3,500
3,500
4-52. (continued)
c.
The total contribution margin with the special order:
Star100
Star150
Total
Special order
Contribution margin per unit*
$180
$230
4-53. (30 min.) Special Orders: Sherene Nili
a. Based on profit, Ms. Nili should accept the special order. Accepting the special
order means Ms. Nili will only be able to produce 10 standard dresses. Each
Without
Special
Order
With
Special
Order
Impact
Revenuea .............................
$ 80,000
$ 89,000
$ 9,000
increase
Materialsb .............................
18,000
20,000
2,000
increase
Heat and light .......................
1,600
1,600
0
Other production costs .........
2,800
2,800
0
Marketing and administration
7,700
7,700
0
Operating profit ....................
$ 13,000
$ 14,510
$ 1,510
increase*
4-53. (continued)
c. Ms. Nili should consider whether there will be customers who planned to order a
4-54. (30 min.) Pricing Decisions: CSU EE
a.
One
Four
Eight
Seminar
Seminars
Seminars
Number of participants ................................................
20
80
140
Setup costs .................................................................
$ 900
$ 900
$ 900
Materials cost (@ $150 per participant) .......................
3,000
12,000
21,000
b.
One
Four
Eight
Seminar
Seminars
Seminars
Differential costs:
Setup costs .................................................................
$ 900
$ 900
$ 900
c. Disagree. The contribution to profit is greatest for eight seminars.
One
Four
Eight
Seminar
Seminars
Seminars
Bid (from requirement a, above, @90% for
eight seminars) .............................................................
$ 8,460
$ 31,860
$ 48,600
4-55. Pricing Decisions: M. Anthony, LLP.
Variable cost per song = $20,000 (= $17,000 + $3,000)
Profit
=
(P – V)X – F
b. Profit will be $40,000 higher if the price is $90,000 per song:
Price per song
$80,000
$90,000
Revenue .......................
$4,800,000
$4,680,000
c. Profit will be $150,000 more if M. Anthony accepts the order. The contribution
margin per song for the school’s songs will be $25,000 (= $40,000 – $15,000):
4-55 (continued)
d. The lowest price on the school’s songs that M. Anthony can accept without reducing
4-56. (120 min.) Comprehensive Differential Costing Problem: Davis Kitchen
Supply.
This problem gives students a good understanding of the fixed/variable cost
dichotomy. It is worthwhile to emphasize to students that fixed costs may be
“unitized” (i.e., allocated to individual units of product) for certain purposes, and that
a. Recommendation: Lowering prices reduces operating profit. Other factors, such as
the reduction of available capacity and the impact on market share, could also affect
the decision.
Before Price
Reduction
After
Price
Reduction
Impact
Sales price ...........................
$ 370
$ 325
Quantity ................................
6,000
7,000
4-56. (continued)
b. Recommendation: Don’t accept contract.
Without
Government
Contract
With Government Contract
Impact
Regular
Government
Total
Revenue ................................................
$2,960,000
$2,590,000
$245,000a
$2,835,000
$125,000
decrease
Variable manufacturing costs ................
1,200,000
1,050,000
150,000
1,200,000
–0–
4-56. (continued)
c. Minimum price = variable mfg. costs + shipping costs + order costs =
Some students solve for this price using the break-even formula:
X = 2,000 units = F/(P – V)
2000 units = $4,000/(P – $190)
d. The manufacturing costs are sunk; therefore, any price in excess of the differential
4-56. (continued)
e. No, the $215 proposed purchase price is not acceptable.
All Production In-house
2,000 Units Contracted
Total revenue .....................................................
$2,220,000
$2,220,000
Total variable manufacturing costs ..................... ……………
900,000
1,030,000
a
The $215 proposed purchase price is not acceptable; it would decrease income by
$12,000.
A shorter approach follows:
Variable manufacturing cost saved ............................
$150
per unit
4-56. (continued)
f.
6,000 Regular
Stoves Produced
Contract 2,000 Regular Stoves;
Produce 1,600 Modified Stoves and 4,000 Regular Stoves
In-house
Regular (In)
Regular (Out)
Modified
Total
Revenue .....................................
$2,220,000
$1,480,000
$740,000
$720,000
$2,940,000a
Variable manufacturing costs .....
900,000
600,000
430,000
440,000
1,470,000b
Now the proposal should be accepted at a price of $215. The use of freed-up facilities makes the deal with the subcontractor
more valuable. Compared to part e, Davis no longer saves any fixed manufacturing cost by subcontracting because the
4-57. (60 min.) Make or Buy: King City Specialty Bikes (KCSB).
a. The in-house unit cost that should be used to evaluate the quotation received from the
outside contractor is $192. Therefore the proposal for $140 from the outside contractor
should be accepted.
Without contract:
Per unit
Number of
Bicycles
Total costs
Variable costs
The unit variable costs incurred by KCSB for the bikes assembled by the supplier are
$144 (= $240 x [1 – 40%]) manufacturing costs and $24 (= $60 x [1 – 60%])
nonmanufacturing costs, for a total of $168 (= $144 + $24) per bicycle.
With contract (before payment to supplier)
Total costs
For the bikes assembled by KCSB:
4-57. (continued)
b. The additional revenue from the racing bicycles is greater than the additional costs
from using the supplier and assembling the racing bicycles. Therefore the supplier’s
offer should be accepted.
Status Quo
Accept
Supplier’s
Offer and
Assemble 80
Racing
Bicycles
Difference
Revenue:
Costs:
Variable costs
From regular bicyclesc ......................
$ 600,000
$ 494,400
$ (105,600)
Payment to supplierd .........................
0
112,000
112,000
For racing bicycles (manufacturing)e .
0
448,000
448,000
For racing bicycles (marketing)f ........
0
16,000
16,000
Total variable cost ...........................
$ 600,000
$ 1,070,400
$ 470,400
4-58. Decision Whether to Add or Drop: Agnew Manufacturing.
a. The regional market should not be dropped as this market not only covers all the
variable costs and separable fixed costs but also gives net market contribution of
$390,000 toward the common fixed costs.
b. Quarterly income statement (in thousands):
Model
Standard
Model
Superior
Model
DeLuxe
Total
Sales revenue .................................
$3,000
$2,400
$2,400
$7,800
Less variable costs .........................
Manufacturing .............................
1,800
1,680
1,440
4,920
Marketing ....................................
90
48
48
186
4-59. Decision Whether to Add or Drop: O’Neil Enterprises.
a.
Status Quo
Alternative:
Drop
Beef Barley
Difference
(all lower under
the alternative)
Revenue .....................
$126,600
$83,800
$42,800
Less Variable Costs ...
(100,700)
(62,100)
(38,600)
.
b.
Status Quo
Alternative:
Drop
Beef Barley
Difference
(all lower under
the alternative)
Revenue .....................
$126,600
$79,610
a
$46,990
Less Variable Costs ...
(100,700)
(58,995)
b
(41,705)
4-60. (30 min.) Decision Whether to Close a Store: Power Music.
We recommend that Power Music close the store. The cost savings are greater than
the lost margin on the sales. The difference, however, is not large and if there are
other considerations, they might outweigh the estimated increase in profits.
The analysis shows that closing the Fifth Avenue Store results in lost gross margin of
$270,000 (= $1,950,000 in sales less $1,680,000 in cost of goods sold). The cost
savings are $283,500:
Payroll, Direct Labor, and Supervisiona
$153,000
Renta
48,300
4-61. (45 min.) Closing a Plant: Ironwood Corporation.
a.
Ironwood Corporation
Computation of Estimated Profit from Operations
after Expansion of Minnesota Factory
Minnesota factory:
Sales ($280,000 x 150%) ..............................................
$420,000
Fixed costs
b.
Ironwood Corporation
Computation of Estimated Profit from Operations
after Negotiation of Royalty Contract
Estimated operating profit:
Wisconsin factory .....................................................................
$108,000
Minnesota factory .....................................................................
82,000
4-61. (continued)
c.
Ironwood Corporation
Computation of Estimated Profit from Operations
after Shutdown of North Dakota Factory
Estimated operating profit:
4-62. (60 min.) Optimum Product Mix: Austin Enterprises.
a.
Basic
Classic
Formal
Total revenuea ............................................
$600,000
$640,000
$5,700,000
Less variable manufacturing costs:
a Revenue:
b Direct materials:
Basic
$200,000
=
$20 x .5 yards x 20,000 units
e Variable marketing:
4-62. (continued)
b. Contribution margin per constrained resource, labor:
Basic
$4.286
=
($60,000 ÷ 20,000 units) ÷ .7 hours
c. The most profitable combination is to produce up to the demand of Classic with a
4-62. (continued)
d.
Basic
Classic
Total revenuea .................................................
$428,550
$640,000
Less variable manufacturing costs:
Direct materialsb ...........................................
142,850
60,000
a Revenue:
b Direct materials:
c Direct labor:
d Variable overhead:
e Variable marketing:
4-62. (continued)
e. At an increase in the cost of labor from $16 to $19, the contribution margins per
constrained resource of labor (10,000 additional hours) would be as follows:
Contribution margins before labor cost increase:
Basic $3.00 = $60,000 ÷ 20,000 units
The contribution per unit of constrained resource would be as follows:
Basic $1.286 = $.90 ÷ .7 hours
4-63. (20 min.) Optimum Product Mix: Bubble Company.
Bubble should produce only 1/2-litre bottles.
Although the capacity of the machine is missing, it is not necessary to answer the
question. Because the demand for both products is essentially unlimited, the machine
An equivalent approach is to consider the machine depreciation when computing the
contribution margin (it is listed as variable with respect to hours). In the solution above,
we recognize that because we will operate the machine at capacity, the cost is really
fixed. If we treat it as variable, the solution is as follows:
1/2-litre
1 -litre
Selling price ...............................
$ 15.00
$27.00
Variable costs
4-64. (20 min.) Optimum Product Mix – Excel Solver: Slavin Corporation.
a. Slavin should produce 150 units of Alpha and 80 units of Delta. The next two pages
show the setup using Excel Solver and the solution. The problem can be solved
without Excel as follows. First, compute the contribution margins per hour on the
machine for the two products:
Alpha:
($60 ÷ 2.0) = $30.00 per hour
b. As shown in the Excel spreadsheet, production of 150 units of Alpha and 80
4-64. (continued)
(i)Setup of Excel Solver:
4-64. (continued)
(ii) Solution to problem:
4-65. (20 min.) Optimum Product Mix – Excel Solver: Layton Machining
Company.
a. Layton should produce 100,000 Standard units 50,000 Custom units. The next two
pages show the setup using Excel Solver and the solution. The problem can be
solved without Excel as follows. First, compute the contribution margins per hour
on the machine for the two products:
Standard (Grinding machine):
($1.50 ÷ 0.2) = $7.50 per hour
Because Standard has a higher contribution margin per unit of both constraining
resources, Layton should produce up to demand (100,000 units) assuming
machine capacity is available. It requires 20,000 grinding hours to produce 100,000
4-65. (continued)
(i)Setup of Excel Solver:
4-65. (continued)
(ii) Solution to problem:
Solutions to Integrative Cases
4-66. (30 min.) The Effect of Cost Structure on Predatory Pricing: American
Airlines.
a The relation between variable cost and price is important in a predatory pricing case
because there is no rational economic reason for setting price below variable cost (and
4-67. (120 min.) Make versus Buy: Liquid Chemical Company.
NOTE: Working this case requires knowledge of how to calculate discounted cash
flows.
a The four alternatives are:
• Alternative A: It is the “status quo,” i.e., Liquid Chemical Co. will continue making the
containers and performing maintenance.
b. The incremental cash flow analyses were conducted assuming a five-year time
horizon. The detailed cash flow analyses for Alternatives A, B, C, and D as well as
more detailed information on the calculations are shown on pages 183-190 below.
General considerations for the incremental cash flows are provided below.
• All cash flows occur at the end of the year.
• The last day of Year 0 is when the decision on the alternatives is made. It can also be
4-67. (continued)
Alternative A
Alternative B
Alternative C
Alternative D
Make
Containers;
Make
Containers; Buy
Buy Containers;
Perform
Buy Containers;
Buy
c. Although Alternative C seems to be the more attractive, its net present value is not
significantly different from the net present values of Alternatives A and D. This
situation requires a careful examination of facts and assumptions made. A brief
4-67. (continued)
Incremental Cash Flow – Alternative A
Make Containers and Perform Maintenance
Year of Operation
0
1
2
3
4
5
Buy GHL
$(240,000)
Tax savings on purchase (40%)
$96,000
Cash flow on purchase
$(144,000)
Other materials
$(500,000)
$(500,000)
$(500,000)
$(500,000)
$(500,000)
4-67. (continued)
Considerations (Alternative A):
• Under this alternative, GHL consumption is 40 tons per year. At the end of Year 4 the GHL stock is zero, and a
4-67. (continued)
Incremental Cash Flow – Alternative B
Make Containers and Buy Maintenance
Year of Operation
0
1
2
3
4
5
Buy GHL
$(120,000)
Tax savings on purchase (40%)
$48,000
Cash flow on purchase
$(72,000)
Other materials
$(450,000)
$(450,000)
$(450,000)
$(450,000)
$(450,000)
Labor: Supervisor
(50,000)
(50,000)
(50,000)
(50,000)
(50,000)
4-67. (continued)
Considerations (Alternative B):
• Under this alternative, GHL consumption is 36 tons per year (= 40 X 90%). At the end of Year 4 the GHL stock is
16 tons, and a purchase of 20 tons is necessary. At that time, the price will be $6,000 per ton.
4-67 (continued)
Incremental Cash Flow – Alternative C
Buy Containers and Perform Maintenance
Year of Operation
0
1
2
3
4
5
Sell machinery
$200,000
Tax savings on sale (40%)
160,000
Cash flow on sale
$360,000
Sell GHL
$560,000
4-67 (continued)
Considerations (Alternative C):
• Under this alternative, GHL consumption is 4 tons per year (40 X 10%), or 20 tons over five years. Therefore,
Liquid Chemical can sell 140 tons (= 160 – 20) at the end of Year 0 at $4,000 per ton.
4-67 (continued)
Incremental Cash Flow – Alternative D
Buy Containers and Buy Maintenance
Year of Operation
0
1
2
3
4
5
Sell machinery
$200,000
Rent: Warehouse
-
-
-
-
-
Severance pay
$(20,000)
-
-
-
-
-
Pension
(30,000)
(30,000)
(30,000)
(30,000)
(30,000)
Other expenses
-
-
-
-
-
Manager's salary
-
-
-
-
-
Container contract
(1,250,000)
(1,250,000)
(1,250,000)
(1,250,000)
(1,250,000)
4-67 (continued)
Considerations (Alternative D):
• Under this alternative, there is no GHL consumption. Therefore, Liquid Chemical can sell 160 tons at the end of
Year 0 at $4,000 per ton.
