Accounting Chapter 4 Homework The Effect of Cost Structure on Predatory Pricing: American Airlines

4-74. (continued)

(i) Setup of Excel Solver:

4-74. (continued)

(ii) Solution to problem:

4-75. (30 min.) Theory of Constraints: Clarke Corporation.

a. 300,000 units of X-1, 48,000 units of X-2, and 20,000 units of X-3.

Because the machine is a bottleneck, we calculate the contribution margin per hour on

the machine for each of the products:

X-1

X-2

X-3

Price ……………………………………………….

$100

$200

$400

Variable cost …………………………………….

Contribution margin per unit ……………….

$160

Contribution margin per machine hour …

Based on the contribution margins per hour, Clarke should produce all X–1’s (to

maximum demand), then X-3’s, and finally X–2’s.

Production

Capacity Used

(machine-hours)

Capacity Available

(machine-hours)

No production ..

500,000

(Given)

(= 300,000  1.0)

200,000

20,000 X-3 …….

(= 20,000  4.0)

120,000

48,000 X-2 …….

(= 48,000  2.5)

– 0 –

d. 755,000 machine hours. At the maximum demands for each product, the total

machine hours used are:

(300,000  1.0 + 150,000  2.5 + 20,000  4.0) = 755,000.

4-76. (30 min.) Theory of Constraints: Clarke Corporation.

a. $2,960,000.

First, solve for the optimal production schedule as in Problem 4-75. Because the

machine is a bottleneck, we calculate the contribution margin per hour on the machine

for each of the products:

X-1

X-2

X-3

Price ………………………………………………..

$100

$200

$400

Variable cost …………………………………….

50

120

240

Contribution margin per unit ………………..

$50

$80

$160

Machine hours per unit ………………………

1.0

1.6

4.0

Contribution margin per machine hour ….

$50

$40

No production ..

500,000

(Given)

300,000 X-1 …..

300,000

(= 300,000  1.0)

200,000

(= 500,000 – 300,000)

(= 125,000  1.6)

– 0 –

(= 200,000 – 200,000)

OR

Production

Capacity Used

(machine-hours)

Capacity Available

(machine-hours)

No production ..

500,000

(Given)

150,000 X-2 …..

240,000

(= 150,000  1.6)

260,000

(= 500,000 – 240,000)

260,000 X-1 …..

260,000

(= 260,000  1.0)

– 0 –

(= 260,000 – 260,000)

4-76. (continued)

b. $320,000.

Solving for the optimal production schedule as in part a, we have:

X-1

X-2

X-3

Price ……………………………………………….

$100.00

$200.00

$400.00

Variable cost …………………………………….

50.00

120.00

240.00

Contribution margin per unit ……………….

$50.00

$80.00

$160.00

Machine hours per unit ………………………

1.0

2.5

3.5

Contribution margin per machine hour …

$50.00

$32.00

$45.71

Based on the contribution margins per hour, Clarke should produce all X-1’s (to

maximum demand), then X-3’s, and finally X–2’s, if there is capacity available.

Production

Capacity Used

(machine-hours)

Capacity Available

(machine-hours)

No production ..

500,000

(Given)

(= 300,000  1.0)

20,000 X-3 …….

(= 20,000  3.5)

(= 52,000  2.5)

– 0 –

.

4-77. (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

losing money on each unit sold) other than to capture market share from a competitor.

Because pricing below variable cost cannot continue indefinitely, the company will

ultimately have to increase the price.

4-78. (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 218-225 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

considered the first day of Year 1.

• The company has an after-tax cost of capital of 10% per year and uses an income tax

rate of 40% for decisions like this.

4-78. (continued)

Alternative A

Alternative B

Alternative C

Alternative D

Make

Containers;

Perform

Maintenance

Make

Containers; Buy

Maintenance

Buy Containers;

Perform

Maintenance

Buy Containers;

Buy

Maintenance

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 discussion of

some points that should be reevaluated, as well as additional information that should

be taken into account, is presented below.

Administrative Overhead: A proportion of general administrative overhead is allocated

to the container department. Is this cost proportional to the number of employees in the

container department? Apparently the answer is yes, and in this case it is not the best

estimate because it is not considering the real administrative resources consumed by

the container department.

4-78. (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)

Labor: Supervisor

(50,000)

Labor: Workers

(450,000)

Rent: Warehouse

(85,000)

Maintenance

(36,000)

Other expenses

(157,500)

Manager’s salary

(80,000)

Total costs

Tax savings (40%)

Cash flow due to costs

$(815,100)

Tax effects of depreciation

60,000

Tax effect of GHL costs

Total cash flow

$(675,100)

$(959,100)

Discount rate factor (10%)

1.0000

Present value

$(613,727)

$(557,934)

$(507,213)

$(461,102)

$(595,526)

4-78. (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

purchase of 40 tons is necessary. At that time, the price will be $6,000 per ton.

• There is no cash outflow due to GHL consumption from Year 1 to Year 4, just “accounting” expenses because the

product is in stock. Due to these GHL expenses, there is tax savings of $80,000 per year (= 40 tons  $5,000/ton

X 40%) from Year 1 to Year 4.

4-78. (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)

Labor: Supervisor

(50,000)

Labor: Workers

(360,000)

Rent: Warehouse

(85,000)

Maintenance

(36,000)

Other expenses

(92,500)

Manager’s salary

(80,000)

Maintenance contract

Total costs

$(1,528,500)

Tax savings (40%)

611,400

Cash flow due to costs

$(917,100)

Tax effects of depreciation

60,000

Tax effect of GHL costs

Total cash flow

$(785,100)

$(957,100)

Discount rate factor (10%)

Present value

$(713,727)

$(648,843)

$(589,857)

$(536,234)

$(594,284)

4-78. (continued)

Considerations (Alternative B):

• Under this alternative, GHL consumption is 36 tons per year (= 40  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.

• Due to lower GHL consumption, during Year 5 there is still an “accounting” expense of $80,000 (= 16 tons 

$5,000/ton). It will generate tax savings of $32,000 (= $80,000  40%) at Year 5.

4-78. (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

Tax savings on sale (40%)

56,000

Cash flow on sale

$616,000

Other materials

$(50,000)

Labor: Supervisor

(50,000)

Labor: Workers

(90,000)

Rent: Warehouse

(85,000)

Severance pay

$(16,000)

Other expenses

(65,000)

Manager’s salary

Container contract

Total costs

$(16,000)

Tax savings (40%)

636,000

Cash flow due to costs

$(9,600)

Tax effects of depreciation

Tax effect of GHL costs

Total cash flow

$966,400

Discount rate factor (10%)

1.0000

0.9091

0.8264

0.7513

0.6830

0.6209

Present value

$966,400

4-78. (continued)

Considerations (Alternative C):

• Under this alternative, GHL consumption is 4 tons per year (40  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.

Market Price = $560,000; Loss on Sale = $140,000

Book Value = $700,000 ; Tax Savings on Sale = $ 56,000

• Machinery is not necessary for maintenance, and can also be sold at the end of Year 0.

Market Price = $200,000 ; Loss on Sale = $400,000

Book Value = $600,000 ; Tax Savings on Sale = $160,000

4-78. (continued)

Incremental Cash Flow – Alternative D

Buy Containers and Buy Maintenance

Year of Operation

0

1

2

3

4

5

Sell machinery

$200,000

Tax savings on sale

160,000

Cash flow on sale

$360,000

Sell GHL

$640,000

Tax savings on sale (40%)

64,000

Cash flow on sale

$704,000

Other materials

$-

Labor: Supervisor

–

Labor: Workers

–

Rent: Warehouse

–

Severance pay

$(20,000)

–

Pension

(30,000)

Other expenses

–

Manager’s salary

–

Container contract

(1,250,000)

Maintenance contract

$-

(375,000)

Total costs

Tax savings (40%)

662,000

Cash flow due to costs

$(12,000)

Tax effects of depreciation

–

Tax effect of GHL costs

–

Total cash flow

Discount rate factor (10%)

1.0000

0.9091

0.8264

0.7513

0.6830

0.6209

Present value

4-78. (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.

Market Price = $640,000 ; Loss on Sale = $160,000

Book Value = $800,000 ; Tax Savings on Sale = $64,000