Fundamentals of Cost Analysis For Decision Making: Solutions To Review Questions

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4

Fundamentals of Cost Analysis for Decision


Making

Solutions to Review Questions

4-1.
Costs that are ―fixed in the short run‖ are usually not fixed in the long run. In fact few, if
any, costs are fixed over a very long time horizon.

4-2.
A sunk cost has taken place in the past and cannot be changed. A differential cost is
one that will change with a given decision.

4-3.
Strictly speaking, sunk costs can never be differential costs. However, sunk costs can
determine the amounts of certain differential costs. For example, federal income taxes
are based on historical (sunk) costs. The disposal of a fixed asset may result in a tax
based on the difference between the sales proceeds and the undepreciated sunk cost.
Many contracts are based on sunk costs as well. Decisions may have contract
implications that arise with changes in plans.

4-4.
Short-run decisions affect operations within one year (for example, the decision to
accept a special order). Long-run decisions affect operations for greater than one year
(for example, expansion of plant capacity).

4-5.
The full cost of a product is the sum of all fixed and variable costs of manufacturing and
selling a unit. Full cost is not always appropriate for making decisions—especially short-
run decisions. Fixed costs are often irrelevant for short-run decisions (i.e., fixed costs
often remain unchanged from the status quo to the alternative).

4-6.
A special order is an order that will not affect other orders and is not expect to recur.

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Solutions Manual, Chapter 4 129
4-7.
Costs that are differential should be considered for any decision. In the case of special
orders, these are generally the variable costs associated with the additional volume.

4-8.
The product life cycle covers the time from initial research and development to the time
at which support to the customer is withdrawn. Managers estimate revenues and costs
throughout the product’s life cycle to make pricing decisions. Life-cycle costs include not
only the costs of development and production, but also the costs of maintenance and
disposal.

4-9.
Cost-plus pricing is most likely to be used for unique products where no market price
information exists—areas like construction jobs, defense contracts, and custom orders.

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.
2. Choose a target price based on consumers’ perceived value of the product and
competitor’s prices.
3. Derive a target cost by subtracting the desired profit margin from the target price.
4. Perform value engineering to achieve target costs.

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.
Predatory pricing is illegal in many jurisdictions because, although there might be a
short-term benefit to consumers, as competitors are driven out of the market, the firm
practicing predatory pricing is able to act as a monoploly.

4-12.
Dumping is the practice of exporting products to consumers in another country at an
export price below the domestic price. A cost accountant would help determine the cost
of the product and the costs of exporting versus distributing the product domestically.

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130 Fundamentals of Cost Accounting
4-13.
Price discrimination is the practice of selling identical goods or services to different
customers at different prices. A cost accountant would help determine the costs of
providing the product to different customers. Examples of costs that might differ would
be support costs (for example, for software) or distribution costs (for example, for urban
versus rural consumers).

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.
Unitizing the fixed costs results in treating them as though they are variable costs when,
in fact, they are not. Moreover, when multiple products are manufactured, the relative
contribution becomes the criterion for selecting the optimal product mix. Fixed costs
allocations can distort the relative contributions and result in a suboptimal decision.

4-15.
The company should compute the contribution margin of each product per unit of the
constraining resource. It should rank the products from highest to lowest contribution
margin per unit of constraining resource, then produce the products in order of this
value.

4-16.
Production constraints mean that managers have to consider the opportunity cost of
using production resources. Producing one unit of Product A means that less of Product
B can be produced. The lost contribution from selling Product B is an opportunity cost of
producing Product A. The optimal product mix is the one that maximizes the total
contribution margin from all products subject to the constraints.

4-17.
Common nonfinancial considerations that are important in deciding to drop a product
line include the effect on employees that work on that line, the impact on sales of other
products if it is important to be known as a company that can produce the product
dropped, the effect on the community from possible plant closings, and so on.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 131
4-18.
The theory of constraints focuses on these three factors:
1. Throughput contribution: Sales dollars minus direct materials and other variable
costs.
2. Investments: Inventories, equipment, buildings, and other assets used to generate
throughput contribution.
3. Operating costs: All operating costs other than direct materials and other variable
costs.

©The McGraw-Hill Companies, Inc., 2017


132 Fundamentals of Cost Accounting
Solutions to Critical Analysis and Discussion Questions

4-19.
The main differential costs are the rent and the additional commission. Staff salaries
and the other costs of providing mortgages would not be differential.

4-20.
The remaining lease costs are sunk (assuming the company cannot sublet the space),
so they are not relevant to the decision.

4-21.
Although the variable cost of a passenger is very low, airlines do not usually price
literally at variable cost, even at the last minute. One reason is that this would lead all
passengers to try this approach. The accounting system does not record this type of
cost.

4-22.
Because the telephones are obsolete, the new price might reflect the value consumers
place on them. It is unlikely that the low price on obsolete equipment will drive
competitors from the market. This is not predatory pricing.

4-23.
This is price discrimination. The airlines are able to segment customers who are more
sensitive to the schedule or to knowing travel plans in advance.

4-24.
There is a danger that in making pricing decisions, especially in the short term,
managers will attempt to recover the fixed costs in pricing. For decision making, it would
be better to consider the variable and fixed costs separately and not combine them into
one unit cost.

4-25.
Variable costs are usually relevant when talking about changes in production volumes.
However, if the change in production volume extends beyond the ―relevant range,‖
some fixed costs may also be differential. In addition, there are opportunity costs that
may be differential for a certain decision. In some cases there may be no change in
variable costs. For example, if a company were to add a second copier in the office
workroom to expedite copying, the number of copies produced would be unchanged,
but the fixed costs of the equipment would approximately double.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 133
4-26.
In the short run, sales revenues need only cover the differential costs of production and
sale. So, from a short-run perspective, so long as the sale does not affect other output
prices or normal sales volume, a ―below cost‖ sale may result in a net increase in
income so long as the revenues cover the differential costs. However, in the long run all
costs must be covered or management would not reinvest in the same type of assets. If
the company must continually sell below the full cost of production then it will most likely
get out of that particular business when it comes time to replace those facilities.

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.
Assuming the passenger who is upgraded is not replaced by another economy
passenger, the differential costs are the costs of any incremental food and beverage
served in first class. If the passenger is replaced, the differential costs would be the
costs of the beverages and meals in first class, plus the additional fuel required for the
additional passenger and associated baggage.
The opportunity cost includes any revenue lost from a last-minute customer willing to
pay for first class, if the upgraded seat is the last one taken. The opportunity costs of not
upgrading the passenger is the possible lost revenue (profit) to the airline, if the elite
passenger becomes unhappy and shift business to another airline.

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
estimate and the measurement error is so great that accountants do not try to place an
estimate in the accounting records. Note, also, that the airline’s managers are in the
best position to estimate these costs, so any estimate would be subject to management
bias as well.

©The McGraw-Hill Companies, Inc., 2017


134 Fundamentals of Cost Accounting
4-29.
The differential costs include:
 Fuel
 Wear and tear related to miles driven such as tires, mileage-related
maintenance, lube and oil
 Parking and tolls, if any
 Car wash if needed due to the trip
 Risk of casualties that vary with mileage
 Other costs that vary with mileage

4-30.
The differential costs include:
 Cost of the car
 Forgone interest income on funds paid for the car
 Interest on debt on the car
 Insurance
 Maintenance that is time-related
 License and taxes
These costs are different than the costs in 4-29. The costs in 4-29 are those required to
operate the car for an additional few miles. The costs that vary with the number of cars
do not vary with mileage. The costs in 4-30 vary with the number of cars and not with
the miles driven.
Of course, there is the possibility that if you buy a new car you will be asked to drive
your friends around more often than otherwise.

4-31.
This approach will maximize profits only if there are no constraints on production or
sales, or if both products use all scarce resources at an equal rate. Otherwise
management would want to maximize the contribution per unit of scarce resource.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 135
4-32.
Fixed costs are relevant anytime they change with the product-mix decision. For
example, if there are fixed costs that can be eliminated with the elimination of one or
more of the individual products, then those fixed costs might be relevant in a multi-
product setting. They would be relevant if the contribution from production of any one
product was insufficient to cover the fixed costs that could be eliminated.

4-33.
Performance can be improved at the bottleneck by increasing capacity or shifting
resources from non-bottleneck areas to the bottleneck.

4-34.
Profits can be increased by decreasing investments, increasing throughput, and
decreasing operating expenses. Most who subscribe to the theory of constraints focus
on increasing throughput contribution.

©The McGraw-Hill Companies, Inc., 2017


136 Fundamentals of Cost Accounting
Solutions to Exercises

4-35. (25 min.) Special Orders: Maria’s Food Service.


a.
Status Quo Alternative
3,000 Units 3,300 Units Difference
Sales revenue ....... $ 18,000 $19,050 $1,050 (higher)
Variable costs:
Mealsa ............... 9,000 9,900 900 (higher)
Administrativeb .. 1,500 1,500 0
Contribution margin $ 7,500 $7,650 $ 150 (higher)
Fixed costs ............ 5,100 5,100 0
Operating profit ..... $ 2,400 $ 2,550 $ 150 (higher)

a Variable costs per meal = ($13,500 – $4,500) ÷ 3,000 units


= $3.00 per unit.
Alternatively, variable costs per meal:
$4.50  [($13,500 – $4,500) ÷ $13,500] = $3.00 per unit.
$3.00 per unit x 300 = $900 additional cost.

b No additional administrative costs according to the exercise.

Alternative presentation.
Per Unit 300 Meals
Sales revenue .............................................................. $3.50 $1,050
Variable costs:
Meal costs:
$4.50  [($13,500 – $4,500) ÷ $13,500] = 3.00 900
Contribution to operating profit ..................................... $0.50 $150

Accepting this order would increase operating profits by $150.


b. The difference is relatively small, so Maria might want to consider how confident she
is in the estimates. In addition, she should consider whether accepting this order would
lead to regular customers asking for special prices.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 137
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 Alternative
80,000 Units 85,000 Units Difference
Sales revenue ....................... $ 12,800 $13,300 $500 (higher)
Variable costs:
Manufacturing .................... 5,120 5,440 320 (higher)
Selling and administrative .. 2,560 2,660 100 (higher)
Contribution margin ............... $ 5,120 $5,200 $ 80 (higher)
Fixed costsa .......................... 1,920 1,920 0
Operating profit .................... $ 3,200 $ 3,280 $ 80 (higher)

a $1,920,000 = 80,000 units x ($16 fixed manufacturing + $8 fixed selling).

Alternative presentation.
Per Unit 5,000 Units
($000)
Sales revenue .............................................................. $100 $500
Variable costs
Manufacturing costs ........................................ 64 320
Selling and administrative costs ...................... 20 100
Contribution to operating profit ..................................... $16 $80

b. Based on incremental profits, the company should accept the offer. However, it
should consider the impact of accepting the order on its regular customers and the
possibility that the customer with the special order will expect special pricing on future
orders.

©The McGraw-Hill Companies, Inc., 2017


138 Fundamentals of Cost Accounting
4-37. (30 min.) Pricing Decisions: MTA Sandwiches.

a. Status Quo Alternative


6,000 units 6,400 units Difference

Sales revenue ............... $43,200a $45,360b $2,160 (higher)


Less variable costs:
Materials.................... 16,200 17,280 1,080 (higher)
Labor ......................... 5,400 5,760 360 (higher)
Variable overhead ..... 2,700 2,880 180 (higher)
Total variable cost . $24,300 $25,920 $ 1,620 (higher)
Contribution margin ...... $18,900 $19,440 $ 540 (higher)
Less fixed costs ............ 10,800 10,800 0
Operating profit ............. $8,100 $8,640 $ 540 (higher)

Operating profits would be higher with the additional order by $540.


a. $43,200 = 6,000 sandwiches x $7.20 per unit.
b. $45,360 = (6,000 units x $7.20 per units) + (400 units x $5.40 per units).

b. The lowest price the sandwiches could be sold without reducing profits is $4.05 per
sandwich, which would just cover the variable costs of the sandwiches.
c. An important factor to consider would be the effect on the regular business once
other customers learn of the special price. It is also important for the manager to
understand that this customer will expect this price concession in the future and at
that time the company may be operating at capacity.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 139
4-38. (30 min.) Pricing Decisions: Rutkey Collectibles.

a. Status Quo Alternative


20,000 Cars 23,000 Cars Difference

Sales revenue ............... $800,000a $884,000b $84,000 (higher)


Less variable costs:
Materials.................... 240,000 276,000 36,000 (higher)
Labor ......................... 160,000 184,000 24,000 (higher)
Variable overhead ..... 80,000 92,000 12,000 (higher)
Total variable cost . $480,000 $552,000 $72,000 (higher)
Contribution margin ...... $320,000 $332,000 $12,000 (higher)
Less fixed costs ............ 160,000 160,000 0
Operating profit ............. $ 160,000 $172,000 $12,000 (higher)

Operating profits would be higher with the additional order by $12,000.


a$800,000 = 20,000 cars x $40 per car.
b$884,000 = (20,000 cars x $40 per car) + (3,000 cars x $28 per car).

b. The lowest price the cars could be sold without reducing profits is $24 per car, which
would just cover the variable costs of the car.
c. An important factor to consider would be the effect on the regular business once
other customers learn of the special price. It is also important for the manager to
understand that this customer will expect this price concession in the future and at
that time the company may be operating at capacity.

©The McGraw-Hill Companies, Inc., 2017


140 Fundamentals of Cost Accounting
4-39. (30 min.) Special Order: Andreasen Corporation.

(All Costs in Thousands of Dollars)


a. Status Quo Alternative
100,000 Units 107,500 Units Difference

Sales revenue ............... $10,000a $10,450b $450 (higher)


Less variable costs:
Materials.................... 3,600 3,885c 285 (higher)
Labor ......................... 1,400 1,505 105 (higher)
Variable overhead ..... 400 430 30 (higher)
Total variable cost . $5,400 $5,820 $420 (higher)
Contribution margin ...... $4,600 $4,630 $ 30 (higher)
Less fixed costs ............ 1,800 1,820d 20 (higher)
Operating profit ............. $ 2,800 $ 2,810 $ 10 (higher)

Operating profits would be higher with the additional order by $10,000.


a $10,000,000 = 100,000 units x $100.00 per unit.
b $10,450,000 = (100,000 units x $100.00 per unit) + (7,500 units x $60 per unit).
c $3,885,000 = (100,000 units x $36.00 per unit) + (7,500 units x $38 per unit).
d $1,820,000 = $1,800,000 fixed cost + $20,000 one-time rental.

b. Based on incremental profits, Andreasen should accept the order. The difference is
so small, however, that other factors might be more important. For example,
Andreasen would want to ensure that accepting this order would not have an
adverse effect on current business.
c. This question can be answered using the break-even analysis of Chapter 3. The
incremental fixed cost is $20,000 (the one-time rental). The contribution margin for
the additional units is $4 (= $60 − $36 − $14 − $4 − $2) where the $2 is for the
additional material. Therefore the break-even point on the incremental units is:
5,000 (= $20,000 ÷ $4).

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 141
4-40. (30 min.) Special Order: Fairmont Travel Gear.

(All Costs in Thousands of Dollars)


a. Status Quo Alternative
45,000 Units 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)
Labor ......................... 810.0 871.5d 61.5 (higher)
Variable overhead ..... 337.5 362.1e 24.6 (higher)
Total variable cost . $2,362.5 $2,547.6 $185.1 (higher)
Contribution margin ...... $1,687.5 $1,691.4 $ 3.9 (higher)
Less fixed costs ............ 405.0 412.5f 7.5 (higher)
Operating profit ............. $ 1,282.5 $ 1,278.9 $ 3.6 (lower)

Operating profits would be lower with the additional order by $3,600.


a$4,050,000 = 45,000 units x $90.00 per unit.
b$4,239,000 = (45,000 units x $90.00 per unit) + (3,000 units x $63.00 per unit).
c$1,314,000 = (45,000 units x $27.00 per unit) + (3,000 units x $33.00 per unit).
d$871,500 = (45,000 units x $18.00 per unit) + (3,000 units x $20.50 per unit).
e$362,100 = (45,000 units x $7.50 per unit) + (3,000 units x $8.2 per unit).
f$412,500 = $405,000 fixed cost + $7,500 one-time rental.

b. Based on incremental profits, Fairmont should not accept the order. If the customer
might develop a longer-term relationship and pay regular prices, Fairmont might
consider accepting the order.
c. This question can be answered using the break-even analysis of Chapter 3. The
incremental fixed cost is $7,500 (the one-time rental). The contribution margin for the
additional units is $1.30 (= $63.00 − $27.00 − $6.00 − $18.00 − $2.50 − $7.50 −
$0.70). Therefore the break-even point on the incremental units is:
5,769 (= $7,500 ÷ $1.30).

©The McGraw-Hill Companies, Inc., 2017


142 Fundamentals of Cost Accounting
4-41. (10 min.) Target Costing and Pricing: Sid’s Skins.

Profit = (Price – Costs) = 20% Costs


Price
= Highest acceptable costs
1.20
$21.00
= Highest acceptable costs
1.20
$17.50 = Highest acceptable costs

The highest acceptable manufacturing cost for which Sid would be willing to produce the
covers is $17.50.

4-42. (10 min.) Target Costing and Pricing: Domingo Corporation.

Profit = (Price – Costs) = 25% Costs


Price
= Highest acceptable costs
1.25
$149.00
= Highest acceptable costs
1.25
$119.20 = Highest acceptable costs

The highest acceptable manufacturing cost for which Domingo would be willing to
produce the headphones is $119.20.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 143
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

Price x (1.0 – 0.30) = Highest acceptable costs

$260 x 0.70 = Highest acceptable costs

$182 = Highest acceptable costs

The target cost is $182 per unit. Thus, the maximum cost that Mira Mesa can pay for
the material and meet its profit goal is $126 (= $182 total cost − $32 labor cost − $24
overhead cost).

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


Price
= Highest acceptable costs
1.20
$66.00
= Highest acceptable costs
1.20
$55.00 = Highest acceptable costs

The target labor cost is $21 per unit (= $55 total cost − $16 material cost − $18
overhead cost). Given a wage rate of $28 per direct labor hour, the maximum direct
labor time per unit is 0.75 hours (= $21 ÷ $28 per hour).

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144 Fundamentals of Cost Accounting
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)
Labor .................................. 212,000 212,000 (lower)
Variable overhead .............. 64,000 64,000 (lower)
Fixed overhead applied ...... 188,000 b 108,000 b 80,000 (lower)
Total costs................... $564,000 $548,000 $ 16,000 (lower)
aBased on 2,000 units.
b$94  2,000 = $188,000; or $94 x 2,000 units – $80,000 = $108,000.

Alternative presentation.
Differential costs to make:
Direct materials ................... $ 50
Direct labor ......................... 106
Variable overhead ............... 32
Avoidable fixed overhead.... 40 (= $80,000 ÷ 2,000 units)
$228

This is more than the $220 purchase price from Trailblazers.


($228 – $220)  2,000 units = $16,000 lower than the cost to make, which is $4,000 less
than management’s required savings.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 145
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 Alternative Difference
(Buy) (Make) (Buy–Make)
Cost to buy ............... $0.60 $ 0 $0.60 (higher)
Direct material .......... 0 0.20 0.20 (lower)
Direct labor ............... 0 0.15 0.15 (lower)
Variable overhead .... 0 0.15 0.15 (lower)
$0.60 $0.50 $0.10 (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
is $13,000 [= ($0.50  20,000 cookies) + $3,000 lost contribution margin on dinners].
The cost of buying the cookies $12,000 (= $0.60 x 20,000 cookies).

4-48. (30 min.) Dropping Product Lines: Cotrone Beverages.

Alternative: Difference
Status Quo Drop (all lower under
Strawberry the alternative)
Revenue ..................... $253,200 $167,600 $85,600
Less Variable Costs ... (201,400) (124,200) (77,200)
Contribution Margin .... $ 51,800 $ 43,400 $ 8,400
Less Fixed Costs........ (35,600) (28,480) a (7,120)
Operating Profit .......... $ 16,200 $14,920 $ 1,280

a$28,480 = $35,600  .80

Cotrone Beverages should keep the Strawberry line because the loss of its contribution
margin is greater than the reduction in fixed costs.

©The McGraw-Hill Companies, Inc., 2017


146 Fundamentals of Cost Accounting
4-49. (30 min.) Dropping Product Lines: Freeflight Airlines.

Alternative: Difference
Status Quo Drop (all lower under
U.S. to Europe the alternative)
Revenue ..................... $ 8.80 $6.00 $2.80
Less Variable Costs ... (3.90) (2.40) (1.50)
Contribution Margin .... $ 4.90 $ 3.60 $ 1.30
Less Fixed Costs........ (4.40) (3.52) a (0.88)
Operating Profit .......... $ 0.50 $ 0.08 $ 0.42

a$3.52 = $4.40  .80

Freeflight should keep the U.S. to Europe route because the loss of its contribution
margin is greater than the reduction in fixed costs.

4-50. (30 min.) Theory of Constraints: CompDesk, Inc.


a. Yes. The bottleneck is in Building 1, which can only produce 600 desks.
b. No. Operating profit would decrease by $11,250 (as shown below).
Differential revenues ($300  150 units) ............ $45,000
Differential costs:
Fixed .............................................................. (30,000)
Variable ($175  150 units) ............................ (26,250)
Net differential operating profit .......................... $ (11,250)

c. Yes. Operating profit would increase by $2,500 (as shown below).


Differential revenues ($300  150) ..................... $45,000
Differential costs:
Fixed .............................................................. (22,500)
Variable ($125  150) ..................................... (18,750)
Net differential operating profit (loss) ................. $3,750

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 147
4-51. (30 min.) Theory of Constraints: Playful Pens, Inc.
a. Yes. The bottleneck is Machine 2, which can only produce 800,000 holders.
b. Yes. Operating profit would increase by $200,000 (as shown below).
Differential revenues ($10  200,000 units) ....... $2,000,000
Differential costs:
Fixed .............................................................. (800,000)
Variable ($5  200,000 units) ......................... (1,000,000)
Net differential operating profit .......................... $ 200,000

c. Yes. Operating profit would increase by $150,000 (as shown below).


Differential revenues ($10  100,000) .......................................... $1,000,000
Differential costs:
Variable cost increase on current production (0.50 x 800,000) .. (400,000)
Variable cost on new production ($4.50  100,000)................... (450,000)
Net differential operating profit (loss)............................................. $ 150,000

©The McGraw-Hill Companies, Inc., 2017


148 Fundamentals of Cost Accounting
Solutions to Problems

4-52. (60 min.) Special Order: Unter Components.


a.
Direct labor hours per unit:
Labor Wage rate
cost per ÷ per = Labor-hours per unit
Model unit labor-hour
Star100 $60 ÷ $40 = 1.5 hours
Star150 $80 ÷ $40 = 2.0 hours
Total hours required for the additional business: 2,500 x 1.5 hours + 2,500 x 2.0 hours =
8,750 hours. Current production uses 10,000 direct-labor hours and capacity is 20,000
direct-labor hours, so capacity will not have to be expanded to accept the order.
Additional profit (contribution margin):
Differential revenues:
Star100................. 2,500 x $400 = $1,000,000
Star150................. 2,500 x $500 = 1,250,000 $2,250,000
Differential costs
Star100................. 2,500 x $220* = 550,000
Star150................. 2,500 x $270* = 675,000 1,225,000
Differential profit ........ $1,025,000
* Total variable cost per unit.

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
the normal business) plus 12,250 hours for the special order. Because capacity,
which is limited to 20,000 hours, cannot be expanded to accept the order, the
company will have to reduce production of the units sold to its regular customers.
(See statement in requirement b that management will reduce sales to regular
customers, so the company can fill the special order.)
There are two alternatives. The company can reduce the number of Star100
machines sold or the number of Star150 machines sold. Because direct labor time is
the constraining resource, the company needs to compute the contribution margin
per direct-labor hour for each product:

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 149
4-52. (continued)

Star100 Star150
Revenue per unit .................................. $580 $780
Variable cost per unit............................ 220 270
Contribution margin per unit ................. $360 $510
Divide by Direct-labor hours per unit .. 1.5 2.0
Contribution margin per hour ................ $240 $255

Because the Star100 has the lower contribution margin per hour, the company
should reduce the production of this product to sell the special order.
After producing the special order, the company will have 7,750 direct labor hours
remaining (20,000 – 12,250). It will use these to first produce the 2,000 units of the
Star150 (4,000 = 2,000 x 2.0 direct labor hours). The company will then use the
remaining 3,750 direct labor hours (7,750 – 4,000) to make 2,500 units of the
Star100.
The total contribution margin with the special order:

Star100 Star150 Total


Special order
Contribution margin per unit
a a
(Price – Variable cost) $180 $230
Number of units 3,500 3,500
Total contribution margin $630,000 $805,000 $1,435,000
Regular production:
Contribution margin per unit $360 $510
Number of units 2,500 2,000
$900,000 $1,020,000 1,920,000
$3,355,000

a. $180 = $400 – $220; $230 = $500 –$270.


The total contribution margin without the special order:

Star100 Star150 Total


Regular production:
Contribution margin per unit $360 $510
Number of units 4,000 2,000
$1,440,000 $1,020,000 $2,460,000

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150 Fundamentals of Cost Accounting
4-52. (continued)
The difference in profit is $3,355,000 - $2,460,000 = $895,000.
The company is better off accepting the special order. (Of course, the company
would earn even more profit if it could first produce for the regular customers and
use any excess capacity to fill part, but not all, of the special order.)
c.
The total contribution margin with the special order:
Star100 Star150 Total
Special order
Contribution margin per unit* $180 $230
Number of units 3,500 3,500
Total contribution margin $630,000 $805,000 $1,435,000
Regular production:
Contribution margin per unit* $360 $510
Number of units 4,000 2,000
$1,440,000 $1,020,000 2,460,000
$3,895,000
Additional direct-labor costs [(22,250 hours – 20,000 hours) x $20] 45,000
Additional variable overhead (2,250 hours x $10 per hour) 22,500
$3,827,500
*Excluding the overtime premium.
The difference in profit is $3,827,500 – $2,460,000 = $1,367,500.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 151
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
standard dress requires 15 (= 300 hours ÷ 20 dresses) hours of machine time per
dress. Because she is committed to the custom dresses (whether more profitable or
not), she must cut back the number of standard dresses by 10. The rent, heat and
light, and other production costs are fixed and will not be affected by this decision.

Without With
Special Special
Order Order Impact
Revenuea ............................. $ 80,000 $ 89,000 $ 9,000 increase
Materialsb ............................. 18,000 20,000 2,000 increase
Laborc .................................. 29,000 34,500 5,500 increase
Machine depreciationd ......... 900 890 10 decrease
Contribution margin… ....... $ 32,100 $ 33,610 $ 1,510 increase*
Rent ..................................... 7,000 7,000 0
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*

* Note the equality.


a Additional revenues with the special order = $24,000 – [10 standard dresses x
($30,000 ÷ 20 dresses)].
b Additional materials with the special order = $6,000 – [10 standard dresses x ($8,000
÷ 20 dresses)].
c Additional labor with the special order = $10,000 – [10 standard dresses x ($9,000 ÷
20 dresses)].
d Reduced machine depreciation with the special order = $140 – $150. (Note the
machine depreciation rate is $1 per hour.)
Alternative solution using differential analysis:
Additional revenue ........................... $9,000 = $24,000 –10 x ($30,000 ÷ 20)
Additional materials .......................... 2,000 = $6,000 – 10 x ($8,000 ÷ 20)
Additional labor ................................ 5,500 = $10,000 – 10 x ($9,000 ÷ 20)
(10) = $140 – $150
Reduced machine depreciation ..........................
Additional contribution margin… ........................
$ 1,510

©The McGraw-Hill Companies, Inc., 2017


152 Fundamentals of Cost Accounting
4-53. (continued)
b. The minumum price that would still provide a (zero) incremental profit is $24,000 −
$1,510 = $22,490. The $1,510 is the additional contribution margin from the special
order as found in requirement (a).
c. Ms. Nili should consider whether there will be customers who planned to order a
standard dress and will now order from a competitor. Although the price of the special
order offsets any lost contribution margin from the standard dresses, these customers
might have been repeat customers who will now buy in the future from her competitors.
She might also consider whether the wedding consultant will provide her more custom
orders (or referrals) if she does this special order.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 153
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 (@ $150 per participant) ...................... 3,000 12,000 21,000
Differential labor costs ................................................. 1,800 7,800 13,200
Allocated fixed costs (@75% of direct labor
costs) ........................................................................... 1,350 5,850 9,900
Total costs ...............................................................$ 7,050 $26,550 $45,000
Fee (@20% of total costs) ........................................... 1,410 5,310 9,000
Bid (Total cost plus Fee) ..............................................$ 8,460 $31,860 $54,000

b. One Four Eight


Seminar Seminars Seminars
Differential costs:
Setup costs .................................................................
$ 900 $ 900 $ 900
Materials cost (@ $150 per participant) ...................... 3,000 12,000 21,000
Differential labor costs ................................................. 1,800 7,800 13,200
Allocated fixed costs..................................................... 0 0 0
Total differential costs .............................................$ 5,700 $20,700 $35,100
Differential bid ............................................................. 8,460 31,860 54,000
Contribution to profit .....................................................$ 2,760 $11,160 $18.900

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
Incremental costs:
Setup costs ................................................................. 900 900 900
Materials cost (@ $150 per participant) ...................... 3,000 12,000 21,000
Differential labor costs ................................................. 1,800 7,800 13,200
Total incremental costs ...........................................$ 5,700 $20,700 $35,100

Contribution to profit .....................................................$ 2,760 $ 11,160 $13,500

©The McGraw-Hill Companies, Inc., 2017


154 Fundamentals of Cost Accounting
4-55. Pricing Decisions: M. Anthony, LLP.
a. Total fixed costs = $2,760,000 [= 60 songs x ($21,000 fixed overhead + $25,000
fixed marketing and administrative)]
Variable cost per song = $20,000 (= $17,000 + $3,000)
Profit = (P – V)X – F
$0 = ($80,000 – $20,000)X – $2,760,000
$60,000X = $2,760,000

$2,760,000
X=
$60,000
X= 46 songs

b. Profit will be $40,000 higher if the price is $90,000 per song:


Price per song
$80,000 $90,000
Number of songs .......... 60 52

Revenue ....................... $4,800,000 $4,680,000


Variable cost ................ 1,200,000 1,040,000
Contribution margin ...... $3,600,000 $3,640,000
Fixed cost ..................... 2,760,000 2,760,000
Profit ............................. $840,000 $880,000

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):
Contribution without the special order = $3,600,000 (= $60,000 x 60 songs).
Contribution with the special order = $3,750,000 (= $60,000 x 50 songs
+ $25,000 x 30 songs).

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 155
4-55 (continued)
d. The lowest price on the school’s songs that M. Anthony can accept without reducing
profit is $35,000 per song.
To produce the school’s songs, M. Anthony has to forgo the contribution margin on
10 songs, which is equal to $600,000 (= $60,000 per song x 10 songs). Thus the
price = variable cost + forgone contribution margin = $15,000 + ($600,000 ÷ 30) =
$35,000.

©The McGraw-Hill Companies, Inc., 2017


156 Fundamentals of Cost Accounting
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
this allocation procedure may make such costs appear to be variable. Indeed, many
students treat the $60 per unit fixed manufacturing overhead and $70 per unit fixed
marketing costs as though they were variable costs, despite the fact that they are
clearly labeled ―fixed.‖
This problem can be used to introduce the concept of opportunity cost. Question b
can be used in this way, as can Question d if you postulate a scrap value for the
obsolete stoves.

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 After


Reduction Price
Reduction Impact
Sales price ........................... $ 370 $ 325
Quantity ................................ 6,000 7,000

Revenue ............................... $2,220,000 $2,275,000 $ 55,000 increase


Variable manufacturing costsa ...........................
900,000 1,050,000 150,000 increase
Variable marketing costs ...... 150,000 175,000 25,000 increase
Contribution margin… ....... 1,170,000 1,050,000 $120,000 decrease*
Fixed manufacturing costs ... 360,000 360,000 0
Fixed marketing costs .......... 420,000 420,000 0
Income ................................. $ 390,000 $ 270,000 $120,000 decrease*

* Note the equality.


a Variable manufacturing costs per unit = $50 + $75 + $ 25 = $150.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 157
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 $245,000 a $2,835,000 $125,000 decrease
Variable manufacturing costs ................ 1,200,000 1,050,000 150,000 1,200,000 –0–
Variable marketing costs ....................... 200,000 175,000 — 175,000 25,000 decrease
Contribution margin ............................... 1,560,000 $1,365,000 $95,000 1,460,000 100,000 decrease
Fixed manufacturing costs .................... 360,000 360,000 –0–
Fixed marketing costs ........................... 420,000 420,000 –0–
Income .................................................. $780,000 $680,000 $100,000 decrease
a Government revenue is 1,000 x $150 + ($360,000 x 12.5%) + $50,000 = $245,000, assuming the government’s ―share‖ of
March fixed manufacturing costs is 12.5% (= 1,000 units  8,000 units). Alternatives are for the company to get
reimbursement for 1/6 x $360,000 fixed manufacturing costs (1/6 = 1,000 units ÷ 6,000 units normal production), which
would increase revenue from $245,000 to $260,000; or get no reimbursement for fixed manufacturing costs, which would
reduce revenue to $200,000.

©The McGraw-Hill Companies, Inc., 2017


158 Fundamentals of Cost Accounting
4-56. (continued)

A shorter approach to Requirement b (but more difficult for some students to


understand) is this:
Forgone contribution (equals forgone income)
on regular sales if government contract is
accepted ............................................................1,000 x $195 = $(195,000) lost
Profit from government contract:
Fixed fee ........................................................ 50,000 gained
Share of fixed mfg. costs ($360,000 ÷ 8) ....... 45,000 gained
Gain ................................................................... 95,000 gained
Differential profit if contract accepted................. ……………… $(100,000)

c. Minimum price = variable mfg. costs + shipping costs + order costs =


$150 + $40 + ($4,000 ÷ 2,000) = $192.
At this price per unit, the $384,000 of differential costs caused by the 2,000 unit order
will just be recovered.
Some students solve for this price using the break-even formula:
X = 2,000 units = F/(P – V)
2000 units = $4,000/(P – $190)
2,000 P – 2,000 x $190 = $4,000
2,000 P = $384,000
P = $384,000 ÷ 2,000 units
P = $192.
d. The manufacturing costs are sunk; therefore, any price in excess of the differential
costs of selling the stoves will add to income. In this case, those differential costs are
apparently the $25 per unit variable marketing costs, since the stoves are to be sold
through regular channels; thus, the minimum price is $25. (If the instructor wishes to
reinforce the concept of opportunity cost, the most general answer to this question is
that the price should exceed the sum of 1) the differential marketing costs and 2) the
potential scrap proceeds, which are an opportunity cost of selling the stoves rather
than scrapping them.)

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 159
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
Total variable marketing costs ............................ …………………… 140,000 b
150,000
Total contribution margin ....................................
$1,170,000…………………………
$1,050,000
Total fixed manufacturing costs .......................... …………………
360,000 252,000 c
Total fixed marketing costs ................................. ……………………… 420,000
420,000
Income ........................................................
$ 390,000 $ 378,000
a$1,030,000 = (4,000 units  $150 per unit) + (2,000 units x $215 per unit).
b$140,000 = (4,000 units  $25 per unit) + (2,000 units  .8  $25 per unit).
c$252,000 = $360,000 – (.3  $360,000)

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
Variable marketing saved ($25 – $20) ....................... 5 per unit
Fixed manufacturing cost saved ................................. 54a per unit
In-house cost savings ................................................. $209 per unit
a$54 = ($360,000 – $252,000)  2,000 units.

The in-house cost savings of $209 per unit is less than the payment to the subcontractor
of $215 per unit. The subcontractor’s proposed price is not acceptable. The $209 is the
most that Davis should pay to the subcontractor.

©The McGraw-Hill Companies, Inc., 2017


160 Fundamentals of Cost Accounting
4-56. (continued)
f.
6,000 Regular Contract 2,000 Regular Stoves;
Stoves Produced 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
Variable marketing costs ............ 150,000 100,000 40,000 80,000 220,000c
Contribution margin ................. 1,170,000 $ 780,000 $270,000 $200,000 1,250,000
Fixed manufacturing costs .......... 360,000 360,000
Fixed marketing costs ................. 420,000 420,000
Income ................................. $ 390,000 $ 470,000

a $2,940,000 = 4,000 x $370 + 2,000 x $370 + 1,600 x $450.


b $1,470,000 = (4,000 x $150) + (2,000 x $215) +(1,600 x $275).
c $220,000 = 4,000 x $25 + 2,000 x $25 x 80% + 1,600 x $50.

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
company will need the plant to operate at its normal level (i.e., the level of 6,000 regular stoves produced). The benefit per
unit of subcontracting, in this case, is:

Variable manufacturing cost saved .................................................................. $150 per unit


Variable marketing saved ($25 – $20) ............................................................. 5 per unit
Contribution from freed-up capacity ($200,000 ÷ 2,000 regular stoves) .......... 100 per unit
In-house cost savings....................................................................................... $255 per unit
Davis would be willing to pay up to $255 per unit to the subcontractor.

©The McGraw-Hill Companies, Inc., 2017


Solutions Manual, Chapter 4 161
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:
Number of
Per unit Bicycles Total costs
Variable costs
Manufacturing ............................... $ 240 2,000 $ 480,000
Non-manufacturing ....................... 60 2,000 120,000
Total variable costs ........................ $ 300 $ 600,000
Fixed costs
Manufacturing ............................... 120 2,000 240,000
Nonmanufacturing ........................ 140 2,000 280,000
Total fixed costs .............................. $ 520,000
Total cost $ 1,120,000

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:
Number of
Variable costs: Per unit Bicycles
For the bikes assembled by KCSB .......... $ 300 1,200 $ 360,000
For the bikes not assembled by KCSB .... 168 800 134,400
Total variable costs ................................. $ 494,400
Fixed costs
Manufacturing [@80% = (1 – 20%)] ....... 192,000
Nonmanufacturing (unchanged) ............ 280,000
Total fixed costs ....................................... $ 472,000
Total cost ................................................. $ 966,400

The in-house unit cost to compare to the supplier’s proposal is $192 (= [$1,120,000 –
$966,400] ÷ 800 bicycles). The company would save $192 per unit while paying only $140
per unit to the outside contractor. What a deal!

©The McGraw-Hill Companies, Inc., 2017


162 Fundamentals of Cost Accounting
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.

Accept
Supplier’s
Offer and
Assemble 80
Racing
Status Quo Bicycles Difference
Revenue:
From regular bicyclesa ...................... $1,200,000 $1,200,000 $ 0
From racing bicyclesb ........................ 0 640,000 640,000
Total revenue ........................................ $1,200,000 $ 1,840,000 $ 640,000

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
Fixed costsg ........................................ 520,000 520,000 0
Total cost............................................... $ 1,120,000 $ 1,590,400 $ 470,400
Profit ...................................................... $80,000 $249,600 $169,600
a $1,200,000 = 2,000 bicycles x $600 per bicycle.
b $640,000 = 80 bicycles x $8,000 per bicycle.
c $600,000 = 2,000 bicycles x $300 per bicycle.
d $112,000 = 800 bicycles x $140 per bicycle.
e $448,000 = 80 bicycles x $5,600 per bicycle.
f $16,000 = 80 bicycles x $200 per bicycle.
g Unchanged from status quo.

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 163
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.

Sales = $1,800
Variable manufacturing costs:
(.6  $600) + (.7  $600) + (.6  $600) = $1,140
Marketing costs = $270
Net market contribution = $390 (= $1,800 – $1,140 – $270)

b. Quarterly income statement (in thousands):


Model Model Model Total
Standard Superior DeLuxe
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
Total variable cost ................... 1,890 1,728 1,488 5,106
Contribution margin 1,110 672 912 2,694
Less fixed costs:
Manufacturing ($6,060 – $4,920) 1,140
Marketing ($630 – $186) ............. 444
Administrative.............................. 312
Total fixed costs....................... 1,896
Operating profit ............................... $ 798

c. The new product must contribute at least $972 (= $912 + $60) per quarter so as not to
leave the company worse off when the DeLuxe model is replaced.

©The McGraw-Hill Companies, Inc., 2017


164 Fundamentals of Cost Accounting
4-59. Decision Whether to Add or Drop: O’Neil Enterprises.
a.
Alternative: Difference
Status Quo Drop (all lower under
Beef Barley the alternative)
Revenue ..................... $126,600 $83,800 $42,800
Less Variable Costs ... (100,700) (62,100) (38,600)
Contribution Margin .... $ 25,900 $ 21,700 $ 4,200
Less Fixed Costs........ (17,800) (13,350) a (4,450)
Operating Profit .......... $ 8,100 $ 8,350 $ 250

a$13,350 = $17,800  .75

Based on the financial information, O’Neil should drop the beef barley line, because the
loss of its contribution margin is less than the reduction in fixed costs.
.
b.
Alternative: Difference
Status Quo Drop (all lower under
Beef Barley the alternative)
Revenue ..................... $126,600 $79,610 a $46,990
Less Variable Costs ... (100,700) (58,995) b (41,705)
Contribution Margin .... $ 25,900 $ 20,615 $ 5,285
Less Fixed Costs........ (17,800) (13,350) (4,450)
Operating Profit .......... $ 8,100 $ 7,265 $ (835)

a. $79,610 = ($32,600 + $51,200) x 0.95


b. $58,995 = ($22,000 + $40,100) x 0.95

Based on the financial information, O’Neil should not drop the beef barley line, because
the loss of its contribution margin is greater than the reduction in fixed costs. This
indicates the importance of considering cross-product demands and the danger of relying
on product-line income statements alone.

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 165
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
State Taxesb 7,500
Insurance on Inventoryb 55,200
Depreciationc 0
Administration and General Officed 6,000
Interest for Inventory Carrying Costsb 13,500
Total Costs $ 283,500

a Saved if the store is closed.


b If the store is closed, there will be no sales and no inventory.
c There is no value to the equipment and the salvage value is zero. Therefore there will be
no savings if the store is closed.
d 10% of these costs could be saved if the store is closed.

©The McGraw-Hill Companies, Inc., 2017


166 Fundamentals of Cost Accounting
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
Factory ($56,000 x 120%) .......................................... $67,200
Administration ($22,000 x 110%) ............................... 24,200
Variable costs [$2  ($420,000 ÷ $5 sales price)] .......... 168,000
Allocated home office costs ............................................ 35,000
Total ............................................................................ 294,400
Estimated operating profit ............................................... $125,600
Wisconsin factory—estimated operating profit ................... 108,000
Less home office costs previously allocated to North
a
Dakota factory ............................................................ (20,000)
Estimated operating profit .................................................. $213,600
a
These costs continue to be incurred by the company even though North Dakota has
been closed.
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
Estimated royalties to be received (30,000  $1)...................... 30,000
$220,000
Less home office costs previously allocated to North Dakota
a
factory .................................................................................. (20,000)
Estimated operating profit ............................................................ $200,000
a
These costs continue to be incurred by the company even though North Dakota has
been closed.

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 167
4-61. (continued)
c.
Ironwood Corporation
Computation of Estimated Profit from Operations
after Shutdown of North Dakota Factory
Estimated operating profit:
Wisconsin factory .................................................................... $108,000
Minnesota factory .................................................................... 82,000
$190,000
Less home office costs previously allocated to North Dakota
a
factory ................................................................................ (20,000)
Estimated operating profit ........................................................... $170,000
a
These costs continue to be incurred by the company even though North Dakota has
been closed.

The best deal for Ironwood is to expand operations of the Minnesota factory.

©The McGraw-Hill Companies, Inc., 2017


168 Fundamentals of Cost Accounting
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:
Direct materialsb..............................
200,000 60,000 360,000
c
Direct labor ....................................
224,000 320,000 3,360,000
d
Variable overhead .........................56,000 80,000 840,000
e
Variable marketing .........................
60,000 64,000 570,000
Total costs ...................................
540,000 524,000 5,130,000
Contribution margin ............................
$ 60,000 $ 116,000 $ 570,000

Total contribution marginf................................... $746,000


Total fixed costsg ............................................... 74,000
Total operating profit .......................................... $672,000
a Revenue:
Basic $ 600,000 = $30 x 20,000 units
Classic $ 640,000 = $64 x 10,000 units
Formal $5,700,000 = $190 x 30,000 units
b Direct materials:
Basic $200,000 = $20 x .5 yards x 20,000 units
Classic $ 60,000 = $20 x .3 yards x 10,000 units
Formal $360,000 = $20 x .6 yards x 30,000 units
c Direct labor:
Basic $ 224,000 = $ 16 x .7 hours x 20,000 units
Classic $ 320,000 = $ 16 x 2 hours x 10,000 units
Formal $3,360,000 = $ 16 x 7 hours x 30,000 units
d Variable overhead:
Basic $ 56,000 = $ 4 x .7 hours x 20,000 units
Classic $ 80,000 = $ 4 x 2 hours x 10,000 units
Formal $840,000 = $ 4 x 7 hours x 30,000 units
e Variable marketing:
Basic $ 60,000 = 10% x $600,000 revenue
Classic $ 64,000 = 10% x $640,000 revenue
Formal $ 570,000 = 10% x $5,700,000 revenue
f Total contribution margin: $746,000 = $60,000 + $116,000 + $570,000
g Total fixed costs: $ 74,000 = $36,000 + $8,000 + $30,000

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 169
4-62. (continued)
b. Contribution margin per constrained resource, labor:

Basic $4.286 = ($60,000 ÷ 20,000 units) ÷ .7 hours


Classic $5.80 = ($116,000 ÷ 10,000 units) ÷ 2 hours
Formal $2.714 = ($570,000 ÷ 30,000 units) ÷ 7 hours
The Classic would be the most profitable product line given the constrained resource,
direct labor.
c. The most profitable combination is to produce up to the demand of Classic with a
contribution of $5.80 per direct labor-hour, and the remaining hours spent on Basic
with a contribution of $4.286.
10,000 Classics x 2 hours per Classic = 20,000 hours
10,000 hoursa ÷ .7 hours per Basic = 14,285 Basics (rounded)
Therefore, Austin should produce 10,000 Classics and 14,285 Basics.
a10,000 hours = 30,000 hours – 20,000 hours.

©The McGraw-Hill Companies, Inc., 2017


170 Fundamentals of Cost Accounting
4-62. (continued)
d.

Basic Classic
Total revenuea .................................................
$428,550 $640,000
Less variable manufacturing costs:
Direct materialsb...........................................
142,850 60,000
c
Direct labor .................................................
159,992 320,000
d
Variable overhead ...................................... 39,998 80,000
e
Variable marketing ...................................... 42,855 64,000
Total costs ................................................
385,695 524,000
Contribution margin .........................................
$ 42,855 $116,000

Total contribution marginf ................................... $158,855


Total fixed costsg................................................ 74,000
Total operating profit .......................................... $ 84,855
a Revenue:
Basic $428,550 = $30 x 14,285 units
Classic $640,000 = $64 x 10,000 units
b Direct materials:
Basic $142,850 = $20 x .5 yards x 14,285 units
Classic $60,000 = $20 x .3 yards x 10,000 units
c Direct labor:
Basic $ 159,992 = $ 16 x .7 hours x 14,285 units
Classic $320,000 = $ 16 x 2 hours x 10,000 units
d Variable overhead:
Basic $39,998 =$4 x .7 hours x 14,285 units
Classic $80,000 =$4 x 2 hours x 10,000 units
e Variable marketing:
Basic $42,855 = 10% x $428,550 revenue
Classic $ 64,000 = 10% x $640,000 revenue
f Total contribution margin: $ 158,855 = $42,855 + $116,000

g Total fixed costs: $ 74,000 = $36,000 + $8,000 + $30,000

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 171
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
Classic $11.60 = $116,000 ÷ 10,000 units
Formal $19.00 = $570,000 ÷ 30,000 units
Additional labor costs would change contribution margins as follows:
Basic $ .90 = $3.00 – (.7 hours x $3 additional labor cost per hour)
Classic: $ 5.60 = $11.60 – (2 hours x $3 additional labor cost per hour)
Formal $(2.00) = $19.00 – (7 hours x $3 additional labor cost per hour)
The contribution per unit of constrained resource would be as follows:
Basic $1.286 = $.90 ÷ .7 hours
Classic $2.80 = $5.60 ÷ 2 hours
Formal $(.286) = $(2.00) ÷ 7 hours
Since Austin would already be producing as many Classics as demand allows, the
additional production would be Basics. Austin could produce an additional 5,715
Basics (20,000 annual demand minus 14,285 already being produced). Austin should
not produce Formals because the contribution from Formals is negative.
The addition to profit would be $5,143.50 (5,715 Basics x $.90).

©The McGraw-Hill Companies, Inc., 2017


172 Fundamentals of Cost Accounting
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
will operate full time. To determine the optimum mix, we need to determine the
contribution margin per hour of machine time for the two products (ignoring the
machine depreciation and the allocated fixed costs).

1/2-litre 1 -litre
Selling price ............................... $ 15.00 $27.00
Variable costs
Materials .................................. 4.00 7.00
Labor ....................................... 1.00 1.00
Total variable cost ..................... $ 5.00 $ 8.00
Contribution margin ................... $ 10.00 $ 19.00
÷ Hours to produce 1 unit .......... ÷1 ÷2
Contribution margin per hour ..... $ 10.00 $9.50

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
Materials .................................. 4.00 7.00
Labor ....................................... 1.00 1.00
Depreciation ............................. 4,00 8.00
Total variable cost ..................... $ 9.00 $16.00
Contribution margin ................... $ 6.00 $11.00
÷ Hours to produce 1 unit .......... ÷1 ÷2
Contribution margin per hour ..... $ 6.00 $5.50

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 173
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


Delta: ($64 ÷ 2.5) = $25.60 per hour

Because Alpha has a higher contribution margin per unit of the constraining
resource, Slavin should produce up to demand (150 units) assuming machine
capacity is available. It requires 300 hours to produce 150 units of Alpha (= 2 hours
per unit x 150 units). This leaves 200 hours (= 500 hours available less 300 hours
for Alpha production) to produce Delta. Each unit of Delta requires 2.5 hours, so
Slavin should use the remaining 200 hours to produce 80 units of Delta (= 200
hours ÷ 2.5 hours per unit).

b. As shown in the Excel spreadsheet, production of 150 units of Alpha and 80


units of Delta leads to profits of $1,120 (= 150 x $60 + 80 x $64 − $13,000). The
current production schedule of 110 units of Alpha and 110 units of Delta yields
profits of $640 (= 110 x $60 + 110 x $64 − $13,000). Therefore, the optimum
production schedules increases profits by $480 (= $1,120 − $640).

©The McGraw-Hill Companies, Inc., 2017


174 Fundamentals of Cost Accounting
4-64. (continued)

(i)Setup of Excel Solver:

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 175
4-64. (continued)

(ii)Solution to problem:

©The McGraw-Hill Companies, Inc., 2017


176 Fundamentals of Cost Accounting
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

Standard (Finishing machine): ($1.50 ÷ 0.1) = $15.00 per hour

Custom (Grinding machine): ($2.00 ÷ 0.3) = $6.67 per hour

Custom (Finishing machine): ($2.00 ÷ 0.4) = $5.00 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
Standard units (= 0.2 hours per unit x 100,000 units) and 10,000 finishing hours (=
0.1 hours per unit x 100,000 units). This leaves 30,000 grinding hours (= 50,000
hours available less 20,000 hours for Standard production) and 20,000 finishing
hours (= 30,000 hours available less 10,000 hours for Standard production) to
produce Custom units. Each Custom unit requires 0.3 hours of grinding machine
time and 0.4 hours of finishing machine time. The company can produce 100,000
Custom units with the grinding machine constraint (= 30,000 ÷ 0.3 hours per unit) or
50,000 units (= 20,000 ÷ 0.4 hours per unit) with the finishing machine. Therefore,
the company can only produce 50,000 Custom units.

b. As shown in the Excel spreadsheet, production of 100,000 Standard units and


50,000 Custom units leads to profits of $137,000 (= 100,000 x $1.50 + 50,000 x
$2.00 − $113,000). The current production schedule of 90,000 Standard units and
50,000 Custom units yields profits of $122,000 (= 90,000 x $1.50 + 50,000 x $2.00
− $113,000). Therefore, the optimum production schedules increases profits by
$15,000 (= $137,000 − $122,000).

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 177
4-65. (continued)

(i)Setup of Excel Solver:

©The McGraw-Hill Companies, Inc., 2017


178 Fundamentals of Cost Accounting
4-65. (continued)

(ii)Solution to problem:

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 179
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
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.
b. Answers will vary. Typically, companies and industries that have low variable costs
compared to fixed costs are in businesses that require large capital investments.
Examples include airlines, utilities, steel, aluminum, railroads, and many high-tech
businesses.
c. Answers will vary. Typically, companies and industries that have high variable costs
compared to fixed costs are in businesses that sell products to consumers. Examples
include auto dealers, grocery stores, clothing stores, and discount stores.

©The McGraw-Hill Companies, Inc., 2017


180 Fundamentals of Cost Accounting
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.
• Alternative B: Liquid Chemical Co. will continue making the containers, but will
outsource the maintenance contracting to Packages, Inc.
• Alternative C: Liquid Chemical Co. will buy containers from Packages, Inc., but will
perform the maintenance.
• Alternative D: It is the completely outsourcing alternative. Packages, Inc. will make
the containers and provide the necessary 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
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.
• Cash flows were not adjusted for inflation.
• 200 tons of GHL were purchased at the beginning of Year 0 (= $1,000,000/$5,000).
40 tons were consumed during Year 0 (expense of $200,000 = 40 tons X $5,000/ton),
leaving 160 tons in stock at the beginning of Year 1.
• Rent on the container department and the proportion of general administrative
overhead allocated to the container department are the same independent of the
alternative. Therefore, they are not considered in the cash flow analyses.
The table below presents the net present values for the four alternatives. Note that all
net present values are negative, so the more attractive alternative for Liquid Chemical
Co. is the one with the smallest negative value, i.e., Alternative C. It means that,
considering our assumptions and the available information regarding costs, Liquid
Chemical Co. should buy containers from Packages, Inc., and keep performing the
maintenance.

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 181
4-67. (continued)

Alternative A Alternative B Alternative C Alternative D


Make Make Buy Containers; Buy Containers;
Containers; Containers; Buy Perform Buy
Perform Maintenance Maintenance Maintenance
Maintenance
NPV ($) $ (2,735,502) $ (3,082,945) $ (2,619,684) $ (2,712,251)

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.
Quality of Outsource Services: Quality issues are always important when a company
is considering outsourcing some services. In this case, it is assumed that Packages,
Inc. will perform maintenance and/or make containers with a quality at least as good as
Liquid Chemical’s quality. Due to the importance of quality, Liquid Chemical Co.
should carefully evaluate Package Inc.’s ability to meet quality requirements imposed
by Liquid Chemical.
Container Contract Terms: Does Packages Inc. have the ability to meet Liquid
Chemical’s future container needs?
Time Horizon and Inflation: Is the price locked in for five years regardless of inflation?
Employees: The effect of eliminating some employees may have a detrimental effect
on the morale of remaining employees.

©The McGraw-Hill Companies, Inc., 2017


182 Fundamentals of Cost Accounting
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)
Labor: Supervisor (50,000) (50,000) (50,000) (50,000) (50,000)
Labor: Workers (450,000) (450,000) (450,000) (450,000) (450,000)
Rent: Warehouse (85,000) (85,000) (85,000) (85,000) (85,000)
Maintenance (36,000) (36,000) (36,000) (36,000) (36,000)
Other expenses (157,500) (157,500) (157,500) (157,500) (157,500)
Manager's salary (80,000) (80,000) (80,000) (80,000) (80,000)

Total costs $(1,358,500) $(1,358,500) $(1,358,500) $(1,358,500) $(1,358,500)


Tax savings (40%) 543,400 543,400 543,400 543,400 543,400
Cash flow due to costs $(815,100) $(815,100) $(815,100) $(815,100) $(815,100)
Tax effects of depreciation 60,000 60,000 60,000 60,000 -
Tax effect of GHL costs 80,000 80,000 80,000 80,000 -
Total cash flow $(675,100) $(675,100) $(675,100) $(675,100) $(959,100)
Discount rate factor (10%) 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209
Present value $(613,727) $(557,934) $(507,213) $(461,102) $(595,526)

$(2,735,502
NPV )

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 183
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
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 X $5,000/ton
X 40%) from Year 1 to Year 4.

 It uses straight-line depreciation, resulting in depreciation expense of $150,000 per year (= $1,200,000/8 years). It
generates a cash inflow of $60,000 per year (= $150,000 X 40%) from Year 1 to Year 4 because the book value of
the machinery at the beginning of Year 1 is $600,000.

©The McGraw-Hill Companies, Inc., 2017


184 Fundamentals of Cost Accounting
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)
Labor: Workers (360,000) (360,000) (360,000) (360,000) (360,000)
Rent: Warehouse (85,000) (85,000) (85,000) (85,000) (85,000)
Maintenance (36,000) (36,000) (36,000) (36,000) (36,000)
Other expenses (92,500) (92,500) (92,500) (92,500) (92,500)
Manager's salary (80,000) (80,000) (80,000) (80,000) (80,000)
Maintenance contract (375,000) (375,000) (375,000) (375,000) (375,000)
Total costs $(1,528,500) $(1,528,500) $(1,528,500) $(1,528,500) $(1,528,500)
Tax savings (40%) 611,400 611,400 611,400 611,400 611,400
Cash flow due to costs $(917,100) $(917,100) $(917,100) $(917,100) $(917,100)
Tax effects of depreciation 60,000 60,000 60,000 60,000 -
Tax effect of GHL costs 72,000 72,000 72,000 72,000 32,000
Total cash flow $(785,100) $(785,100) $(785,100) $(785,100) $(957,100)
Discount rate factor (10%) 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209
Present value $(713,727) $(648,843) $(589,857) $(536,234) $(594,284)

$(3,082,945
NPV )

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 185
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.

 Due to lower GHL consumption, during Year 5 there is still an ―accounting‖ expense of $80,000 (= 16 tons X
$5,000/ton). It will generate tax savings of $32,000 (= $80,000 X 40%) at Year 5.

 When the department contracts external maintenance, it decreases materials costs by 10%, and reduces
employee expenses by 20%. Other expenses total $92,500.

 There is no severance pay or pension under this alternative.

©The McGraw-Hill Companies, Inc., 2017


186 Fundamentals of Cost Accounting
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
Tax savings on sale (40%) 56,000
Cash flow on sale $616,000
Other materials $(50,000) $(50,000) $(50,000) $(50,000) $(50,000)
Labor: Supervisor (50,000) (50,000) (50,000) (50,000) (50,000)
Labor: Workers (90,000) (90,000) (90,000) (90,000) (90,000)
Rent: Warehouse (85,000) (85,000) (85,000) (85,000) (85,000)
Severance pay $(16,000) - - - - -
Other expenses (65,000) (65,000) (65,000) (65,000) (65,000)
Manager's salary - - - - -
Container contract $- (1,250,000) (1,250,000) (1,250,000) (1,250,000) (1,250,000)

Total costs $(16,000) $(1,590,000) $(1,590,000) $(1,590,000) $(1,590,000) $(1,590,000)


Tax savings (40%) 6,400 636,000 636,000 636,000 636,000 636,000
Cash flow due to costs $(9,600) $(954,000) $(954,000) $(954,000) $(954,000) $(954,000)
Tax effects of depreciation - - - - -
Tax effect of GHL costs 8,000 8,000 8,000 8,000 8,000
Total cash flow $966,400 $(946,000) $(946,000) $(946,000) $(946,000) $(946,000)
Discount rate factor (10%) 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209
Present value $966,400 $(860,000) $(781,818) $(710,744) $(646,131) $(587,392)

NPV $(2,619,685)

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 187
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.

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

 When the department performs maintenance and buys containers, it decreased materials costs by 90%, and
reduces employees by 80%. Other expenses total $65,000.

 In this case, there is a severance pay of $16,000 (= $20,000 X 0.8). The supervisor is still necessary, but Mr.
Duffy can be transferred to another department.

 Tax effects on GHL consumption are computed based on an expense of $20,000 per year (= 4 tons X $5,000/ton).
It results in savings of $8,000 per year (= $20,000 X 40%).

©The McGraw-Hill Companies, Inc., 2017


188 Fundamentals of Cost Accounting
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
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) (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)
Maintenance contract $- (375,000) (375,000) (375,000) (375,000) (375,000)

Total costs $(20,000) $(1,655,000) $(1,655,000) $(1,655,000) $(1,655,000) $(1,655,000)


Tax savings (40%) 8,000 662,000 662,000 662,000 662,000 662,000
Cash flow due to costs $(12,000) $(993,000) $(993,000) $(993,000) $(993,000) $(993,000)
Tax effects of depreciation - - - - -
Tax effect of GHL costs - - - - -
Total cash flow $1,052,000 $(993,000) $(993,000) $(993,000) $(993,000) $(993,000)
Discount rate factor (10%) 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209
Present value $1,052,000 $(902,727) $(820,661) $(746,056) $(678,232) $(616,575)

NPV $(2,712,251)

©The McGraw-Hill Companies, Inc., 2014


Solutions Manual, Chapter 4 189
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.
Market Price = $640,000; Loss on Sale = $160,000
Book Value = $800,000; Tax Savings on Sale = $64,000

 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

 There is a severance pay of $20,000 at Year 0, and a pension payment of $30,000 per year from Year 1 to Year 5

©The McGraw-Hill Companies, Inc., 2017


190 Fundamentals of Cost Accounting

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