CHAPTER 6

DECISION MAKING IN THE SHORT TERM

TRUE/FALSE

1. A temporary gap between the demand and supply of available capacity results because, in the short
term, businesses have a fixed supply of capacity but confront changing demand.
LO1 – True

2. An example of a decision that deals with excess supply is altering the product mix to focus on the
most profitable ones.
LO1 – False An example of a decision that deals with excess demand is altering the product mix to
focus on the most profitable ones.

3. The decision of how much capacity to put in place is a long-term decision.

LO1 – True

4. In the short term, businesses can alter capacity that they have when dealing with fluctuations in
demand.
LO1 – False In the short term, businesses must do the best with the capacity that they have when
dealing with fluctuations in demand.

5. With proper planning, businesses can match supply and demand exactly all the time.
LO1 – False Despite adjustments, businesses can rarely match supply and demand exactly all the
time.

6. One reason it might be profitable for a caterer to accept a catering job for Wednesday but reject it
for Saturday is because the caterer has excess capacity on Wednesdays.
LO2 – True

7. When picking the best decision option from among a set of available options, we could consider
controllable costs and benefits or relevant costs and benefits.
LO2 – True

8. Relevant cost analysis involves focusing on only those costs and revenues that differ from a
benchmark option.
LO2 – True

9. An approach that includes controllable and non-controllable costs and benefits to construct a
contribution margin statement for each decision option is referred to as a incremental product
approach.
LO2 – False An approach that includes controllable and non-controllable costs and benefits to
construct a contribution margin statement for each decision option is referred to as a
totals (gross) approach.

6-1
Balakrishnan Managerial Accounting

10. In general, analysis that considers only controllable or relevant costs is less efficient when decision
options differ only with respect to a few benefit and cost items.
LO2 – False In general, analysis that considers only controllable or relevant costs is more efficient
when decision options differ only with respect to a few benefit and cost items.

11. Price gouging occurs when a firm exploits temporary excess demand to raise prices to unreasonable
levels.
LO3 – True

12. Our ultimate decision will differ when we use incremental analysis versus construct a contribution
margin statement for each option.
LO3 – False We get the same answer with both approaches.

13. Using the gross approach to choose the best decision option is preferable to the incremental
method when the decision option involves many costs and benefits.
LO3 – True.

14. A sunk cost is a relevant cost in decision making under the gross approach.
LO3 – False A sunk cost is not a relevant cost in decision making under the gross approach.

15. A differential approach is an approach for framing and solving decisions that involves expessing the
benefits and costs of the various decision options relative to one of the options.
LO3 – True

16. When demand is high and a scarce resource is in short supply, a company should decide how much
of each product to produce by ranking products by the contribution margin per unit of the product.
LO4 – False When demand is high and a resource is in short supply, a company should decide how
much of each product to produce by ranking products by the contribution margin per
unit of the resource.

17. For a resource in short supply, the opportunity cost of the resource is positive.
LO4 – True

18. To maximize profit when capacity is in short supply, minimize the contribution margin per unit of
capacity.
LO4 – False To maximize profit when capacity is in short supply, maximize the contribution margin
per unit of capacity.

19. When faced with a situation where supply is limited for multiple resources managers use linear and
integer programming to evaluate decision options.
LO4 – True

20. When demand is high and a resource is in short supply, the contribution margin per unit of the
resource from its best possible use should exceed that forgone by putting it to the next best use.
LO4 – True

6-2
 Decision Making in the Short Term

21. Because potential longer-term effects could vary across short-term decision options, they might be
relevant.
LO5 – True

22. Quantifying the longer-term implications of short-term actions is relatively simple.

LO5 – False Quantifying the longer-term implications of short-term actions is difficult.

23. Because quantitative analysis of different decision options is extremely important, it should be the
only input into final decision.
LO5 – False Quantitative analysis of different decision options is extremely important, yet it
constitutes just one input into decision making.

24. It is important for effective managers to consider the longer-term implications of short-term
decisions because of potential tradeoffs between short-term and long-term interests.
LO5 – True

25. Managers often use the term “real options” to denote the flexibility associated with different
options and use advanced mathematical techniques to value the real options.
LO5 – True

26. Products that are produced in a joint process where it is not possible to produce one product
without producing the others as well are called joint products.
Appendix A – True

27. Split-off point is the step in a joint process after which the products are completely processed.
Appendix A– False Split-off point is the step in a joint process after which we can identify and
process the joint products separately.

28. Joint costs are incurred after the split-off point.

Appendix A – False Costs incurred before the split-off point are joint costs that we cannot trace to
individual products.

29. Joint cost is not relevant for product-related decisions beyond the split-off point.
Appendix A – True.

30. Usually, firms do not process individual products further beyond the split-off point.
Appendix A – False Usually firms process individual products further beyond the split-off point.

31. Managers should not rely on income statements that allocate common costs to product lines or
sections to evaluate the effect on short-term profit because such statements mingle controllable
and non-controllable costs.
Appendix B – True

32. Avoidable fixed costs are costs that need not be incurred if an option is not chosen.
Appendix B – True

33. Avoidable fixed costs are also referred to as non-controllable fixed costs.
Appendix B – False Avoidable fixed costs are also referred to as controllable fixed costs.

6-3
Balakrishnan Managerial Accounting

34. The segmented income statement offers a convenient way to evaluate short-term profit effects.
Appendix B – True

35. An example of a an avoidable cost over the short term is the lease payments for a building
Appendix B – False Lease payment for the building is not avoidable or controllable over the short
term.

6-4
 Decision Making in the Short Term

MULTIPLE CHOICE

36. Most short-term decisions deal with temporary gaps between:

A. A flexible supply of capacity and a fixed demand.
B. The inability to change selling price and the ability to estimate controllable costs.
C. The amount of fixed costs that can be avoided and the contribution margin.
D. The demand of and the supply of available capacity.
E. Company goals and employee goals.
LO1 – D

37. Capacity is the maximum volume of activity that a company can sustain with available:
A. Resources.
B. Discretionary orders.
C. Inventory.
D. Employees.
E. None of the above.
LO1 – A

38. Which of the following is an example of utilizing capacity effectively?

A. Building a plant large enough so that production can be increased as demand increases.
B. Hiring extra temporary employees to work extended hours during Christmas season at a retail
store.
C. Having all employees of a donut shop work a regular 8-hour shift every day.
D. A caterer having a limited number of chefs working during the week and on weekends.
E. An airline selling 20% more tickets for a flight than their airplane has available seats.
LO1 – B

39. One way businesses may manage demand is:

A. Building a plant large enough so that production can be increased as demand increases.
B. Rent additional office space.
C. Decreasing variable costs.
D. Raising prices during periods of high demands.
E. None of the above.
LO1 – D

40. Most short-term decisions can be classified as decisions that:

A. Deal with excess supply.
B. Deal with excess demand.
C. Deal with limited capacity.
D. Both A and B.
E. A, B and C.
F. None of the above.
LO1 – D

6-5
Balakrishnan Managerial Accounting

41. The Owens Company budgeted sales of 20,000 printers at $90 per unit last year. Variable
manufacturing costs were budgeted at $46 per unit, and fixed manufacturing costs at $12 per unit. A
special order for 1,000 printers at $72 each was received by Owens in April. There is enough plant
capacity to meet these additional units without incurring any additional fixed manufacturing costs;
however, the production would have to be done on an overtime basis at an estimated additional
cost of $5 per printer. Acceptance of the special order would not affect Owens’ normal sales and no
selling expenses would be incurred. What would be increase to net operating income if the special
order were accepted?
A.$21,000
B.$9,000
C.$14,000
D.$10,000
LO1 – Self-test – A

42. When making a decision regarding a special order management must consider:
A. Whether there is enough capacity to meet the order.
B. Additional costs associated with the order.
C. Whether the selling price of the special order covers the variable costs of making the product .
D. All of the above.
LO1 – Self-test – D

43. Warner Company has some material that originally cost $41,500. The material has a scrap value of
$21,600 as is, but if reworked at a cost of $4,600, it could be sold for $29,100. What would be the
incremental effect on the company's overall profit if it is reworked?
a. $17,000 decrease.
b. $38,600 decrease.
c. $2,900 increase.
d. $24,500 increase.
LO1 – Self-test – C

44. When management must decide whether to offer special promotions in order to reduce excess
inventory, which of the following is not relevant?
A. The cost of offering the promotion.
B. The selling price of the product during the promotion.
C. The unit product cost of the inventory being sold.
D. The regular selling price of the product when not on promotion.
LO1 – Self-test – D

6-6
 Decision Making in the Short Term

45. The Huffman Tire Company has 3,000 tires in its inventory which are considered obsolete. Each unit
originally cost the company $35. Management is considering options to reduce these inventory
levels. Units can be sold directly to car dealerships for $30 per tire as opposed to the normal selling
price of $45 per tire. The other option is to offer their current customers a $10 per tire rebate on
their purchase. In addition to the $10 rebate, the program would cost the company approximately
$24,000 to manage. They predict that either option will rid them completely of their excess
inventory. The decision to sell directly to the car dealerships over offering the rebate will result in:
A. A $21,000 increase in profits.
B. A $9,000 increase in profits.
C. A $15,000 decrease in profits.
D. A $24,000 decrease in profits.
LO1 – Self-test – B

46. Which of the following short-term decisions deal with excess capacity?
a. Special order.
b. Product mix.
c. Make or buy.
d. Increasing prices.
LO1 – Post-test – A

47. Beach Surf Boards is making a decision on whether to add long boards as a new product line to
complement its short boards. A recent analysis determined that the average long board can be sold
for $300.00 with unit variable costs of $225. Fixed costs are currently $51,000 per month but would
be increased to $69,000 if long boards are added. How much is incremental profit or (loss) if long
boards are added and its sales volume is expected to be 250?
a. $750
b. $18,750
c. ($32,250)
d. ($50,250)
LO1 – Post-test – A

48. Which of the following options might a consultant choose when making a decision to accept or
reject a new client when capacity is limited? (That is, the consultant already has all the clients her
present circumstances can handle.)
A. Refer the client to a competitor, but charge a referral fee to the competitor.
B. Reject the client.
C. Accept the client knowing that the consulting job cannot be completed.
D. A and B only.
E. A, B and C.
LO2 – D

6-7
Balakrishnan Managerial Accounting

49. The excess supply/excess demand classification is a helpful way for us to evaluate which of the
following decision problems?
A. Whether to accept a special order.
B. Whether to make or buy an item.
C. What product mix to adopt.
D. B and C only.
E. A, B and C.
LO2 – E

50. If selling price is $25, unit contribution margin equals $15 and fixed costs are $12,000, then
breakeven volume is:
A. 300 units.
B. 1,200 units.
C. 800 units.
D. 2,500 units.
E. 1,500 units.
LO2 – C

51. Consider the following decision option data:

Option #1 Option #2
Number of units 150 200
Revenue per unit $25 $25
Variable cost per unit $12 $12
Lost revenue from choosing option ($500) ($4,000)
Cost savings from choosing option $0 $1,000
Avoidable fixed cost $0 $0

What is the incremental profit for Option #2?

a. $5,600
b. ($2,400)
c. $2,600
d. ($400)
e. $1,400
LO2 – D

6-8
 Decision Making in the Short Term

52. Consider the following decision option data:

Option #1 Option #2
Number of units 150 200
Revenue per unit $25 $25
Cost per unit $12 $12
Lost Revenue from choosing option ($500) ($4,000)
Cost savings from choosing option $0 $1,000
Avoidable Fixed Cost $0 $0

What is the best choice?

a. Option #1
b. Option #2
c. Option #1 and Options #2 are equally good choices.
d. Neither Option #1 nor Option #2 should be chosen
LO2 – A

53. Brand X Computers makes and sells computers. Each computer sells for $400. The following cost
data per computer are based on a full capacity of 10,000 computers each period:
Direct materials $150
Direct labor $100
Variable manufacturing overhead $38
Unavoidable fixed overhead $12

Brand X is considering a special order for a sale of 2,500 computers to an overseas customer.
The only selling costs that would be incurred for the order would be shipping charges of $15 per
computer. Brand X is currently selling 7,500 computers through its regular orders. What should
be the minimum selling price per computer in negotiating a price for the special order.
a. $303
b. $250
c. $300
d. $265
e. $315
LO3 – A

54. In a make-or-buy decision relevant costs would include all of the following except:
A. Depreciation expense on the plant equipment currently used to make the part
B. Direct labor costs of the employees in that department which makes the part
C. Direct material costs of the part
D. The cost of buying the part from an outside company
LO1 – Self-test – A

6-9
Balakrishnan Managerial Accounting

55. Which of the following would be relevant in a make-or-buy decision?

Variable
costs assigned Cost to buy
to the item when
made
A. No Yes
B. Yes No
C. Yes Yes
D. No No
LO3 – Self-test – C

56. Gecko Company is evaluating the use of a supplier versus making the wheels for its skateboards
internally. The currently manufactured wheels have a variable unit cost of $2. Fixed costs are
$16,000 per month, however, 25% can be eliminated if wheels are no longer produced. A supplier
has offered to produce this part for $3 per wheel and can produce the 3,200 wheels for the 800
skateboards needed monthly. Should Gecko outsource wheels or make them internally?
a. Outsource because the incremental cost savings is $12,800.
b. Make the product because the incremental cost savings is $3,200.
c. Outsource because the incremental cost savings is $800.
d. Outsource because the incremental cost savings is $8,800.
LO3 – Post-test – C

57. Which of the following is not a short-term decision that is a reaction to excess capacity?
a. Management makes the decision to emphasize sales in a particular market to boost poor sales.
b. Management makes the decision to issue a rebate, offering customers a rebate of $0.50 for
every widget sold, because inventory is too large.
c. Management makes the decision to close a plant because of increased competition.
d. Management accepts a special order at a reduced selling price since the order ‘s relevant costs
will be less than the special order’s sales price.
e. All of the above are short-term decisions that are reactions to excess capacity.
LO3 – C

58. Which of the following is a short-term decision that is a reaction to excess demand?
a. Management makes the decision to emphasize sales in a certain market to boost poor sales.
b. Management makes the decision to close a plant because of increased competition.
c. Management makes the decision to buy parts rather than make them after calculating a positive
opportunity cost for capacity.
d. Management makes the decision to make parts rather than buy them after calculating a positive
opportunity cost for capacity.
e. All of the above a short-term decisions that are reactions to excess demand.
LO3 – C

6-10
 Decision Making in the Short Term

59. Hobbs Electronics makes and sells portable DVD players. Each DVD player has a selling price of
$100. The following cost data per DVD player is based on a capacity of 5,000 DVD players per
period.
Direct Material $30
Direct Labor $20
Manufacturing Overhead
(70% variable; 30% fixed) $10
Hobbs receives a special order for 100 DVD players. The only additional costs Hobbs will incur is $2
shipping charges per item. Hobbs has sufficient idle capacity to produce the additional DVD players.
What is the minimum price Hobbs should charge per DVD player for the special order?
a. $60
b. $59
c. $57
d. $55
e. $62
LO3 – B

60. Spikes Company manufactures 5,000 high-end racing bicycles each period. Spikes has been making
all the components for the bikes, but a supplier has approached Spikes with an offer to sell her
bicycle seats at a price of $40. The cost per unit of manufacturing one bicycle seat is computed as
follows:
Direct Material $10
Direct Labor $18
Manufacturing overhead
(100% fixed) $10

If the bicycle seats are purchased from the outside supplier, $1 per unit of the fixed manufacturing
overhead costs can be avoided. If Spikes purchases the seats, the facility used to manufacture the
seats would be rented for $20,000 per period. If Spikes chooses to purchase the bicycle seats, then
the change in annual net operating income is an:
a. $35,000 decrease.
b. $35,000 increase.
c. $5,000 decrease.
d. $5,000 increase.
e. $10,000 increase.
LO3 – A

6-11
Balakrishnan Managerial Accounting

61. The Pleasantville Company makes 20,000 units per year of a part used in production. The unit
product cost is as follows:
Direct materials $ 6.20
Direct labor 2.30
Variable Manufacturing Overhead 1.20
Fixed Manufacturing Overhead .80
Unit product cost $10.50
An outside supplier has offered to sell the company the same part at a cost of $9.00 per unit. If the
company purchases the part only half of the fixed overhead would be avoided. How much of the
unit product cost is relevant in making this decision?
A. $9.70
B. $10.50
C. $2.30
D. $10.10
LO3 – Self-test – D

62. Augusta Company manufactures stereo components. One of its most popular products is the
LoudBoom Speaker. Data concerning this product are given below:

Normal Selling Price $50.00

Direct materials $12.20
Direct labor $3.60
Variable Manufacturing Overhead $1.80
Fixed Manufacturing Overhead $2.00
Variable Selling Expense $1.90
Fixed Selling & Administrative Expense $.80
The above per unit data are based on annual production of 3,000 units of the component. The
company has received a special, one-time-only order for 200 units of the speaker. There would be
no selling expenses on this special order and the total fixed manufacturing overhead and fixed
selling and administrative expenses of the company would not be affected by the order. Assuming
that Augusta Company has excess capacity and can fill the order without any production disruptions,
what is the minimum price per unit on the special order the company should charge?
A. $50.00
B. $19.60
C. $17.60
D. $22.30
LO3 – Self-test – C

63.Shickman Company makes the widgets it uses in one of its products at a cost of $8 per unit. This cost
includes $2 of fixed overhead. The company needs 10,000 of these plugs annually, and Orlando
Company has offered to sell them at $5 per unit. If Shickman Company purchases the plugs, the
company would:
a. Increase profits by $30,000.
b. Decrease profits by $10,000.
c. Increase profits by $10,000.
d. Decrease profits by $30,000.
LO3 – Self-test – C

6-12
 Decision Making in the Short Term

64. Little Toy Company makes and sells miniature doll houses. Little produces two kinds of houses:
Standard and Deluxe. The demand for doll houses is highest in November and December. Expecting
this trend to continue, Little is interested in how to best utilize available capacity. Given the
following information, what combination of doll houses should Little produce?
Standard Deluxe
Demand 8,000 3,000
Unit Price $60 $80
Unit variable cost $25 $35
Unit contribution margin $35 $45
Production rate (units per hour) 2 1
Available production hours 5,000 hrs
Total fixed costs $40,000
a. 8,000 Standard; 3,000 Deluxe.
b. 8,000 Standard; 1,000 Deluxe.
c. 5,000 Standard; 3,000 Deluxe.
d. 3,636 Standard; 7,364 Deluxe.
e. 3,636 Standard; 1,363 Deluxe.
LO4 – B

65. The general rule to apply to maximize profit when capacity is in short supply is:
a. Minimize the contribution margin per unit of capacity.
b. Maximize the margin of safety per unit of capacity.
c. Maximize the contribution margin per unit of capacity.
d. Minimize the margin of safety per unit of capacity.
e. Maximize the unit contribution margin.
LO4 – C

66. Handi-Tool Company manufactures and sells lawn and garden tools. Handi manufactures three
kinds of pruning shears: Snip-It, Deluxe Clipper, and Limb-Away. The demand for the pruning
shears is highest in April. Expecting this trend to continue, Handi is interested in how to best utilize
available capacity. Given the following information, what combination of pruning shears should
Handi-Tool produce?
Deluxe Limb-
Snip-It Clipper Away
Demand 200,000 100,000 60,000
Unit Price $20 $30 $50
Unit variable cost $10 $15 $20
Unit contribution margin $10 $15 $30
Production rate (units per hour) 50 25 15
Available production hours 8,000 hrs
Total fixed costs $400,000
a. 200,000 Snip-It; 100,000 Deluxe Clipper, 0 Limb-Away.
b. 200,000 Snip-It; 60,000 Limb-Away; 0 Deluxe Clipper.
c. 100,000 Deluxe Clipper; 60,000 Limb-Away; 0 Snip-It.
d. 200,000 Snip-It; 100,000 Deluxe Clipper; 60,000 Limb-Away.
e. 150,000 Snip-It; 75,000 Deluxe Clipper; 45,000 Limb-Away.
LO4 – B

6-13
Balakrishnan Managerial Accounting

67. When capacity is limited, which of the following are alternative courses of action to consider?
a. Produce the items with the largest contribution margin per unit of capacity.
b. Purchase some components from outside suppliers.
c. Produce the items with the largest selling price to maximize revenue.
d. A and B only.
e. A, B and C.
LO4 – D

68. The Southeast Company makes three products in one manufacturing facility. Data regarding these
products are as follows:
A B C
Direct Materials $5.70 $6.20 $8.90
Direct Labor 2.05 1.90 2.20
Variable Overhead .70 .80 .90
Fixed Overhead 1.10 1.40 1.60
Unit Product Cost $9.55 $10.30 $13.60

Machine Hours Per Unit .5 1 .25

Selling Price per Unit $16.00 $18.00 $20.00
Demand (units) 1,200 1,400 800
How many machine hours would be required to meet the demand for all products?
A. 3,400
B. 2,200
C. 1,700
D. 850
LO4 – Self-test – B

69. The Southeast Company makes three products in one manufacturing facility. Data regarding these
products are as follows:
A B C
Direct Materials $5.70 $6.20 $8.90
Direct Labor 2.05 1.90 2.20
Variable Overhead .70 .80 .90
Fixed Overhead 1.10 1.40 1.60
Unit Product Cost $9.55 $10.30 $13.60

Machine Hours Per Unit .5 1 .25

Selling Price per Unit $16.00 $18.00 $20.00
Demand (units) 1,200 1,400 800
If there are only 2,000 machine hours available, which is the MOST profitable product?
A. Product A
B. Product B
C. Product C
D. Cannot be determined
LO4 – Self-test – C

6-14
 Decision Making in the Short Term

70. The Southeast Company makes three products in one manufacturing facility. Data regarding these
products are as follows:
A B C
Direct Materials $5.70 $6.20 $8.90
Direct Labor 2.05 1.90 2.20
Variable Overhead .70 .80 .90
Fixed Overhead 1.10 1.40 1.60
Unit Product Cost $9.55 $10.30 $13.60

Machine Hours Per Unit .5 1 .25

Selling Price per Unit $16.00 $18.00 $20.00
Demand (units) 1,200 1,400 800
If there are only 2,000 machine hours available, how much is the profit per machine hour for
product A?
A. $12.90
B. $6.45
C. $7.70
D. $6.40
LO4 – Self-test – A

71. When there is a production constraint, the company should first produce the product with:
A. The highest contribution margin per unit
B. The highest contribution margin ratio
C. The highest revenue per unit
D. The highest contribution margin per unit of the constrained resource
LO4 – Self-test – D

72. The Jackson Company produces 2 different products, each of which has unlimited demand. If there
are 4,000 total available labor hours, and the company desires to maximize its contribution margin,
how many units of each product should be produced?
Product
X Z
Selling price per unit........................... $8 $16
Variable cost per unit......................... $4 $9
Labor hours per unit........................... 2 4

A. 2,000 units of Product X and 0 units of Product Z

B. 0 units of Product X and 1,000 units of Product Z
C. 0 units of Product X and 4,000 units of Product Z
D. 2,000 units of Product X and 4,000 units of Product Z
LO4 – Self-test – A

6-15
Balakrishnan Managerial Accounting

73. The production of two products has the same selling prices per unit. If total fixed costs will be
$5,000 for product A and $4,500 for product B, what factors are relevant in determining which of
the two products to produce and sell?
a. Selling and variable costs per unit, and the fixed cost savings.
b. Variable costs per unit and total fixed costs.
c. Total variable and fixed costs and total sales revenue
d. .Variable costs per unit and the fixed cost savings
LO4 – Post-test – D

74. Which of the following is in the context of a short-term decision?

a. Special order.
b. Product promotion.
c. Product mix.
d. A and B only.
e. A, B and C.
LO4 – E

75. Which of the following statements is not true?

a. Quantifying longer-term implications of short-term actions is relatively simple.
b. It is important to consider longer-term implications of short term decisions because of potential
tradeoffs between short-term and long-term interests.
c. Many managers follow a “peel the onion” approach to assessing decision effects, first by
estimating the short-term effects, and then expanding the range of considered factors.
d. For longer-term actions, in many cases, qualitative assessments are the only ones possible, and
large estimations errors accompany such assessments.
e. All of the above statements are true.
LO5 – A

76. Quantifying the longer-term implications of short-term actions is difficult. Consequently:

a. It is impossible to make an informed decision.
b. Frequently, only qualitative assessments are possible.
c. Long-term implications should be ignored in the decision-making process.
d. A and B only.
e. A, B, and C are consequences.
LO5 – B

77. Which consideration is most relevant for a startup manufacturing company?

a. Short-term decisions regarding production.
b. Implications that arise from people outside the firm such as customers, suppliers, and suppliers.
c. Qualitative aspects of decisions.
d. Decisions that cause profit to be highest in the short-run
LO5 – Post-test – B

6-16
 Decision Making in the Short Term

78. A cost that is common to two or more products is a:

a. Split-off cost.
b. Incremental cost.
c. Joint cost.
d. Opportunity cost.
e. Fixed cost.
Appendix A – C

79. Which of the following is not an example of a joint product?

a. Mined zinc and lead from the same ore.
b. Kerosene and aviation fuel from crude oil.
c. Goats’ milk and cows’ milk.
d. Pine bark and pine cones from a pine tree.
Appendix A – C

80. Which of the following statements is true?

a. Joint costs occur after the split-off point.
b. Joint costs occur before the split-off point.
c. Joint costs can be traced to specific outputs.
d. Joint costs are considered relevant costs beyond the split-off point.
e. None of the above statements are true.
Appendix A – B

81. A joint product costs $20 (including $8 allocated joint cost) and sells for $15. Which of the following
statements is true?
a. The production of the product should be discontinued since it creates a loss of $5.
b. The product should be processed further so the joint cost can be allocated to additional
products.
c. The product should be analyzed further to determine its profitability since the joint cost will be
incurred whether or not the product is discontinued.
d. Profit will be increased if the product is discontinued.
e. Both A and D are true statements.
Appendix A – C

82. Which of the following is not relevant to make a decision to process further or sell ‘as is’?
a. Selling price if processed further.
b. Cost incurred to produce the product after the split-off point.
c. Joint costs.
d. Costs incurred to process further.
Appendix A – Post-test – C

83. Which of the following statements is not true?

a. Common costs are not relevant in determining whether to drop a product line.
b. If a segment of a company has been losing money for several periods because a competitor has
opened in the area, the segment should be dropped.
c. Neither of the above statements if true.
d. Both of the above statements are true.
Appendix B – B

6-17
Balakrishnan Managerial Accounting

Problems

1. Robin offers Christmas tree decorating services six days per week during late November and
December. She charges $50 per live tree regardless of the size of the tree. Robin’s clients provide
all the decorations. Her variable cost, solution to keep the tree fresh, is $10 per tree and the fixed
costs per month total $100. Robin has had more calls by the end of October than she had expected
and is considering hiring a helper. She will pay the helper $8 per hour. Robin estimates that she can
decorate 8 trees in a 10-hour day (before hiring a helper) during the holiday season (25 days.)

Required:
a. Does Robin’s decision deal with excess supply or excess demand?

b. If Robin decides not to hire a helper, list three alternatives she should consider.

c. List three long-term effects of Robin’s decision alternative courses of action..

6-18
 Decision Making in the Short Term

2. Trisha Hardin owns Ice Flavors, a small business selling fruit-flavored slush drinks. Each drink sells
for $2.50. Trisha derived her price as follows:

Drink mixture and crushed ice $0.60

Labor per drink ($8 per hour ÷ 20 drinks per $0.40
hour)
Variable overhead per drink (cups, etc) $0.35
Fixed overhead per drink $0.40
Total cost per drink $1.75

Trisha is considering a special order for a sale of 100 drinks for a local birthday party. The
hostess is willing to pay $1.50 per drink. The party will be in the evening, which is not during
Trisha’s regular business hours. Trisha will provide the drink mixture, ice and labor. Her only
additional expense will be one employee for two hours ($8 per hour), travel to and from the
party location (estimated to be $15). Since the party is not at Trisha’s business, Her fixed
overhead will not change. The party hostess will furnish all cups, napkins and other variable cost
items.

Required:
a. What is the incremental cost associated with accepting the special order?

b. List the costs that are not relevant to the decision.

c. Should Trisha accept the special order? Why?

6-19
Balakrishnan Managerial Accounting

3. Outdoor Flames manufactures 5,000 outdoor gas fireplaces each period. The company has been
manufacturing the ignition system for the fireplaces. The unit cost of each ignition is as follows:

Direct Material $12

Direct Labor 5
Variable manufacturing overhead 2
Fixed manufacturing overhead 14
Unit product cost $33

A local supplier has offered to sell the company the ignition system for $30 each. If the ignition
systems are purchased from the outside supplier, the facilities now being used to make them
can be used to make other units of a product that is in high demand. The additional
contribution margin on the other unit would be $42,000 per year. If the ignition systems are
purchased from an outside supplier, all the direct labor would be avoided, but $8 of the fixed
cost would continue and be applied to the remaining products even if the part is purchased.

Required:
a. How much of the unit product cost of $33 is relevant to the decision to make or buy the
ignition systems?

b. What is the net total dollar advantage or disadvantage of purchasing the ignition systems
rather than making them?

c. List three qualitative characteristics that the owner of Outdoor Flames should consider in
looking at the long-term effect of purchasing the ignition systems.

6-20
 Decision Making in the Short Term

4. The Gant Company produces three items in its manufacturing plant. The plant has a total capacity
of 9,600 minutes per month for production. The following information is provided for the products:
Products
X Y Z
Direct material $16 $10 $14
Direct labor (all variable) 15 14 15
Variable overhead 2 3 4
Fixed overhead 20 23 30
Unit cost $53 $50 $63

Minutes required per unit 5 4 6

Selling price per unit $70 $65 $80
Variable selling expense per unit $5 $4 $2
Monthly demand in units 2,200 1,000 800

Required:
a. How many minutes would be required to meet the demand for all three products?

b. How many units of each product should Gant product to maximize profit? Show your
calculations.

6-21
Balakrishnan Managerial Accounting

5. Hermitage Farms produces two products, X and Y, in a joint process. The products may each be sold
at the split-off point or processed further. The selling price $1.10 for X and $0.80 for Y if the
products are sold without further processing. Data for the two products, if processed further, is
presented below:

Product X Product Y Total

Sales volume 28,000 units 16,000 units
Revenues $42,000 $18,400 $60,400
Traceable processing cost 12,000 5,000 17,000
Segment Margin $30,000 $13,400 $43,400
Joint costs $35,000
Profit before Taxes $6,000

Required: What is the monetary advantage (disadvantage) of further processing the products?
Show calculations.

6. Creative Lawn Ornaments sells three categories of lawn structures: Fountains, Bird and Butterfly
Houses, and Obelisks. For the current year, Creative reported the following results:

Fountains Houses Obelisks Total

Revenue $175,000 $145,000 $95,000 $415,000
Variable costs 85,000 43,000 45,000 173,000
Contribution margin $ 90,000 $102,000 $50,000 $242,000
Traceable fixed costs 30,000 33,000 30,000 93,000
Common fixed costs 35,000 35,000 35,000 105,000
Profit $ 25,000 $ 34,000 ($15,000) $ 44,000

Creative’s owner is pleased with the overall profit, but is concerned about the loss on the
Obelisks line and is considering eliminating it. The owner believes that if the Obelisk sales are
discontinued he will be able to display more Fountains and increase the revenues by 5% without
increasing any fixed costs. If the Obelisk line is discontinued, all of its traceable fixed costs will
be avoided, but its common fixed costs will be allocated to the Fountains.

Required:
Evaluate whether Creative Lawn Ornaments should discontinue its line of Obelisk structures.
Show all calculations.

6-22
 Decision Making in the Short Term

Solutions to Problems

1. Short-term decision (LO1)

a. Robin’s decision deals with excess demand.

b. Answers may vary. Some alternative courses of action include:

 Instead of hiring a helper, work longer hours.
 Instead of hiring a helper, extend business from six days to seven days per week.
 Increase the price per tree, and thereby, reduce the number of clients.
 Limit the size of tree, thereby being able to complete more trees in the same amount of
time.
 Instead of hiring a helper paid per hour, outsource some work for a fixed fee per tree.
 Begin decorating a few days earlier in November.

c. Answers may vary. Some long-term effects include:

 If Robin increases the price per tree, in the long-run she may lose clients.
 By hiring a helper and accepting additional clients, in the long run Robin may have to
consider hiring additional employees.
 If Robin increases business and hires helpers, in the long-run she may wish to offer
additional services such as decorating mantels, doorways, dining rooms, etc.
 With increased business, Robin should consider the long-term effect on her health.
 With increased business, Robin should consider the long-term effect on her personal
and family obligations.

6-23
Balakrishnan Managerial Accounting

2. Special Order (LO2)

a. Incremental cost associated with accepting the order:
Accept Order Reject Order
Revenue $150 $0
Drink mix and ice $ 60 $0
Labor ($8 per hr x 2 hrs) $ 16 $0
Transportation $ 15 $0

Total Incremental costs: $60 + $16 + $15 = $91

b. Non-relevant costs:
Fixed overhead $0.40 per drink
Variable overhead $0.35 per drink

c. Trisha should accept the order:

Incremental Revenue $150
Incremental Costs $ 91
Incremental profit $ 59

Because Trisha’s incremental revenue exceeds her incremental costs and she has the
capacity to accept the order (it does not interfere with regular business), it would be
profitable to accept the special order.

3. Make or buy decision (LO2, LO3, LO5))

a. Relevant unit product cost:

$12 + $5 + $2 + $6 = $25

b. Net total dollar advantage (disadvantage) of purchasing:

Relevant cost $125,000

Additional contribution margin 42,000
Cost of purchasing (150,000)
Net advantage $17,000

c. Qualitative considerations:
 Will the supplier continue to sell the ignition systems at the $30 price?
 Over the long run, will the company be able to absorb all the employees from the
ignition system into other areas of the company?
 What are the alternatives if the purchased ignition systems turn out to be a lower
quality than expected?
 Does the high-demand item expected to use the space formerly used for making the
ignition systems have a long-range high demand?

6-24
 Decision Making in the Short Term

4. Best use of resources in short supply( LO4)

a. Total minutes required to meet demand:

(2,200 units x 5 minutes) + (1,000 x 4 minutes) + (800 x 6 minutes) = 16,600 minutes

b. Production to maximize profit:

Products
X Y Z
Selling price per unit $70 $65 $80

Direct material $16 $10 $14

Direct labor (all variable) 15 14 15
Variable overhead 2 3 4
Variable selling expense per unit 5 4 2
Total variable cost $38 $31 $35

Contribution margin per unit $32 $34 $45

Minutes required per unit 5 4 6
Contribution margin per minute $160 $136 $270

Gant should produce the following units to maximize profit:

Optimal Units Minutes Used Available Minutes
9,600
Product Z 800 units @ 6 minutes 4,800 4,800
Product X 1,000 units @4 minutes 4,000 800
Product Y 160units @ 5 minutes 800 -0-

5. Joint costs (Appendix A)

Product X Product Y Total

Process Further:
Sales volume 28,000 units 16,000 units
Revenues $42,000 $18,400 $60,400
Traceable processing cost 12,000 5,000 17,000
Segment Margin $30,000 $13,400 $43,400

Sell at Split-Off
Revenue $30,800 $12,800 $43,600
Traceable processing costs 0 0 0
Segment Margin $30,800 $12,800 $43,600

a. The disadvantage of processing Product X further is $800.

($30,000 - $30,800)

b. The advantage of processing Product Y further is $600.

($13,400 - $12,800)

6-25
Balakrishnan Managerial Accounting

6. Dropping product line (Appendix B

Fountains Houses Obelisks Total

Revenue $175,000 $145,000 $95,000 $415,000
Variable costs 85,000 43,000 45,000 173,000
Contribution margin $90,000 $102,000 $50,000 $242,000
Traceable fixed costs 30,000 33,000 30,000 93,000
Segment Profit $ 60,000 $ 69,000 $20,000 $149,000
Increased revenue if
Obelisk

Continue Discontinue
Fountain Obelisk Total Fountain Obelisk Total
Revenue $175,000 $95,000 $270,000 $183,750 0 $183,750
Variable costs 85,000 45,000 130,000 89,250 0 89,250
Traceable fixed costs 30,000 30,000 60,000 30,000 0 30,000
Common fixed costs 35,000 35,000 70,000 70,000 0 70,000
Net Income $ 25,000 ($15,000) $ 10,000 ($5,500) 0 ($5,500)

Creative’s owner should not discontinue its Obelisk line of products. The increase in revenue
from the additional fountain sales does not offset the portion of common fixed costs that the
Obelisk absorbs.

6-26
 Decision Making in the Short Term

End of Chapter Content

Short Answer

1. What do short-term decisions deal with in most business environments?

2. What does the term “capacity” mean?

3. Why is the decision of how much capacity to put in place a long-term decision?

4. What are the two broad classifications of short-term decisions? List two examples of each.

5. Briefly describe the incremental or differential method approach to making short-term decisions.

6. Briefly describe the totals or the gross approach to making short-term decisions.

7. Which approach, incremental or totals, requires more computations? Why?

8. When might the gross approach be preferable to the incremental approach for making short-term
decisions?

9. Are sales promotion decisions typically responses to an excess supply situation or an excess demand
situation?

10. What is a make-or-buy decision?

11. When does it make sense to compute the contribution margin per unit of a particular resource in
making short-term decisions?

12. What is the general rule for allocating a scarce resource to making multiple products?

13. How might managers deal with the possible long-term implications that may arise from short-run
decisions?

6-27
Balakrishnan Managerial Accounting

Solutions to Short Answer

1. (LO1) The temporary gaps between the demand and supply of available capacity.

2. (LO-1) The maximum volume of activity that a company can sustain with available resources.

3. (LO-1) Because organizations make capacity decisions based on the expected volume of
operations over a horizon spanning many years. They build plants, buy equipment, rent office space,
and hire salaried personnel in anticipation of the demand for their products and services.

4. (LO-1) (1) Decisions that deal with excess supply. Examples include reducing prices to stimulate
demand, running special promotions, processing special orders, and using extra capacity to make
production inputs in-house; (2) Decisions that deal with excess demand. Examples include increasing
prices to take advantage of favorable demand conditions, meeting additional demand by
outsourcing production, and altering the product mix to focus on the most profitable ones.

5. (LO-2) This method focuses only on those costs and revenues that differ from the benchmark
option.

6. (LO-2) This method considers the gross revenues and costs associated with each option, rather
than the incremental amounts relative to the benchmark option.

7. (LO-2) The totals approach requires more computations because it includes some
noncontrollable benefits and costs.

8. (LO-2) In decisions involving many costs and benefits – it helps us ensure that we do not
“forget” to include a relevant cost or benefit.

9. (LO-3) Excess supply – usually, the firm cuts prices to stimulate demand.

10. (LO-3) In a make or buy decision, the firm is deciding whether to make a product, or piece
thereof, internally or outsource and buy them from a supplier.

11. (LO-4) When demand is high and a resource is in short supply.

12. (LO-4) To maximize profit when capacity is in short supply, maximize the contribution margin
per unit of capacity.

13. (LO-5) Typically on a qualitative basis – by considering how customers, suppliers, and
competitors might respond to the decision being made.

6-28
 Decision Making in the Short Term

Short Essay

1. The definition of “short-term” depends on the business context. What would General Motors
consider as short-term? Is this period longer than what a bakery would consider as short-term?
Why?

2. Automobile dealers frequently advertise sales because their lots are “overflowing.” The ads suggest
a shortage of storage capacity but the price-cutting action indicates a demand shortfall. How can
you reconcile these seemingly contradictory inferences?

3. Identify the one resource whose daily supply is fixed for each person. How could we improve the
effectiveness with which we consume this resource?

4. Some people argue that the gross method is also, at some level, “incremental.” Evaluate this
argument.

5. When faced with a sudden spurt in demand, why does it sometimes make sense for a company to
increase prices? For example, why do airlines raise fares during peak travel periods? Why might it
not be a good idea for consulting companies?

6. In periods of excess capacity, does it make sense for a manufacturing company to produce some
products to stock (i.e., build up inventory) for sale in future periods of high demand? Give two
examples of industries where this might be a good idea. Give two examples where it might be a bad
idea.

7. How does holding inventory help reduce theexpected gap between available capacity and uncertain
demand?

8. Inventory is one mechanism that a firm could use to protect itself from the impact of fluctuating
demand. What are other long-term strategies a company could adopt to insulate itself against
uncertain demand?

9. Often, the capacity of the most expensive machine defines a plant’s capacity. That is, firms will
deliberately install excess capacity in “cheap” resources. Why might this practice be optimal?

10. The general allocation procedure in the text assumes few constraints on how we could use
resources. Why might this general rule not hold when individual uses require a minimum amount of
the resource? (For example, if we are allocating space, each use might need a minimum of 10 units
of space.) How might we modify our approach to incorporate lumpy uses of capacity?

11. How does the notion of maximizing the contribution per unit of the scarce resource apply when
some products have minimum production quantities?

6-29
Balakrishnan Managerial Accounting

12. Outsourcing is the practice of having an external party take over some business and/or
manufacturing processes. How does outsourcing change a firm’s cost structure and, therefore, its
ability to be nimble in responding to competition? What are some long-term costs and benefits of
outsourcing?

13. Suppose that buying a component is estimated to save $50,000 annually over making it in-house.
However, outsourcing the component means that 20 long-term employees would be laid off,
adversely affecting employee morale. How might a manager trade off these two factors?

6-30
 Decision Making in the Short Term

Solutions to Short Essay

1. (LO-1) Yes, the definition of what is short-term and what is long-term depends on the business
context. For General Motors anywhere from few weeks to a few months may be considered short-
term, as pricing and promotion decisions depend on how fast different models of cars and trucks are
moving from the dealers’ inventories. For a baker, a day or two days may be too long as baked
goods do not retain their “freshness’’ for long. Thus, product characteristics often play a critical role
in determining how “long” the short-term horizon is.

2. (LO-1) The reason why the lots are overflowing is that vehicles are not being sold at the
expected rate. Unsold vehicles occupy space in the lot. Thus, it is not correct to define capacity in
terms of the lot space available. Rather, capacity should be defined in terms the number of vehicles
that can potentially be sold per day. When demand falls short of supply based on the anticipated
number of vehicles to be sold per day, lots overflow, and price-cutting and other promotions
become necessary to move the vehicles.

3. (LO-1) Most of us drive to work, and so the demand for gasoline is fairly stable. One way to
economize on gasoline consumption is to car pool.

4. LO-2) Yes, it is. The gross method considers all cash inflows and cash outflows that are
associated with the options being considered in the context of a particular decision, even though
some of them may be non-controllable. But, it does not consider cash flows associated with many
other decisions that the companies may be considering. From an overall organizational standpoint,
each decision has an incremental effect, and, therefore, the gross method is also incremental when
viewed in this context.

5. (LO-3, LO-5)Increasing prices is a natural way of decreasing demand. In fact, in most market settings,
demand for a product decreases as its price increases. When a firm does not have enough capacity
to meet a sudden spurt in demand, it can reduce the demand by increasing prices and “turning
away” some customers to a point where the demand can be met. The airline industry is a good
example. In peak times, an increase in airfare induces some travelers to seek other means of travel
or postpone their travels. Only those that are able to afford the higher prices, or have rigid and
noncancelable schedules, will continue to travel. Airline companies usually face no long-term
adverse implications from increasing prices to deal with peak demand situations. Air travelers
usually understand this behavior and plan their travel accordingly. On the other hand, consulting
companies rely on longstanding relationships with their customers. Raising their rates when their
business is good usually backfires because it hurts reputation and goodwill in the long-run.

6. (LO-3) Yes, it does. This is typically referred to as “production smoothing” and makes good
business sense as long the product is storable for sale in the future period, and as long as inventory
carrying costs are manageable. The toy industry and the apparels industry are good examples.

7. (LO-3) Companies can produce and stock up during periods of lean demand to be ready for
peak periods whenever demand outstrips capacity. However, such use of inventory is beneficial
when demand follows reasonably predictable cycles of high and low demand. On the other hand,
whenever demand is low and there is considerable uncertainty as to whether demand would rise
again, producing and stocking for future may backfire.

6-31
Balakrishnan Managerial Accounting

8. (LO-3) One strategy is to invest less in capacity and rely more on outsourcing. By doing so, the
company would embrace a cost structure with less fixed costs and more variable costs i.e., a cost
structure with lower operating leverage. Another strategy to find other uses for capacity so that
excess capacity can be put to profitable alternate use during periods of lean demand (such as
accepting special custom jobs, turn key projects and so on).

9. (LO-4) The idea is to make the most profitable use of critical and most expensive resources.
The opportunity cost of such a resource is by assumption, high. Any situation in which such a
resource has to wait because some other “cheaper” resource is in short supply is undesirable. To
avoid such situations, it makes more economic sense to install excess capacity in other resources.

10. (LO-4) When a resource is in short supply, and it is used in a lumpy manner, calculating
contribution margin per unit of the resource to allocate its use to various products is at best
approximate and can often lead to wrong decisions. Advanced techniques such as integer
programming may have to be employed to come up with the right way to allocate scarce resources
to products in such settings.

11. (LO-4) Products requiring minimum production quantities involve committing requisite
amounts of capacity to these products if they are chosen production. Whenever capacity is in short
supply, such products may well necessitate leaving out products with higher contribution margins
per scarce capacity unit in order to meet their minimum production requirements. The alternative is
to not lock up capacity by scheduling such products, but instead use the capacity to schedule
products that yield lower contribution margins per unit of the scarce capacity resource. The
consequent trade-off will determine whether it is profitable to make products with minimum
production requirements.

12. (LO-5) Test marketing is a way to minimize risk associated with large investments. Offering a
new product often involves putting in place and committing to various organizational resources.
Once the product is launched it is often extremely costly to cut back should the product fail. Plants
and offices have to be closed down and people have to be fired and so on. Risk of failure is an
inherent part of business, and products do fail. But one way to reduce this risk is to do a small scale
launch aimed at representative customers. If this test marketing effort fails, then a larger scale
launch is unadvisable. Moreover, feedback from the test market is often useful in redesigning the
product to reduce the risk of failure subsequently.

13. (LO-5) Employee morale is an important factor in outsourcing decisions, especially if

outsourcing is a sign of things to come. Loss of morale leads to a loss in productivity which might
make outsourcing even more attractive. The company may lose talented and experienced
personnel, who may prefer jobs elsewhere to being fired. Managers therefore have to be clear
about the impact of outsourcing on employee morale so that they can make the appropriate trade-
off between immediate cost savings from outsourcing and longer-term adverse impact of a loss in
morale. Certain critical activities are better done in-house for strategic reasons, while others can be
outsourced. However, decision making with respect to outsourcing has to be clearly communicated
to the employees to avoid disgruntlement.

6-32
 Decision Making in the Short Term

Exercises

1. Ajay Singh offers gift-wrapping services at the local mall. Ajay wraps each package, regardless of size,
in the customer’s choice of wrapping paper and bow for a price of $3. Ajay’s variable costs total $1
per package wrapped, and his fixed costs amount to $600 per month. Due to the anticipated
increase in demand over the holiday season, Ajay is considering hiring a helper, at a cost of $8.50
per hour, to help him wrap packages. With the helper, Ajay estimates that he can wrap 110
packages in a 10-hour day. Without the helper, Ajay estimates that he can wrap 60 packages in a 10-
hour day. Ajay plans on operating his business for thirty 10-hour days during the holiday season.

Required:
a. Does Ajay’s decision deal with excess supply or excess demand?

b. Using the gross approach, determine whether Ajay should hire the helper.

c. Using controllable cost analysis, determine whether Ajay should hire the helper.

d. Assume Ajay’s fixed costs were $1,000 rather than $600. Would this affect Ajay’s decision
to hire a helper?

2. The Déjà Vu Card Company offers greeting cards for every occasion at unmatched prices. The
following information comes from Déjà Vu’s accounting records for December of the most recent
year: Greeting cards sold 100,000 cards Selling price $1.00 per card Fixed costs:
Manufacturing $0.30 per card
Marketing & administrative $0.21 per card
Variable costs:
Manufacturing $0.15 per card
Marketing & administrative $0.08 per card

Required:
Déjà Vu has an extra stock of 5,000 holiday greeting cards. The company is considering two options:
(1) holding a 50% off sale and (2) holding an 80% off sale. Déjà Vu expects to sell 1,500 cards if it
holds a 50% off sale and 4,000 cards if it holds an 80% off sale. The remaining cards would be
discarded. Which option should Déjà Vu pursue?

6-33
Balakrishnan Managerial Accounting

3. Myers Quarry produces coarse gravel and sand in an 8:2 ratio. Joint costs for a month (volume 5
9,000 tons of rocks input) amount to $225,000. Values at the split-off point are $30 per ton for
gravel and $40 per ton for sand.

Required:
a. Allocate joint costs to the two products using the relative sales value at split off as the allocation
basis.

b. Suppose Myers can run the sand through a sieve to remove small rocks and make fine sand used
to fill sandboxes. The process will, however, reduce the yield of sand from 1,800 tons to 900 tons.
This superior grade of sand (“sandbox” quality) retails for $160 per ton. However, Myers will incur
$18,000 to process the sand into “sandbox” quality. Should Myers sell the coarse sand as is or
process it further into sandbox quality sand?

6-34
 Decision Making in the Short Term

Solutions to Exercises

1. (LO1, LO2)
a. Ajay’s decision deals with excess demand. Due to the holidays, Ajay expects a surge in gift-
wrapping needs. To handle this surge, Ajay is considering hiring a helper. This is akin to a
manufacturing firm outsourcing some production in periods of high demand.

b. We can construct the entire CVP model for Ajay. We then compare the profit under each option,
selecting the option with the higher profit. With the information provided, we have:

Without Helper With Helper

60 packagesPer 110 packages
day per day
Daily revenue ($3  60; $3  110) $180.00 $330.00
Daily variable costs ($1  60; $1  110) 60.00 110.00
Daily pay for help (0; $8.50  10) 0.00 85.00
Daily contribution Row 1– rows 2 & 3 $120.00 $135.00
Total contribution Row 4  30 $3,600.00 $4,050.00
Total fixed costs Given 600.00 600.00
Profit $3,000.00 $3,450.00

Ajay’s profit increases by $450 ($3,450 – $3,000) for the season, if he hires the helper.
Accordingly, if he wishes to maximize profit then Ajay should hire the helper.

In constructing the income statement for each option, we could leave out the non-controllable
fixed costs of $600. While the absolute profit numbers would change, the difference in profit
would be preserved. Thus, the gross approach provides decision makers some flexibility in terms
of what is included and excluded from the income statement.

c. We compute only the incremental revenues and costs associated with a particular decision
option relative to the status quo. Since operating without the helper is the status quo, we have:

Incremental revenue 50 packages per day  $3 $150

Incremental variable cost (packages) 50 packages per day  $1 50
Incremental cost (helper) $8.50  10 hours 85
Incremental profit per day $15
Value of hiring helper $15  30days $450
Ajay increases monthly profit by $450 if he hires a helper. The difference in profit derived with
controllable cost analysis exactly equals the difference in profit under the gross approach.

d. If Ajay seeks to maximize profit, the change in fixed costs will not alter his decision to hire the
helper. The fixed costs are equal under each option and are not relevant for this particular
problem. Even though the gross approach uses fixed costs, they “wash” because they are
included in the total cost for both options.

6-35
Balakrishnan Managerial Accounting

2. (LO2) Similar to the Superior Cereals problem in the text, the key to this problem is to realize
that the variable costs associated with manufacturing the greeting cards are sunk – thus, they are
not relevant to Déjà Vu’s decision. Additionally, Déjà Vu’s fixed costs are non-controllable for the
decision, as they are not expected to change. Thus, the problem is one of revenue maximization.

At a 50% off sale, Déjà Vu’s profit increases by $0.50 × 1,500 = $750.
At an 80% off sale, Déjà Vu’s profit increases by $0.20 × 4,000 = $800.

Thus, Déjà Vu maximizes its profit by holding the 80% off sale, even though the resulting price is
below the $0.23 (= $0.15+$0.08) in variable costs associated with producing and selling a card.
What we need to remember is that this is the variable cost of a card yet to be produced, not a
card that has already been produced.

Note: This problem links to a common business practice. Specifically, we often observe stores
employing a staggered discounting strategy – the store starts with, for example, a 25% discount
and increases the discount rate over time (perhaps by as much as 15-25% a week). In this way,
the store attempts to capture as much consumer surplus (gross revenue) as possible by grouping
customer types according to their willingness to wait and run the risk of having the item selling
out. Such a strategy may work quite well for Déjà Vu – i.e., the company could sell the first 1,500
cards at $0.50 and 4,000 – 1,500 = 2,500 cards at $0.20. By employing such a strategy, Déjà Vu
could earn:

Expected Profit = ($0.50 × 1,500) + ($0.20 × 2,500) = $1,250.

This amount represents a $450 (= $1,250 - $800) increase over its best option.

6-36
 Decision Making in the Short Term

3. (Appendix A)
a. Let us begin by calculating relative sales values.
Gravel: 9,000 tons × 0.8 × $30 $216,000
Sand: 9,000 tons × 0.2 × $40 $72,000
Total $288,000

Thus, 75% of the joint cost (=$216,000/$288,000) would be allocated to gravel and the 25% to
sand. We have the cost allocated as 0.75 × $225,000 = $168,750 and 0.25 × $225,000 = $56,250.

Alternatively, we can calculate the rate per sales $ at the split off as $225,000/$288,000 =
$0.78125. We then allocate $216,000 × $0.78125 = $168,750 to gravel and $72,000× 0.78125 =
$56,250 to sand.

b. We know that only incremental revenues and costs are important for this decision. Let us
therefore calculate the net gain from processing the sand further.

Value of sandbox quality 900 tons × $160 $144,000

Lost value at split off 9,000 tons × 0.2 × $40 $72,000
Net gain in revenue $72,000
Cost of additional processing given ($18,000)
Net value $54,000
Thus, Myers should process the sand at split off into sandbox quality sand because it increases
profit by $126,0001 - $72,000 = $54,000.

Note: The important point to note is that the joint cost, or how it is allocated, is not relevant for
the decision in [b]. That joint cost is sunk for this decision. These allocations are usually done
only for the purpose of valuing inventory.

6-37