MGAB03H3 Lecture Notes - Lecture 4: Variable Cost, Gross Margin, Sunk Costs
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Tactical decision making
Tactical decision making means choosing among alternatives withan immediate or limited end in view. For example, a company mayaccept a special order for less than the normal selling price touse idle capacity. Tactical decisions tend to be short-runin nature; however, it should be emphasized that short-rundecisions often have long-run consequences. A general tacticaldecision-making model is outlined here.
1. | Recognize and define theproblem. |
2. | Identify possible alternativesolutions to the problem, and eliminate any unfeasiblealternatives. |
3. | Identify the costs and benefitsassociated with each feasible alternative. Eliminate the costs andbenefits that are not relevant to the decision. |
4. | Compare the relevant costsand benefits for each alternative. |
5. | Assess qualitative factors. |
6. | Select the alternative with thegreatest overall benefit. |
Identifying and comparing relevant costs and revenues is theheart of the tactical decision model. Relevant costs (revenues) arefuture costs (revenues) that differ across alternatives. (Revenuesare treated in the same way as costs, so we will simplify thediscussion by referring to costs.) All decisions relate to thefuture; so, only future costs can be relevant. In addition, thecost must differ from one alternative to another. If a future costis the same for more than one alternative, it has no effect on thedecision. Such a cost is an irrelevant cost.
Assume that Reeves Company is considering accepting a specialorder for $25 per unit when the normal selling price is $30 perunit. Reeves has enough excess capacity to make the order withoutdisplacing normal sales. The alternatives facing Reeves Company are(Select "Yes" for the statements that are applicable and "No" forthe items that do not apply):
Accept the special order. | - Select your answer -YesNoItem1 |
Reject the special order. | - Select your answer -YesNoItem2 |
Sell normal sales for $25 perunit. | - Select your answer -YesNoItem3 |
Choose which of the following are relevant in deciding whetheror not to accept the special order. (Select "Yes" for thestatements that are applicable and "No" for the items that do notapply)
$25 price. | - Select your answer -YesNoItem4 |
$30 normal price. | - Select your answer -YesNoItem5 |
Variable cost of making the unitsin the special order. | - Select your answer -YesNoItem6 |
Depreciation on factory equipmentused in making the special order units. | - Select your answer -YesNoItem7 |
Increased property taxes on thefactory building which are due while the special order would bemade. | - Select your answer -YesNoItem8 |
While cost and revenue information is important, otherinformation may be needed to make an informed decision. Thesenon-financial factors are termed qualitative and are often relevantin decision making. For example, in deciding whether to make acomponent in-house or purchase it from an outside supplier, thecompany may consider any difference in quality or in responsivenessto the company's production schedules.
Andretti Company has a single product called a Dak. The company normally produces and sells 78,000 Daks each year at a selling price of $50 per unit. The companyâs unit costs at this level of activity follow: |
Direct materials | $ | 16.00 | |
Direct labour | 10.50 | ||
Variable manufacturing overhead | 8.30 | ||
Fixed manufacturing overhead | 5.00 | $390,000 total | |
Variable selling expenses | 3.00 | ||
Fixed selling expenses | 3.50 | $273,000 total | |
Total cost per unit | $ | 46.30 | |
A number of questions relating to the production and sale of Daks follow. Consider each question separately. |
Required: |
1. | Assume that Andretti Company has sufficient capacity to produce 150,000 Daks every year without any increase in fixed manufacturing overhead costs. The company could increase its sales by 25% above the present 78,000 units each year if it were willing to increase the fixed selling expenses by $28,750. |
a. | Calculate the incremental net operating income. (Do not round intermediate calculations.) |
b. | Would the increased fixed expenses be justified? | ||||
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2. | Assume again that Andretti Company has sufficient capacity to produce 150,000 Daks every year. A customer in a foreign market wants to purchase 26,000 Daks. Import duties on the Daks would be $2.90 per unit, and costs for permits and licences would be $11,700. The only selling costs that would be associated with the order would be $5.00 per unit shipping cost. Compute the per-unit break-even price on this order. (Do not round intermediate calculations. Round your answer to 2 decimal places.) |
3. | The company has 1,600 Daks on hand that have some irregularities and are therefore considered to be seconds. Due to the irregularities, it will be impossible to sell these units at the normal price through regular distribution channels. What unit cost figure is relevant for setting a minimum selling price? (Round your answer to 2 decimal places.) |
4. | Due to a strike in its supplierâs plant, Andretti Company is unable to purchase more material for the production of Daks. The strike is expected to last for two months. Andretti Company has enough materials on hand to continue to operate at 30% of normal levels for the two-month period. As an alternative, Andretti could close its plant down entirely for the two months. If the plant were closed, fixed overhead costs would continue at 60% of their normal level during the two-month period; the fixed selling costs would be reduced by 20% while the plant was closed. What would be the dollar advantage or disadvantage of closing the plant for the two-month period? (Do not round intermediate calculations.) |
5. | An outside manufacturer has offered to produce Daks for Andretti Company and to ship them directly to Andrettiâs customers. If Andretti Company accepts this offer, the facilities that it uses to produce Daks would be idle; however, fixed overhead costs would be reduced by 75% of their present level. Since the outside manufacturer would pay all the costs of shipping, the variable selling costs would be only two-thirds of their present amount. Compute the unit cost figure relevant for comparison to whatever quoted price is received from the outside manufacturer. (Do not round intermediate calculations. Round your answer to 2 decimal places.) |
Cane Company manufactures two products called Alpha and Beta that sell for $215 and $160, respectively. Each product uses only one type of raw material that costs $7 per pound. The company has the capacity to annually produce 125,000 units of each product. Its unit costs for each product at this level of activity are given below: |
Alpha | Beta | |||||||
Direct materials | $ | 42 | $ | 21 | ||||
Direct labor | 35 | 28 | ||||||
Variable manufacturing overhead | 23 | 21 | ||||||
Traceable fixed manufacturing overhead | 31 | 34 | ||||||
Variable selling expenses | 28 | 24 | ||||||
Common fixed expenses | 31 | 26 | ||||||
Total cost per unit | $ | 190 | $ | 154 | ||||
The company considers its traceable fixed manufacturing overhead to be avoidable, whereas its common fixed expenses are deemed unavoidable and have been allocated to products based on sales dollars. |
PLEASE ANSWER THE FOLLOWING:
1. Assume that Cane expects to produce and sell 106,000 Betas during the current year. One of Caneâs sales representatives has found a new customer that is willing to buy 4,000 additional Betas for a price of $74 per unit. If Cane accepts the customerâs offer, how much will its profits increase or decrease?
2. Assume that Cane expects to produce and sell 111,000 Alphas during the current year. One of Cane's sales representatives has found a new customer that is willing to buy 26,000 additional Alphas for a price of $144 per unit. If Cane accepts the customerâs offer, it will decrease Alpha sales to regular customers by 12,000 units. Calculate the incremental net operating income if the order is accepted? (Loss amount should be indicated with a minus sign.)
3. Assume that Cane normally produces and sells 76,000 Betas and 96,000 Alphas per year. If Cane discontinues the Beta product line, its sales representatives could increase sales of Alpha by 16,000 units. If Cane discontinues the Beta product line, how much would profits increase or decrease?
4. Assume that Cane expects to produce and sell 71,000 Alphas during the current year. A supplier has offered to manufacture and deliver 71,000 Alphas to Cane for a price of $144 per unit. If Cane buys 71,000 units from the supplier instead of making those units, how much will profits increase or decrease?
5. Assume that Caneâs customers would buy a maximum of 96,000 units of Alpha and 76,000 units of Beta. Also assume that the companyâs raw material available for production is limited to 246,000 pounds. What is the maximum contribution margin Cane Company can earn given the limited quantity of raw materials?
6. Assume that Caneâs customers would buy a maximum of 96,000 units of Alpha and 76,000 units of Beta. Also assume that the companyâs raw material available for production is limited to 246,000 pounds. How many units of each product should Cane produce to maximize its profits?
7. How many pounds of raw material are needed to make one unit of Alpha and one unit of Beta? |