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Sociology
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SOC 25A/B
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Margaret Buckby
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Fall

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150 Cost Management Chapter 4 Relevant Information for Decision Making SOLUTIONS LEARNING OBJECTIVES Chapter 4 addresses the following questions: LO1 Identify and use relevant information in decision making. LO2 Analyze the quantitative and qualitative information used in keep and drop decisions. LO3 Analyze the quantitative and qualitative information used in outsourcing (make or buy) decisions. LO4 Analyze the quantitative and qualitative information used in special order decisions. LO5 Analyze the quantitative and qualitative information used in product emphasis and constrained resource decisions. LO6 Describe factors that affect the quality of operating decisions. These learning questions (Q1 through Q8) are cross-referenced in the textbook to individual exercises and problems. © 2012 John Wiley and Sons Canada, Ltd. 151 Cost Management QUESTIONS 4.1 Future costs are relevant only if they differ between the decision alternatives. 4.2 The confirmation bias is a tendency to seek and interpret information to affirm preconceptions. When faced with a special order decision, managers may have a preconceived idea about whether the order should be accepted or rejected. Then, the manager may put more weight on information that supports the preconceived viewpoint when interpreting financial and qualitative data. For example, managers who wish to accept a special order may place greater weight on future potential orders from the customer or place less weight on other customers’ reactions to a lower price for this customer. Managers who wish to reject a special order may tend to overestimate opportunity costs by assuming that regular business will fill capacity. 4.3 If variable cost plus 40% is greater than or equal to the contribution margin on products for which capacity is currently used, take the special order. If the contribution margin on current products is higher, do not take the special order. 4.4 Yes, it applies.The decision rule is to accept a special order as long as it covers at least the variable costs if it does not replace regular business. The pricing decision has to do with the fact that most relevant costs are fixed, rather than variable. Weekend internet specials for the airlines are similar. Hotels and restaurants in resort areas often reduce prices during the off-season. 4.5 Constraints can be relaxed a number of ways. If capacity is constrained, it can be expanded by purchasing new equipment, space, and hiring more labour. If there is a bottleneck, it can be relaxed by using it during all hours of operation, inspecting units before they go through the bottleneck to be certain only good units are processed by it, and by offloading demand to other machines or processes if possible. Material constraints are relaxed by changing the product design or by purchasing more materials. 4.6 Quantitative information is data that can be used in a mathematical analysis. Qualitative information is information that is not numerical, that is, it cannot be quantified easily. 4.7 Possible quantitative factors include the incremental cost of growing bedding plants and the cost to purchase the plants from someone else. Possible qualitative factors include: • Timeliness of delivery • Quality of bedding plants • Whether the bedding plants are appropriate for this climate • Whether Grover can get the quantities of plants needed • Whether there are other wholesale nurseries to purchase from if this relationship does not work well. © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 152 4.8 Business risks that affect the decision to outsource include quality and timeliness of delivery. If the supplier market is competitive, it may be easy to ensure high quality because the organization can switch vendors when quality drops. If only one or two vendors supply the product or service, it may be difficult to ensure high quality. Similar issues arise with ensuring timely deliveries of products or services that are outsourced. 4.9 Managers examine the contribution margin per product, or per constrained resource to determine the products that should be emphasized. If there are no constraints, then the product with the highest contribution margin should be emphasized. The products can be rank-ordered by contribution margin and emphasized in that order. If resources are limited and more than one constraint exists,a linear program can be used to determine the optimal sales mix if. If only one resource is constrained, the product with the highest contribution margin per unit of constraint should be emphasized. 4.10 Opportunity costs play an important role in make or buy decisions. When management decides to make the product internally, it may forego an opportunity to rent out the extra space that would be made available through outsourcing or the contribution margin from a different product that could be manufactured in that space. The potential rent payments or contribution margin are examples of opportunity costs for insourcing. The opportunity cost of outsourcing could be the ability to monitor product quality, which may be easier when products are produced internally. The opportunity cost of a “keep” decision is the contribution margin that could be realized from sales of alternative products. Finally, the opportunity cost of “drop” decision is the lost customer base for the product that is no longer produced by the company. 4.11 A special order decision for a retail clothing factory might be uniforms for a ball team. It’s likely that the order would not replace regular business, unless they routinely sell uniforms. Another short-term decision would be whether to keep or drop a particular line of clothing, such as a line of jeans with a special treatment to make them look worn after the popularity of this style of jeans wanes. Another short-term decision would be whether to outsource administrative functions, such as payroll, or factory functions, such as sewing certain garments. If resources are constrained, product emphasis decisions under constrained resources need to be made. If resources are not constrained, products need to be identified for emphasizing through advertising or promotions. 4.12 Business risk considerations for special orders include whether the order would replace regular business, whether there is ample capacity, whether other customers might learn about a special pricing arrangement and demand the same price, and whether the price is above the variable cost plus any relevant fixed costs. 4.13 Barring any potentially negative qualitative factors, discounted offers that benefit a company’s bottom line should be accepted. As long as the price covers relevant costs, management should consider making a sale. However, opportunity costs may need consideration. For example, in retail stores, items should not be sold at discount if they are limited in quantity and it is likely that nearly all of the items could be sold at the regular price. For manufacturers, capacity is an issue if the sale limits future sales of higher contribution products. In other cases, unless qualitative factors such as the © 2012 John Wiley and Sons Canada, Ltd. 153 Cost Management consequence of other customers learning of a discounted price outweigh the quantitative benefit obtained with extra sales, the discounted price should be accepted 4.14 Following is a list of potential customer support costs for software providers. Students may think of other costs. • Qualified representatives and equipment for telephone calls requesting support • Qualified representatives and website activity to support questions posted on the web or email questions requesting support • Cost of returns, replacements, and/or software updates for faulty disks or dissatisfied customers • Cost of analyzing and correcting bugs when security problems arise that are related to a single customer or group of customers • Cost of helping customers install and begin using new software programs • Cost of follow-up calls and visits to customers who were having problems with the software or to whom technical follow-up was promised 4.15 Here is a list of constraints for higher education. Similar constraints could be identified in many service industries. For example, the number of professors is a constraint at universities, while the number of nurses or accountants would be a constraint in hospitals or accounting firms. For higher education: • Physical constraints include number of classrooms available at peak load times • Could be relaxed by offering cheaper tuition when students take classes at off-peak times, by building more classrooms, or by increasing the size of each classroom • Number of professors available for the number of classes needed • Could be relaxed by hiring more professors, replacing professors with less expensive lecturers, or by increasing class size • Number of computer labs available to students • Could be relaxed by providing incentives for students to use the labs at off-peak hours, by building more labs, or by encouraging or requiring students to use laptops • Availability of the university’s internet and website services such as Blackboard or D2L • Could be relaxed by increasing the technological capabilities at the university or by outsourcing some of the services (e.g., using Google for webmail) • Availability of presentation technology and equipment in each classroom • Could be relaxed by purchasing mobile technology carts with personnel devoted to moving the carts between classrooms or by purchasing more technology for classrooms • Availability of health and mental health services for students • Could be relaxed by increasing services or outsourcing them • Adequate parking for students and faculty © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 154 • Could be relaxed by providing convenient and cheap public transportation in and around campus or by building more parking lots • Availability of dormitory housing for undergraduate and graduate students • Could be relaxed by outsourcing housing or building new dormitories © 2012 John Wiley and Sons Canada, Ltd. 155 Cost Management MULTIPLE CHOICE QUESTIONS 4.16. Which of the following statements is true? a) In a special order decision, additional fixed costs are irrelevant costs. b) In a keep-or-drop decision, allocated fixed costs are relevant costs. c) In a product emphasis decision due to constrained resources, the contribution margin per unit is irrelevant. d) In a make-or buy decision, opportunity cost is irrelevant. Ans: C 4.17. In a make-or-buy decision, which costs are usually irrelevant? a) Direct material costs b) Fixed costs that will not change regardless of the decision c) Variable sales and administrative costs d) Variable production costs Ans: B Use the following information to answer questions 4.18 – 4.20. A manufacturer of skating equipment has met all its production requirements for the current month and has the opportunity to produce additional skates with its excess capacity. There is sufficient demand for the additional production of any model of the product line. The selling prices and unit costs of the four models of skates are as follows: Junior Teen International Pro Selling price $ 75 $ 100 $ 140 $ 250 Direct materials 25 30 40 55 Direct labour 20 30 50 110 Variable overhead1 10 15 25 55 Fixed overhead2 26 26 30 60 1 2Applied on the basis of direct labour hours at the rate of $10 per hour Applied on the basis of machine hours at the rate of $30 per machine hour 4.18. If the manufacturer has excess machine capacity and can add as much labour as needed, which model should be manufactured with the excess production capacity? a) Junior b) Teen c) International d) Pro Ans: D Ignore Fixed Overhead. CM/unit = Junior $130; Teen $175; Inter’l $255, Pro $470 © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 156 4.19. If the manufacturer has excess machine capacity but limited labour hours, which model should be manufactured with the excess production capacity? a) Junior b) Teen c) International d) Pro Ans: A Ignore Fixed Overhead. CM/DL$ = Junior $6.50; Teen $5.83; Inter’l $5.10, Pro $4.27 4.20. If the manufacturer can add labour as needed but has limited machine capacity, which model should be manufactured with the excess production capacity? a) Junior b) Teen c) International d) Pro Ans: C Ignore Fixed Overhead. CM/MH = Junior $20/(26/30) = $23.26/MH; Teen $25/(26/30) = $28.83/MH; Inter’l $25/(30/30) = $25.00/MH, Pro $30/(60/30) = $15/MH © 2012 John Wiley and Sons Canada, Ltd. 157 Cost Management EXERCISES 4.21 Make or Buy, Qualitative Factors - Yoklic Corporation A. The relevant information for this problem includes the variable costs to make and the purchase price to buy. Cost to make ($4.00 + $30.00 + $15.00) $49 Cost to buy 55 Savings if decision is to make $ 6 Yoklic should make the subassembly because they save $6/unit. B. Yes, this new information changes the decision. The cost to make is increased by the amount of fixed costs that will be eliminated if the part is purchased, which is $10.00 ($50,000/5,000) per unit. Cost to make ($4.00 + $30.00 + $15.00 + $10) $59 Cost to buy 55 Savings if decision is to buy $ 4 C. Two qualitative factors would be very important for Yoklic. First, delivery times need to be reliable. Delivery delays can disrupt Yoklic’s ability to deliver products to its customers on a timely basis. In addition, quality is important. Yoklic needs to be assured that the quality will meet its needs. 4.22 Constrained Resource, Qualitative Factors - Johnson and Sons A. Constrained resource problem. The manager needs to decide whether or not to buy more juice from a neighbour. B. The general rule is that managers can pay what they pay now plus up to the entire contribution margin per constrained resource to relax a constraint. Therefore, the manager is willing to pay up to $3.00 ($2.50 contribution margin plus $0.50 variable cost). C. If the company can supply its total demand this year, it is likely to affect its demand next year. If it cannot fill orders this year, customers may find another supplier. D. Yes, quality is a concern. If the neighbour’s juice is lower quality, customers will be disappointed and may not come back. If the neighbour’s juice is much higher quality, customers may be disappointed later, and not come back. Customers may even seek out the true supplier of this higher quality juice. © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 158 E. The timeliness of delivery could be a factor, and the reliability of the supplier is important. 4.23 Cumulative Exercises (Chapter 3): CVP, Single Constrained Resource - Snowbird Snowboards [Note: This problem requires application of knowledge from Chapter 3.] A. It is first necessary to categorize costs and create a cost function: Fixed Variable Variable production $60,000 Fixed production $25,000 Variable selling and 10,000 administration Fixed selling and 35,000 administration Total $60,000 $70,000/500 boards = $140 each Selling price per snowboard = $150,000/500 = $300 CVP calculation in units: $30,000 = ($300 - $140)*Q - $60,000 $30,000 = $160*Q - $60,000 $160*Q = $90,000 Q = $90,000/$160 = 562.5 rounded to 563 snowboard B. Managers are willing to pay what they pay now ($85) plus up to the entire contribution margin ($160), or $245 to buy more snowboards. C. The incremental profit for 200 snowboards would be zero because the company has paid its entire contribution margin to buy additional snowboards. 4.24 Multiple Products, Multiple Resource Constraints, Sensitivity - Mrs. Meadows Target function: = $50*Chip Dip + $40*Soft Chunk Constraints: Mixing: 20*Chip Dip + 30*Soft Chunk <4,000 minutes Baking: 40*Chip Dip + 20*Soft Chunk<6,000 minutes Dipping: 15*Chip Dip < 2,000 minutes © 2012 John Wiley and Sons Canada, Ltd. 159 Cost Management The following reports are produced from Microsoft Excel Solver: A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). Answer Report Objective Cell (Max) Original Cell Name Value Final Value Target Cell: Contribution $B$8 Margin for Product Mix $8,250 $ 8,250 Variable Cells Original Integ Cell Name Value Final Value er Changing Cells: Chip Dip $B$5 Units 125.00 125.00 Contin Changing Cells: Soft $C$5 Chunk Units 50.00 50.00 Contin Constraints Cell Statu Slac Cell Name Value Formula s k $C$1 $C$11<=$D Bindin 1 Mixing Used 4,000 $11 g 0 $C$1 $C$12<=$D Bindin 2 Baking Used 6,000 $12 g 0 Not $C$1 $C$13<=$D Bindin 3 Dipping Used 1,875 $13 g 125 Sensitivity Report Variable Cells Reduce Final d Objective Allowable Allowable Valu Coefficien Cell Name e Cost t Increase Decrease Changing Cells: Chip Dip 23.3333333 $B$5 Units 125 0 50 30 3 Changing Cells: Soft $C$5 Chunk Units 50 0 40 35 15 Constraints Constrain Final Shadow t Allowable Allowable © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 160 Valu Cell Name e Price R.H. Side Increase Decrease $C$1 333.333333 1 Mixing Used 4000 0.75 4000 5000 3 $C$1 222.222222 3333.33333 2 Baking Used 6000 0.875 6000 2 3 $C$1 3 Dipping Used 1875 0 2000 1E+30 125 A. The optimal sales mix (from the answer report – final value under adjustable cells) is 125 batches of Chip Dip and 50 batches of Soft Chunk. B. Total contribution margin is $8,250 (answer report target function final value). C. From the sensitivity report, Mrs. Meadows would be willing to pay $0.75 per minute (the shadow price) for mixing and $0.875 per minute (the shadow price) for baking. D. From the answer report, mixing and baking are binding (under constraints – status). E. From the sensitivity report, the contribution margin for soft chunk could increase by $35 per batch to $75 ($40 +$35), and then the sales mix would change (see allowable increase of objective coefficient for soft). 4.25 Keep or Drop and Constrained Resource - King Salmon Sales A. This is a keep or drop decision, where the options are whether or not to produce salmon this year. Price is $8 per lb ($800,000/100,000) Variable costs per pound are $5.60 [($200,000 + $20,000 + $30,000 + $300,000 + $10,000)/100,000] So contribution margin is $2.40 per lb. At sales of 50,000 pounds, the contribution margin will be $2.4 x 50,000 = $120,000. Fixed costs consist of administration, or $150,000. If King Salmon can avoid the fixed costs by not producing, the company should not produce this year. However, if the fixed costs are unavoidable, then it should produce because the loss will be reduced from $150,000 to $30,000. B. This is a constrained resource problem, and the general rule is that managers are willing to pay what they pay now, plus up to the entire contribution margin. Right now they are paying $2.00 per pound for fish and the contribution margin is $2.40, so they are willing to pay up to $4.40 per pound for more fish. This assumes that demand does not change and that future supply prices will not be affected by this decision. © 2012 John Wiley and Sons Canada, Ltd. 161 Cost Management 4.26 Product Emphasis and Constrained Resource - Emily A. Contribution margins per hour HBM = ($49 – $5)*20 = $880 HBM2 = ($29 – $2.50)*30 = $795 HBM3 = ($29 – $2.50)*45 = $1,192.50 The development costs are sunk costs and are not included in the analysis. B. First sell HBM3, then HBM, and then HBM2. C. (Assume an 8 hour work day) First produce and sell 90 games of HBM3, which takes 2 hours (90 demand/45 per hour), then produce and sell HBM, which takes 6 hours (120 demand/20). There are no more hours left. Since the contribution margin per hour for HBM2 is $795/hour, Emily could spend up to $795 per hour for 4 more hours to fill the demand of HBM2 (120 demand/30). If Emily is unable to hire part-time help, she would still be able to pay $3,180 (4 x $795) for an eight hour day and let the worker do other things for four hours. 4.27 Multiple Products and Resource Constraints, Sensitivity Analysis - Wildlife Foods The following reports are produced from Microsoft Excel Solver: A spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). Answer report Objective Cell (Max) Origin al Cell Name Value Final Value $B$ Target Cell: Contribution $45,00 8 Margin for Product Mix 0 $45,000 Variable Cells Origin al Integ Cell Name Value Final Value er $B$ Changing Cells: Flight Fancy Conti 5 Units 10.00 15.00 n $C$ Changing Cells: Multi Grain Conti 5 Units 10.00 30.00 n © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 162 Constraints Cell Stat Slac Cell Name Value Formula us k $C$ $C$11<=$D Bindi 11 Mixing Used 6,000 $11 ng 0 $C$ $C$12<=$D Bindi 12 Sterilization Used 12,000 $12 ng 0 Not $C$ $C$13<=$D Bindi 300 13 Packaging Used 1,500 $13 ng 0 A. Produce 15 batches of Fancy Flight and 30 batches of Multigrain B. Mixing and sterilization are binding. C. Packaging and sterilization are binding (i.e., packaging becomes binding). The optimal mix changes to 45 batches of Fancy Flight and 10 batches of Multigrain. 4.28 Special Order - The Cone Head House A. This is a special order decision and the manager needs to set a price for the order.The manager’s options are to accept or reject the special order. B. The manager needs to know the variable cost and any relevant fixed costs. Specifically, the variable costs are $530 for ingredients for 1,000 cones and the special cover cost of $0.05 per cone. The rent and store attendant are fixed costs and will not change if the special order is accepted, so they are irrelevant costs. C. The minimum acceptable price is ($530/1,000) +$.05 = $0.58. D. By selling cones at the breakeven price, new customers may eat the ice cream and come into the store to buy. Brand recognition is increased. The employees are not busy otherwise. 4.29 Special Order, Qualitative Factors - Cute Cookies A. The minimum price is the variable cost plus any additional fixed costs incurred to produce the special order. Variable cost is $0.75 + $0.05 per container = $0.80 per brownie. B. Yes, the special order should be accepted. The brownies can be made when workers are not busy, so capacity is not a problem. CC may receive other orders in the future from parents of children at the school. Good publicity may result for the company. © 2012 John Wiley and Sons Canada, Ltd. 163 Cost Management C. If other customers find that they are paying a lot more than the school, they may ask for price reductions. If another special order came in that would be more profitable, but workers cannot fill the order, CC may regret having set the price at breakeven. 4.30 Outsourcing Computations, Business Risks - Saguaro Systems A. This is an insource or outsource (make or buy) problem. The manager can choose to make the speakers or buy them from a Mexican company. The variable costs of making the system and any avoidable fixed costs are relevant, as is the outside purchase price. B. Cost under each alternative is calculated below: Make Buy Purchase price $48.00 Variable costs: Direct materials $22.00 Direct labour 16.00 Variable overhead 2.00 Avoidable fixed cost ($260,000/25,000) 10.40 ______ Total $50.40 $48.00 Saguaro should buy because the units are $50.40-$48.00 = $2.40 less expensive. C. The managers will be indifferent at the volume where the cost in-house is the same as the cost of outsourcing: Total variable costs = $22 + $16 + $ 2 = $40 $40X + $260,000 = $48X $260,000 = $48X - $40X $8X = $260,000 X = $260,000/8 X = 32,500 systems D. Will the vendor be reliable in timeliness of deliver and quality? Will the vendor increase the price for the next batch? Will Saguaro find an alternative use for the production that brings in a contribution margin? Will Saguaro be able to discontinue the contract if sales fall? 4.31 Special Order Computations, Qualitative Factors - The Feed Barn A. This is a special order decision. The manager needs to price the order. The manager’s options are to accept or reject the special order. B. The variable cost of production and any incremental fixed costs associated with the order need to be determined. © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 164 C. Minimum price for Premium = $8/tonne x 1,000 tonnes + $2,000 = $10,000 for the order. D. Although the problem states that this sale will not affect domestic sales, it is uncertain whether that means sales volumes, prices, or both. Therefore, the manager needs to know whether domestic customers will know the price set for this sale. They may demand the same price. The manager needs to know whether there is enough capacity to produce this order without replacing regular business. The manager also needs to know whether this customer is part of Feed Barn’s regular business. 4.32 Cumulative Exercise (Chapter 3): Keep or Drop, Multiple Product Breakeven, Qualitative Factors - Horton and Associates [Note: This problem requires application of knowledge from Chapter 3.] A. The following solution assumes that labour is a fixed cost. The average contribution margin per unit is used below to solve for the breakeven, but the contribution margin ratio could also be used. Big Loser Winner Total Volume 1,000 4,000 5,000 Price per unit $95 $225 Variable cost per unit: Direct materials $40 $ 95 Variable overhead 5 15 Total per unit $45 $110 Product line fixed cost per unit: Direct labour $ 5 $25 Product line fixed 10 40 Total per unit $15 $65 Multiply Per Unit Amounts x Volume: Total revenue $95,000 $900,000 $995,000 Total variable cost 45,000 440,000 485,000 Contribution margin $50,000 $460,000 $510,000 Total Fixed Costs: Product-line fixed costs $15,000 $260,000 $275,000 Corporate fixed costs 125,000 Total fixed costs $400,000 © 2012 John Wiley and Sons Canada, Ltd. 165 Cost Management The overall corporate breakeven in revenues is: Total fixed costs/Contribution margin ratio = $400,000 /($510,000/$995,000) = $780,392 B. To calculate the breakeven in units for Loser, the first step is to calculate the avoidable fixed costs for the product line and the contribution margin per unit: Avoidable fixed costs: Product line fixed costs $15 * 1000 units $15,000 Corporate fixed costs $10 * 1000 units 10,000 Total $25,000 Price per unit $95 Total variable cost per unit (see Part A) 45 Contribution margin per unit $50 The breakeven point in units for Loser is calculated by dividing its avoidable fixed costs by its contribution margin per unit: $25,000/$50 = 500 units C. One potentially important qualitative factor is whether dropping one product would affect the sales of the other product. Another factor is employee morale if the company lays off personnel. A third factor is whether prices of inputs on any other products could change because the company reduces its purchase quantities, and any other potential responses from vendors. Students may think of other qualitative factors. 4.33 Product Emphasis and Keep or Drop, Product Breakeven, Relevant Information – Waterford Ginseng Growers A. The problem gives no information about resource constraints, so this solution assumes there are none. Therefore, managers should emphasize the product with the highest contribution margin: Emphasize Premium first (contribution margin = $800), then Royal (contribution margin = $720), and then Regular (contribution margin = $600). B. For Premium and Royal, contribution margin minus avoidable fixed costs is positive. For Regular, contribution margin minus avoidable fixed costs is negative $125, indicating that operating income would increase by $125 per 100 kg if this product were dropped. The operating income should increase to $85 if the Regular product line is dropped. If Regular is dropped, the following income statement results: © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 166 Revenue $4,000 Variable costs 2,480 Contribution margin 1,520 Product line fixed costs 1,160 360 Corporate fixed costs 275 Operating income $ 85 C. If the contribution margin from Regular would cover the avoidable fixed costs, they would be indifferent between keeping or dropping the Regular product line. The contribution margin is $6per kg($600 CM/100 kg). Solve for Q = the number of kgs at which the total contribution margin for the product equals avoidable fixed costs $6Q = $725 Q = $725/$6 Q = 121 kg D. Will dropping Regular affect the sales of any other products? Has there been a trend in sales (either decreasing or increasing) for Regular over time? What kinds of products and prices are competitors offering? Can some of the avoidable fixed costs be reduced so that the company can still carry the product? Can the selling price be raised? 4.34 Product Emphasis, Opportunity Cost, Special Order – Manley Company A. Since the constraint is the number of hours available on the processing machine we will choose to produce the product that generates the highest contribution margin per machine hour. Labour hours may be ignored since employees are paid equally to work on any of the three products. A B C Sales price per unit $80 $95 $70 Variable costs per unit 40 30 25 Contribution margin per unit $40 $65 $45 Processing hours per unit 2 3 2 Contribution margin per processing hour $20.00 $21.67 $22.50 The firm should first produce product C, which has the highest contribution margin per hour of capacity. The firm should next produce product B, which has the second-highest contribution margin per hour of capacity. © 2012 John Wiley and Sons Canada, Ltd. 167 Cost Management B. Assuming that sufficient capacity is available for Products B and C, additional capacity would allow the company to sell additional units of Product A. The company’s contribution margin per hour of capacity for Product A is $20 (calculated in Part A). Assuming that variable costs per unit would be unchanged, the company would be willing to pay up to the contribution margin per hour for additional capacity (i.e., up to $20 per hour). For 1,000 units, the total maximum amount the company would be willing to pay for additional capacity is: $20 per hour × 2 hours per unit × 1,000 units = $40,000 C. Each unit of Product D requires 1.5 hours of machine time. If production time is used for Product D and capacity exists for production of more than one product, time would be taken away from the production of Product B (the less valuable of the two products in Part A). For each unit of Product D produced, the firm would forego a contribution margin of 1.5 hours × $21.67 per hour = $32.51. Assuming that the selling price and variable cost for Product D are unchanged from the past, the contribution margin earned by producing product D = $40 selling price – $22 variable cost = $18 per unit. The opportunity cost for producing product D = $32.51 – $18.00 = $14.51 per unit. For the entire order of 500 units, the opportunity cost would be 500 units × $14.51 per unit = $7,255. (Note: Answers may vary slightly because of differences in rounding.) 4.35 Cumulative Exercise (Chapter 2): Two-Point Method, Multiple Products with Multiple Constraints -- Terrell Company [Note: This exercise requires application of knowledge from Chapter 2.] A. To determine the variable factory overhead cost per labour dollar, the two-point method is used as follows: (85,000 – 80,000) = $0.50 variable factory overhead per labour dollar (30,000 – 20,000) The contribution margins are: Alpha Beta Zeta Sales price $20.00 $25.00 $40.00 Variable costs Materials 4.00 12.00 10.00 Labour 5.00 7.00 15.00 Overhead ($0.50×Labour) 2.50 3.50 7.50 Contribution margin $ 8.50 $ 2.50 $ 7.50 © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 168 Target function equation is: = 8.5*Alpha+2.5*Beta+7.5*Zeta B. Machine requirements are: Alpha Beta Zeta Grinding hours 2.00 0.25 0.50 Polishing hours 0.50 1.00 2.00 The constraint equations are: Grinding Hours: 2*Alpha+.25*Beta +.5*Zeta<10,000 Polishing Hours: .5*Alpha+1*Beta+2*Zeta<8,000 C. The following report isproduced from Microsoft Excel Solver and indicates that the optimal sales mix is 4,267 units of Alpha and 2,934 units of Zeta. Answer Report D. When the contribution margin for Beta increases by $1.26 to $3.76, the contribution margin is just a little more than half of Zeta’s ($7.50/2 = $3.75). Therefore, the product mix changes so that only Beta is produced and no Zeta. © 2012 John Wiley and Sons Canada, Ltd. 169 Cost Management See the optimal solution from Solver below in the case where Beta’s contribution margin is increased by $1.26 to $3.76 per unit. Answer Report 4.36 Make or Buy, Alternative Cost Functions, Qualitative Factors – Fielder Company A. Find the indifference point, where the cost of purchasing is equal to the cost of making the part under each alternative. Alternative 1: $13Q = $12,000 + $9Q $13Q - $9Q = $12,000 $4Q = $12,000 Q = $12,000 / $4 Q = 3,000 units If more than 3,000 units are needed, it will cost less to make the units Alternative 2: $13Q = $20,000 + $7Q Q = 3,333 units If more than 3,333 units are needed, it will cost less to make the units B. Find the indifference point, where the cost of Alternative 1 is equal to the cost of Alternative 2. $12,000 + $9Q = $20,000 + $7Q $2Q = $8,000 Q = 4,000 units If more than 4,000 units are needed, Alternative 2 will cost less than Alternative 1 © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 170 Combining the results of calculations from Parts A and B: 1. For demand under 3,000 units, purchase the part 2. For demand between 3,000 and 4,000 units, adopt Alternative 1 3. For demand over 4,000 units, adopt Alternative 2 C. Based on the answer to Part B, we know that Alternative 1 will have the lowest cost and highest profit at 3,500 units. This answer can be proven by calculating the cost under each option: Purchase: $13 per unit × 3,500 units = $45,500 Alternative 1: $12,000 + $9 per unit × 3,500 units = $43,500 Alternative 2: $20,000 + $7 per unit × 3,500 units = $44,500 D. Examples of qualitative or risk factors are listed below. Students may think of others. • Whether quality of the part is easier to maintain through insourcing or outsourcing • Whether timely delivery to customers is more likely through insourcing or outsourcing • Quality and maintenance costs of the equipment purchased under Alternative 1 and Alternative 2 • Availability of qualified workers and/or training costs for the equipment under Alternative 1 and Alternative 2 4.37 Cost of Inventory Stock-Out -- Babe’s Bats The expected loss in contribution margin from being out of stock for an order of 25 bats: Cost to prepare backorder $ 1.50 Expected cost of rejection customer: Contribution margin per bat ($20–$12) $8 Times number of bats ×25 Total contribution margin $200 Times probability of rejection ×35% 70.00 Total expected loss $71.50 4.38 Cumulative Exercise (Chapter 2): Savings from Inventory Reduction -- Waldon Company [Note: This exercise requires application of knowledge from Chapter 2.] Incremental cost of carrying inventory consists of two costs: Variable warehousing costs and interest on borrowed funds. © 2012 John Wiley and Sons Canada, Ltd. 171 Cost Management Variable warehousing cost (two-point method) per dollar of inventory: __$845,000 – 320,000__ = $0.15 per dollar of inventory $4,500,000 – 1,000,000 Reduction in costs if inventory is reduced by $4,500,000 – $1,600,000 = $2,900,000: Warehousing costs ($2,900,000 × $0.15) $435,000 Interest ($2,900,000 × 12%) 348,000 Total savings $783,000 4.39 Keep or Drop, Customer Profitability, Qualitative Factors -- Ross and Jones CAs A. John Crow is the more profitable customer based on revenues less relevant costs: John Crow Mabel Farley Revenue (3 Hours×$140) $420 $300 Partner (2 Hours×$100) 200 (1 Hour×$100) 100 Staff (1 Hour×$20) 20 (6 Hours×$20) 120 Profit $200 $ 80 B. This question can be answered in two ways: Assuming staff and partner costs are fixed (and no capacity constraints): Ross and Jones would be indifferent if the fees received from each client are the same. Thus, the firm would be indifferent if Mabel was charged $420. Assuming staff and partner costs are variable (and no capacity constraints): Ross and Jones would be indifferent if the contribution margins were the same. Thus, the firm would be indifferent if the profit for Mabel was $200 instead of $80, or $120 higher. The fee would be $300 + $120 = $420. C. In a small town there may not be anyone else to do Mabel’s taxes, and dropping Mabel could cause other customers to drive to another town with Mabel and take their tax work, too. If the partners raise Mabel’s fee and she feels this is an unfair increase, this may also affect other clients because the town is small and word of mouth can affect future business. Students may think of other qualitative factors. 4.40 Outsourcing, Qualitative Factors, Strategic Priorities – S-Mart and Galatea A. Here is one possible ranking from the viewpoint of each company. © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 172 S-Mart Galatea _8_ _5_ Reasonable worker conditions and labour standards _7_ _6_ Low worker turnover _6_ _1_ Precise quality standards _5_ _7_ Short transportation time (nearby physical location) _1_ _9_ Lowest price _2_ _3_ On-time delivery _4_ _4_ Ability to satisfy rush orders _9_ _2_ Compliance with intellectual property rights _3_ _8_ Sufficient capacity for the customer’s entire clothing manufacturing needs Students may rank items differently; however, their answers should recognize that S- Mart emphasizes low price and high inventory turnover, while Galatea emphasizes quality and customer relationships. The goal of this exercise is to encourage students to consider differences across companies in the qualitative factors that are likely to influence decisions. B. Assuming that S-Mart is competing on the basis of low prices, convenience, and wide selection, the most important aspect for an outsourcing relationship would be low price. Volume of sales is important, so the characteristics that relate to delivering as many goods as needed in a timely manner would be next most important. A particular level of quality would be ranked after these and the remaining characteristics are not as important. Assuming that Galatea competes primarily on fashion design and quality, in addition to developing customer relations, then quality and design would be most important. Delivery timeliness and ability to satisfy a rush order may also be important. Customers of the boutique may care about worker conditions and labour standards, so these factors may rank higher for the boutique. © 2012 John Wiley and Sons Canada, Ltd. 173 Cost Management PROBLEMS 4.41 Special Order Capacity Constraint, Relevant Information, Qualitative Factors - Rightway Printers A. This is a special order problem with a capacity constraint. The manager chooses whether to take the special order or not, but capacity limits will be exceeded if the order is taken. B. Relevant information for the decision includes the variable cost, the contribution margin, and the selling price for regular business. The problem does not provide the selling price per book for regular business. Additional information that would be needed includes relevant qualitative factors. C. The manager can pay up to $1.50 per book, plus the amount of variable cost that is related to capacity, to relax the constraint. D. Capacity makes a difference in the minimum price that can be set. If Rightway is close to capacity limits, it would replace regular business with the special order and need to price the order the same as regular business that it would forego to take the order. In this problem, 5% of capacity would be used for regular business, and 5% would be excess capacity. So, the special order would need to be priced high enough to replace the lost contribution margin of the 5% of regular business. E. Usually when operations get close to capacity limits, costs go up. Bottlenecks are more common, there may be congestion in the plant, and production could slow down. These costs need to be considered when setting a price for a special order that will move an organization out of its normal operating range (relevant range). In addition, managers need to think about whether the business will lose some customers because demand cannot be filled. 4.42 Make or Buy, Qualitative Factors - The Vernom Corporation A. The firm should make the tubes because the estimated cost to manufacture the tubes is less than the cost to purchase them: Cost to purchase tubes ($1.80 * 100,000) $180,000 Avoidable costs to manufacture tubes: Direct labour (10% * $4 * 100,000) $ 40,000 Direct material (20% * $6 * 100,000) 120,000 a Variable overhead (10% * $1.00 * 100,000) 10,000 Total avoidable cost $170,000 a Total overhead is projected at $300,000 ($3 x 100,000 boxes), of which $200,000 is fixed. Therefore, variable overhead must be $100,000, or $1.00 per box. © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 174 B. $170,000/100,000 = $1.70 is the price at which the firm would be indifferent between making and buying the tubes. C. The company should purchase the tubes during the first year because the avoidable cost for that option is lower: Total cost to purchase ($1.80 * 125,000) $225,000 Avoidable cost to manufacture: Variable manufacturing cost ($1.70 * 125,000) $212,500 Equipment rental 20,000 Total $232,500 D. The company should make 100,000 tubes and purchase 25,000, based on the following cost comparison: Cost to make 100,000 and purchase 25,000: Manufacture 100,000 [email protected] $1.70 $170,000 Purchase 25,000 tubes at $1.80 45,000 For a total cost of $215,000 Cost to purchase 125,000 (from part C) $225,000 E. Control over quality of the tubes, convenient delivery schedules, and control over future price increases would be factors that favour insourcing. 4.43 Special Order, Capacity Constraint, Relevant Information – Yoshi Co. A. PS1 PS2 PS3 Sales $360 $540 $480 Variable Cost 240 360 340 Contribution Margin $120 $180 $140 Hours 6 12 8 CM/Hr $20.00 $15.00 $17.50 Ranking 1 3 2 PS1 should be produced first, then PS3, if there are any hours available, then PS2. B. Capacity 90,000 Total Hours Required: PS1: 4,800 x 6 hrs = 28,800 PS2: 3,200 x 12 hrs = 38,400 PS3: 4,200 x 8 hrs = 33,600 100,800 © 2012 John Wiley and Sons Canada, Ltd. 175 Cost Management Exceed Capacity: (10,800) PS2 is the lowest priority, so we should reduce PS2. Each PS2 takes 12 hours to make, so Yoshi should reduce PS2 by 900 units (10,800 ÷ 12 = 900) Each PS2 produces $180 contribution margin. Yoshi will be willing to give up its contribution to acquire additional hours: $162,000 ($180 x 900) C. Special order from Chiyo Co: Sales $435 Variable Cost 305 Contribution Margin $130 x 4,800 $624,000 Incremental Fixed Costs (62,000) Incremental Operating Income $562,000 Opportunity Cost: Loss of Sales in PS3 ($480) Cost Savings: Variable Cost 340 Contribution Margin Loss ($140) x 4,200 ($588,000) Avoidable Fixed Costs: 52,500 Total Opportunity Costs: (535,500) Net Benefit (Cost) of Accepting $26,500 the Order Yoshi should accept the special order. D. Total hours required to make 4,800 of simplified PS3 are 33,600 hours (4,800 x 7 hours), which is the same as the total hours required to make 4,200 of regular PS3 (4,200 x 8 hours). Therefore, there is no impact on the production of PS1 or PS2. 4.44 Special Order Computations and Decision –JacksonWhitecrow A. 1. Incremental cost: Materials ($2.00 * 5,000) $10,000 Labour ($3.60 * 5,000) 18,000 Special device 2,000 Total $30,000 © 2012 John Wiley and Sons Canada, Ltd. Chapter 4: Relevant Information for Decision Making 176 2. Full cost: Incremental costs, from above $30,000 a + 1/2 of standard unit's allocated costs Rent $500 Heat and Light 50 550 Total $30,550 a Amortization on the equipment used for standard sales is not included on the assumption that the equipment is used only to produce the standard sales product. There is insufficient information to estimate the amount of power and "other" costs which would be required by the new units. Therefore full cost is inexact and could be misleading if used. 3. Contribution margin on standard units: Sales $25,000 Variable costs: Material $8,000 Labour 9,000 Power 400 Other 900 18,300 Contribution margin on standard sales $ 6,700 Opportunity cost of the special order is $6,700/2 = $3,350 for the lost contribution margin from foregone standard unit sales. 4. Relative to the order, amortization on the equipment for the standard sales is a sunk cost. Rent and the fixed portion of heat and light would also be sunk costs. B. Differential revenue ($7 * 5,000) $35,000 Differential costs (A.1) (30,000) Opportunity costs (A.3) (3,350) Differential income $ 1,650 The firm will be approximately $1,650 better off by accepting the order (this is somewhat overstated because variable power or "other" costs have not been included in the total cost to produce the special order). 4.45 Foreign versus Domestic Production and Comparative Advantage – Scott Mills A. This is a keep or drop problem. Based only on quantitative factors, the company should produce at the facility having the lowest cost. Because the company’s managers could choose to produce different products at different facilities, quantitative calculations are performed separately for each product. The variable costs to produce and deliver each of © 2012 John Wiley and Sons Canada, Ltd. 177 Cost Management the products to the firm's distribution center from each plant are as follows. Note: Because employees operate the machines, this solution assumes that machine hours = labour hours. Domestic Foreign Sweatshirts: Materials ($1.52 x 1 kg) $1.52 ($1.60 x 1 kg) $1.60 Labour ($16.40 x 6/60 min) 1.64 ($0.70 x 1/5 hr) 0.14 Var. overhead ($4 x 6/60 min) 0.40 ($1 x 1/5 hr) 0.20 Shipping ($0.10 x 1 kg) 0.10 ($1.80 x 1 kg) 1.80 Total $3.66 $3.74 Dress Shirts: Materials ($1.52 x 1/4 kg) $0.380 ($1.60 x 1/4 kg) $0.4000 Labour ($16.40 x 15/60 min) 4.100 ($0.70 x 1/3 hr) 0.2333 Var. overhead ($4 x 15/60 min) 1.000 ($1 x 1/3 hr) 0.3333 Shipping ($0.10 x 1/4 kg) 0.025 ($1.80 x 1/4 kg) 0.4500 Total $5.505 $1.4166
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