CHAPTER 5 Prepared by: Kristofferson G.

Gonzales CPA Xavier University-Ateneo de Cagayan SHORT-TERM DECISIONS AND ACCOUNTING INFORMATION

5-1

"Where Do You Start?"

The question emphasizes the need for decision makers to know the starting place, the circumstances from which they begin. If a person already has a car and is planning a trip to the vicinity of Monroe, the incremental costs of giving a ride to the advertiser are for the extra mileage to go to that specific town (e.g., tolls, additional gasoline, possibly an extra meal) instead of going straight home. If a person has a car but isn't planning a trip to the Monroe area, the incremental costs of giving a ride are the incremental costs of the trip (all gasoline, tolls, meals, perhaps motels). And if a person doesn't already have a car, the incremental costs of giving a ride to the advertiser include the cost of buying a car and obtaining insurance and a license, plus the costs listed in the two alternatives above. Thus, the advertiser made a serious error in the wording of the offer. Note to the Instructor: This question can be used to begin discussion of decision making. After establishing the idea of incremental costs, you can cover the concept of joint costs (and allocations thereof) by directing attention to those costs that would not change with the extra passenger. The question can be used to cover the same general concepts in an executive development program by turning the situation into one of carpooling rather than one of student ride-sharing. 5-2 Unit Costs The $52 is $1,800/50 plus $16. The $34 is $1,800/100 + $16.

The analysis is unsound because the incremental cost of playing a round is $16. The $1,800 dues are sunk and should not affect decisions whether to play an additional round. The dues, and a per-round computation of cost, are appropriate in deciding whether to continue as a member of the club or to seek an alternative place to play golf. The average cost is irrelevant to deciding whether to play a single round. Note to the Instructor: So as not to lead students to consider the dues-per-round calculations, we didn't ask whether the dues would ever be relevant. If the person is deciding whether to remain a member of the club, dues are relevant. The point to be made with this assignment is that whether a cost is relevant depends on the particular decision to be made.

5-1

5-3

The Generous Management

Paper, printers' labor, and ink might be expected to be variable costs, giving a total variable cost per paper of $1.20. The two other costs mentioned, salaries for editorial employees and other operating expenses, are likely to be composed of primarily fixed elements. From Chapter 2, it is known that the per-unit cost amounts for those two items must be based on some particular level of output (quantity of papers produced). If there were no other considerations, and if the per-unit fixed costs were based on current circulation quantities, it might be said that the subscriber was getting the paper at less than total cost per unit. Were circulation higher than at present, of course, the per-unit cost would decrease. The analysis in the newspaper's advertisement ignores the revenues derived from advertisers. That is, the advertisement implies that the only revenues available to cover the listed costs are the revenues from sales of the paper. Advertising accounts for a substantial portion of total newspaper revenues. Moreover, the cost per paper includes the costs of printing the advertising in that paper. In effect, the situation is one of joint revenues, and the costs of the newspaper are joint to the two types of revenue-producing aspects of the paper, advertising and distribution and sale. The management of the newspaper is not being generous at all. For most newspapers, revenues from advertisers exceed revenues from subscribers. 5-4 Short-term Pricing Policy The airline would gain by accepting your offer because the incremental profit from accepting is the entire $50 fare. But this is so only because the carrier is committed to making the flight. The airline knows, however, that a consequence of accepting your offer is that other potential passengers would be encouraged to follow your example. The implications of large numbers of customers following that example are many, and only a few are listed here. For example, any stated rate structure becomes irrelevant as potential passengers spurn reservation systems with the intention of negotiating fares just before departure. Further, customer dissatisfaction would increase because of delayed departures (while airline personnel negotiated with passengers about rates) and because of late flight cancellations or the inability to accommodate potential passengers who showed up with the intention of negotiating their fares. Note to the Instructor: Like question 5-1, this question makes the point that a company is always in some position before it faces a decision. The special order decisions discussed in this chapter assume the company has already planned for the period, much as the airline has already committed to make this flight. Just as a company considering a special order must consider the effect of accepting the order on the actions of regular or potential customers, the airline must evaluate the impact of accepting the immediately profitable offer on the actions of its potential customers. Another point that merits discussion is the time-period aspect of committed fixed costs. Although the text usually identifies fixed costs with a time period, that need not be the case. For example, an airline has some costs that are fixed per period and some that are fixed per flight.

5-2

5-5 Economic and Qualitative Factors The trustees are responsible for the church's property, reputation, and finances, so many factors, monetary and nonmonetary, are relevant to their decision. If their only objective in sponsoring the dances is to generate revenue to offset costs of the facilities, incremental revenues and costs are important. Monetary issues are far less important if the trustees are trying to increase interest in the church among young people and/or to provide an organized and supervised activity for youth. In either case, the trustees must act responsibly with the church's money, but their decision should not ignore the value of achieving nonmonetary objectives. Revenues most relevant are admissions fees and perhaps receipts from sales of snacks and beverages. Incremental costs include increases in utilities during the additional hours the facility is open, cleaning services, and costs related to the entertainment. Decorating costs are also relevant. The church might engage a band, or a disk jockey. The church might also use volunteers for cleaning or music. The availability of adults for supervision and oversight is important for success. If the church now has an active youth group, its members might perform many of the required tasks. In all likelihood, dances will go much better if the youth do much of the work. 5-6 Theory of Constraints

You must elevate the constraint by making sure that the person is helped at all times and does not become a bottleneck. Whenever the person starts to fall behind, others should help him until the flow is back to normal. You must concentrate on keeping that person's flow up and not be concerned with others, until their flows begin to constrain. 5-7 Special Order (5 minutes)

Accepting the order increases expected profit by $70,800, as shown below. Additional contribution margin, 25,000 x ($14 - $11) Additional packing costs Incremental profit on the order $75,000 4,200 $70,800

You might ask students about the possibility of leakage of regular sales that might accompany accepting the special order. You might also ask whether the company should accept the order if profit were $3,000 or so. Some students will say that any additional profit is good, but accepting business with low margins is potentially troublesome. First, the numbers are estimates. Unit variable manufacturing costs could turn out to be higher than now expected. Second, ABC tells us that some indirect costs are likely to rise if we increase activities. While such costs might not increase if we accepted a single order, making acceptance a habit could well result in significant increases in indirect costs. Finally, why bother turning out more product for minimal increases in profit? If $3,000 or so is significant to the company, then go ahead, but if not, why go through the effort especially in view of the first two objections? 5-8 Joint Products (10 minutes)

Byxral and Frazinine should be processed further, and Dyzaline should be

5-3

sold at the split-off point. Selling price after processing Selling price before processing Incremental revenue from processing Incremental cost of processing Incremental profit (loss) from processing 5-9 Joint Products (Extension of 5-8) Byxral $24 10 14 10 $ 4 Dyzaline $18 10 8 12 ($4) Frazinine $8 0 8 2 $6

(20 minutes)

1. Frazinine should be processed further; Byxral should now be sold at split-off, and Dyzaline should still be sold at split-off. Analyzing Dyzaline is unnecessary because if it was unwise to process Dyzaline further when there were no fixed costs of such processing, such costs simply increase the disadvantage of further processing. Below is an analysis for Byxral and Frazinine. Byxral Frazinine 100-gallon batches per period (120,000/100) times gallons of product from each batch (given) Gallons of product per period Times, per-gallon incremental contribution margin from additional processing (from 5-8) Total incremental contribution margin from additional processing Less, avoidable costs of further processing (given) Incremental profit (loss) from further processing 2. 1,200 40 48,000 $4 $192,000 196,000 ( $4,000) 1,200 50 60,000 $6 $360,000 34,000 $326,000

Total monthly profit is $808,000 as computed below. Revenues: Byxral, 48,000 x $10 Dyzaline, 10 x 1,200 x $10 Frazinine, 60,000 x $8 Total revenues Variable costs (costs of processing Frazinine, at $2 per gallon for 60,000 gallons) Contribution margin Fixed costs: Avoidable costs of further processing Frazinine $34,000 Unavoidable costs of all further processing $50,000 + $60,000 + $8,000 118,000 Expected profit ignoring costs of joint process Dropping a Segment (15 minutes)

$480,000 120,000 480,000 1,080,000 120,000 960,000

152,000 $808,000

5-10

1. $70,000. The company loses $40,000 contribution margin from hats ($90,000 - $50,000) and saves nothing in fixed costs. An income statement, in thousands, shows

5-4

Sales Variable costs Contribution margin Fixed costs Income

Shirts $110 30 $ 80

Jeans $350 160 $190

Total $460 190 270 200 $ 70

This income statement avoids the allocation of common fixed costs and so presents the picture more clearly. 2. $95,000, the $70,000 from requirement 1 plus the $25,000 saved fixed costs. Note to the Instructor: You might wish to review the several reasons why fixed costs could fall if a segment were eliminated. The text states that the fixed costs are allocated to the segments and that they are unavoidable. However, in requirement 2, we changed the conditions. As early as Chapter 2 we pointed out that fixed costs are not fixed in the sense that they cannot change in total. Rather, they are fixed in total within the relevant range, and given the company's plans for discretionary spending. Dropping the entire hat segment could put the company in a different relevant range. For instance, if the company now has four employees whose work is common to the three segments, dropping an entire segment might allow restructuring duties so as to eliminate one person. The situation in requirement 2 could also come about if some of the allocated costs are in fact direct. The original product-line income statement could well have been prepared as described, with total fixed costs allocated based on floor space even if some are direct and avoidable. This case is more likely if the product lines are not so related as they are in this assignment. For instance, an appliance dealer might decide to stop selling washers and dryers, while still carrying television sets, stereos, CD players, and other electronic products. At a minimum, such a retailer would avoid the cost of separate listings in the Yellow Pages, possibly separate advertisements in local newspapers, and maybe some costs of the service department. 3. $68,000. From the $95,000 in requirement 2 we subtract $27,000 in contribution margin lost from the other two lines. Lost contribution margin from: Shirts $80,000 x .10 Jeans $190,000 x .10 Total lost contribution margin $ 8,000 19,000 $27,000

Note to the Instructor: To expand the discussion, you might ask what sorts of product-line mixes would be most logical in requirement 2 and in requirement 3. That is, what types would not have, or would have, complementary effects, as illustrated in the chapter? Some students will recall the substitution principle and will comment on that. The discussion here should be open-ended and comments will reflect the perceptions of individual students. The important point is that students should get into the habit of being alert when evaluating decisions that could include unintended effects. That is, it's not far-fetched that someone would advocate closing a department without thinking of possible adverse effects on other departments. 5-11 Capacity Constraint (15 minutes)

5-5

1.

Trekker because they have the highest contribution margin per unit.

2. Walkers are the most profitable product, producing $140 contribution margin per hour, $28,000 contribution per month. The relative profitabilities per machine-hour and in total for the three products are as follows: Contribution margin per unit Number made in one hour* Contribution margin per hour Hours available Total monthly contribution Walker 14 10 $ 140 200 $28,000 $ Runner 18 6 $ 108 200 $21,600 $ Trekker $ 28 4 $ 112 200 $22,400

* 60 minutes divided by machine time required Note to the Instructor: Many students will determine the total contribution for all products, as we did above. Students should be reminded that knowing the total time available is not necessary for determining the relative profitabilities. It is enough to know that there is some constraint on capacity and that all output can be sold. 3. The selling price of Trekkers, the second most profitable product per machine hour, must rise $7.00 (to $63.00) to be as profitable as Walkers. Hourly contribution margin of Walkers Divided by number of Trekkers per hour Required unit contribution margin of Trekkers Plus variable cost per Trekker Required price 5-12 Make or Buy (5 minutes) The variable costs to produce the part are $ 9.00 10.00 9.00 $28.00 $140.00 4 $ 35.00 28.00 $ 63.00

Fairbo should make the part. Materials Direct labor Variable overhead Total variable cost per unit

Another approach is simply to subtract the $13.00 per unit cost of fixed overhead from the $41.00 total cost per unit given in the problem. However one arrives at the $28 per unit, it's clear that internal production cost of $28 is $4 less than the $32 outside purchase cost. With a volume of 20,000 units, the total savings from making rather than purchasing the part is $80,000. 5-13 Special Order (15 minutes)

1. Hi-Flight should accept the order. The company has enough capacity to make the balls and the incremental revenue exceeds the incremental costs.

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Revenue from sale (80,000 x $9) Variable costs (80,000 x $ 6) Incremental profit

$720,000 480,000 $240,000

2. The answer might or might not change. The factor to consider is whether regular sales would be lost if people knew they could buy the balls at $16 instead of $21 per dozen. The maximum loss might be 80,000 dozen balls, the number that the chain could sell. In that case, the company would lose $400,000 by accepting the offer. Decline in regular sales Contribution margin per dozen, $14 - $6 Lost contribution margin Gain from requirement 1 Loss 80,000 $ 8 $640,000 240,000 $400,000

More simply, if the company lost the whole 80,000 dozen, it would have traded sales at $14 for sales at $9, losing $5 per dozen. The lost sales might even be greater if the availability of the product at a lower price through the chain created ill will with regular customers. Note to the Instructor: This early exercise raises the opportunity to reinforce the importance of estimating the effects of special orders on sales at regular prices. It can also be used to introduce the general idea of determining the maximum number of regular sales that could be lost for the order to be unacceptable. In this situation, Gain from order Divided by contribution margin per unit, regular sales Allowable lost regular sales 5-14 1. TOC (15 minutes) $240,000 $ 8 30,000 dozen

Sandy should produce 100 more units of product C. Time to produce one unit = labor charge / labor rate A: $2/$8 = .25 hours B: $4/$8 = .5 hours C: $8/$8 = 1 hour Time used for current production: A: .25 10,000 units = 2,500 B: .5 4,000 units = 2,000 C: 1 2,000 units = 2,000 Total time used 6,500 Time available is 7,000 total hours 6,500 hours used = 500 hours Contribution margins A Selling price $20 Materials (8) Labor (2) Variable overhead (2) Variable selling (3) Contribution margin$ 5 B $30 (7) (4) (4) (3) $12 C $50 (10) (8) (8) (5) $19

Since time is not a constraint, profits will be maximized by choosing the product with the highest contribution margin per unit.

5-7

2.

10,000 product A, 4,000 product B, and 1,500 product C

Since current demand will require 6,500 hours, time is a constraint. Sandy should choose the products with the largest contribution margin per hour. A: $5/.25 = $20 / hour B: $12/.5 = $24 / hour C: $19/1 = $19 / hour Produce B first, followed in order by A and C Available hours Product B: 4,000 units .5 = Remaining time Product A: 10,000 units .25 = Remaining time Product C: 1,500 hours 1 = 1,500 units 1 = 5-15 1. Short-Term Decisions (15-20 minutes) 6,000 2,000 4,000 2,500 1,500 1,500 0

$280, an increase of $20. The quickest way is to work with changes. Increase in contribution margin of product A ($250 x 0.30) $75 Decrease in contribution margin of product B ($300 x 0.05) 15 Net increase in contribution margin $60 Less additional fixed costs 40 Increase in income $20

Using totals produces the same answer. Sales Variable costs Contribution margin Fixed costs ($290 + $40) Income * $450 x 1.30 **$400 x 0.95 The income statement doesn't show fixed costs for either product; it shows them only in total. It is plausible to use the old allocated fixed costs plus the $40 for product A, but that isn't necessary to find the new income. 2. About 11.7% ($35/$300). The increase in income just from the change in product A's sales is $35 ($75 increased contribution margin less $40 increased fixed costs). This increase divided by the $300 current contribution margin of product A gives the allowable reduction. Product A $585* 260 $325 Product B $380 95 $285 Total $965 355 610 330 $280

5-8

3.

$620 Contribution margin from product A Increase in fixed costs Required contribution margin from product C Divided by contribution margin percentage for product C Equals required sales from product C $250 60 $310 50% $620

Using the totals, Required income Total fixed costs ($290 + $60) Required contribution margin Less contribution margin from product B Contribution margin required from product C Divided by contribution margin percentage Equals required sales from product C 5-16 Product-Line Emphasis (5-10 minutes) $260 350 610 300 $310 50% $620

1. Porter should concentrate on Local Area Connectors (LACs). Their contribution margin is 70% ($3,780/$5,400) while Internet Connectors (ICs) have a margin of 50% ($3,300/$6,600). Increasing sales of LACs by $1 million increases contribution margin by $700 thousand while the loss of contribution margin from the loss of $1 million sales of ICs is only $500 thousand. LACs have a much lower percentage of product margin to sales than do ICs, which might catch some students who struggle with cost behavior. The lower total product margin is relevant for the next requirement . 2. Porter should drop LACs in favor of the new product. Although LACs have a higher contribution margin percentage, their contribution to covering common fixed costs is, because of its relatively high direct, avoidable fixed costs, lower than that for ICs. Note to the Instructor: This exercise reinforces the point that different data are relevant for different decisions. In requirement 1, neither type of fixed cost was relevant because there was no change in either type as long as the company continued selling both products. In requirement 2, however, fixed costs become relevant because they will change (in this case, be avoided altogether) if the entire product line were dropped. 5-17 Special Order for Service Firm (5 minutes)

So long as Burns and Cross cannot profitably employ the staff, there is no incremental cost associated with the audit. The monthly salaries are irrelevant because the firm will pay them regardless. The firm should accept the offer. This situation is quite common for CPAs and some will even do slack-time audits gratis for charitable or other not-for-profit organizations.

5-9

5-18

Joint Products

(15-20 minutes)

1. Sell M and O at split-off. The company would probably find it better to sell O at split-off simply to avoid the extra work and the likely effects on indirect costs of doing more work. M N O P Sales value, further processed $450 $140 $45 $20 Sales value, split-off 120 40 35 0 Incremental revenue 330 100 10 20 Additional processing costs 360 70 10 15 Gain (loss) on added processing ($ 30) $ 30 $ 0 $ 5 2. $120 M $120 0 $120 N $140 70 $ 70 O $35 0 $35 P $20 15 $ 5 Total $315 85 230 110 $120

Sales Additional processing costs Margin Joint costs Profit

5-19 1.

Dropping a ProductComplementary Effects $280,000.

(15-20 minutes)

The quickest analysis is (in thousands of dollars) ($200) 240 40 240 $280

Lost contribution margin Saved fixed costs Gain from dropping lotion Current income Income if lotion dropped

Alternatively, working with the totals of the remaining products, Contribution margin Avoidable fixed costs Segment margin Joint fixed costs Income 2. $80,000 Lost contribution margin: Lotion Blades (20% x $720) Cream (10% x $560) Total lost contribution margin Saved fixed costs, lotion Net loss from dropping lotion Current income Income if lotion dropped ($200) (144) (56) ($400) 240 (160) 240 $ 80 After-Shave $720 300 $420 Cream $560 140 $420 Total $1,280 440 840 560 $280

Note to the Instructor: This exercise illustrates the concept of complementary effects. By themselves, lotion is unprofitable; but it should be continued in the line because of its effects on the sales of the other products. 5-20 TOC (10-15 minutes)

5-10

1.

Maple Grove should acquire the equipment. $320,000 (140,000) $180,000

Increased contribution margin, 40,000 x $8 Increased costs Increased profit

2. Maple Grove should not acquire the equipment because it cannot sell the additional output. 5-21 Quality Costs and TOC (15 minutes)

1. No, because the savings are about $21,000 ($30,000 x 70% reduction in scrap), for an expenditure of $25,000. 2. Yes, because the increased contribution margin is about $42,000 ($60,000 x 70%). This assignment gets to a fundamental difference between TOC and most other approaches to continuous improvement. TOC pays attention to constraints, virtually ignoring non-constraining resources. Someone of the qualityis free school would probably opt to make the change even though it appeared not to be cost-effective because of the expectation of increased benefits other than those indicated. Of course, it is also reasonable to extend the search for scrap-reducing steps that might be more effective. 5-22 Inventory Values (15-20 minutes)

1. The relevant cost is $1,530, which is the $5.10 per pound selling price times 300 pounds. Stout should accept the order. Incremental Incremental Opportunity Incremental revenue costs cost of xyrex profit $2,600 $ 900 1,530 2,430 $ 170

2. The relevant cost is now $1,830, which is the $6.10 replacement cost times the 300 pounds, and Stout should not accept the order. Incremental Incremental Opportunity Incremental revenue costs cost of xyrex profit (loss) $2,600 $ 900 1,830 2,730 ($ 130)

The $7.50 per pound purchase price is irrelevant under either situation because it is sunk. Note to the Instructor: Though this exercise is straightforward and emphasizes the idea of relevant costs, invariably some students have trouble with it because they do not want to ignore the historical cost of the on-hand xyrex. You might wish to use the following comparison that includes the historical cost in an analysis for requirement 1, where the choice is between selling the xyrex and accepting the order: Revenue [$2,600, ($5.10 x 300)] Incremental cost Cost of xyrex ($7.50 x 300) Loss Accept Order $2,600 $ 900 2,250 3,150 ($ 550) Reject Order $1,530 2,250 ($ 720)

5-11

The $170 difference is the incremental profit computed in requirement 1. 5-23 1. Make or Buy No. (15-20 minutes) Make 0 40,000 90,000 80,000 50,000 20,000 $280,000 Buy $310,000

Its income would fall by $30,000. $

Purchase price Materials Direct labor Variable overhead Avoidable fixed overhead Foregone rent Net cost

$310,000

The $20,000 rent, an opportunity cost, could be subtracted from the cost of buying. The $180,000 total fixed overhead could be shown under the make decision, with $130,000 ($180,000 - $50,000) shown under the buy decision as cost that the company would not avoid by buying. Any such manipulations still show that the advantage to making is $30,000. 2. $2.80. To equalize the cost of making and buying we must make the buy alternative cost $280,000, which requires a $2.80 price. Or, to equate the choices, we must erase the $30,000 advantage of making. Over 100,000 units, the advantage is $0.30 per unit. So a price of $2.80 equalizes costs. 3. 70,000 units, which we can determine in several ways. The variable cost to make the part is $2.10, ($40,000 + $90,000 + $80,000)/100,000 Total cost to make $3.10Q - $20,000 $1.00Q Q = Total cost to buy = $2.10Q + $50,000 = $70,000 = 70,000

Note to the Instructor: This requirement allows you to focus on the relevance of volume to make-or-buy decisions. If there are no avoidable costs and no opportunity cost, volume has no effect on the decision because all costs are variable. But if there are either avoidable fixed costs or opportunity costs, volume matters. In general, the higher the expected volume the more likely the company will make instead of buy. Qualitative factors are also important, including the quality of the purchased part, the reliability of the supplier in meeting scheduled delivery dates, and whether the part is of sufficient importance that the company should ensure its supply by making it. In addition, the company should consider the future behavior of costs. (Will the supplier raise prices faster than the firm's manufacturing costs will rise?)

5-12

5-24

Capacity Constraint

(10-15 minutes)

1. Gray should make Zs because they have the higher contribution margin per minute of machine time. Total contribution margin making Zs is $384,000. Contribution margin per unit, $11 - $7, $18 - $10 Divided by required minutes Contribution margin per minute Minutes of production, 10 x 200 x 60 Total contribution margin Q $4 2 $2 Z . $8.00 2.50 $3.20 120,000 $384,000

We could also calculate total contribution margin as follows. Minutes available Divided by 2.5 = number of Zs Times $8 CM = total contribution margin 2. Gray should make 40,000 Zs and 10,000 Qs. contribution margin doing so. Annual capacity, minutes Less minutes to make 40,000 Zs, 40,000 x 2.5 Available for Qs Minutes per Q Number of Qs that company can make Contribution margin from Zs, 40,000 x $8 Contribution margin from Qs, 10,000 x $4 Total contribution margin 120,000 48,000 $384,000 It will earn $360,000 120,000 100,000 20,000 2 10,000 $320,000 40,000 $360,000

You might point out the obviousness of the company's producing as many Zs as it can, then devoting the remaining available capacity to Qs. If the company wants to make and sell 48,000 Zs, but cannot sell more than 40,000, it certainly would want to make and sell all it could. The only question, then, is how many Qs it can produce in the remaining time. 5-25 TOC and Quality (15 minutes)

1. $40,000, 2,000 motors at $20 per motor, $8 material plus $12 variable costs in fabrication. 2. $64,000 Lost revenue, 2,000 x $42 Less saved variable cost of assembly, 2,000 x $10 Lost monthly profit $84,000 20,000 $64,000

5-13

Some students will see the point better using totals. As-Is Sales, 18,000 x $42 20,000 x $42 Less variable costs: Material costs, 20,000 x $8 Fabrication, 20,000 x $6 Assembly, 18,000 x $10, 20,000 x $10 Total variable costs Contribution margin $756,000

No Defectives $840,000

$160,000 120,000 180,000 $460,000 $296,000

$160,000 120,000 200,000 $480,000 $360,000

The purpose of this assignment is to show how poor quality can create bottlenecks. 5-26 1. Joint Products (15 minutes)

High Plains gains $20 thousand by processing the bones. $50 30 $20 The company is $80 thousand $150 40 $110 30 $ 80

Incremental revenue from processing bones Incremental cost of processing bones Incremental profit from processing bones 2. High Plains should not accept the offer. better off tanning the hides itself. Incremental revenue from hide sales Incremental cost of tanning hides Incremental profit from tanning hides Offer price, equals split-off value Gain from tanning hides

3. The contribution from processing bones further is $20 thousand as computed in requirement 1. High Plains must receive at least that from bone sales to be no worse off. 5-27 Opportunity Cost Pricing (10-15 minutes)

1. CD-R, because the contribution margin per minute of machine time is highest. CD-R CD-RW DVD Unit contribution margin $10 $15 $25 Divided by minutes needed 5 10 15 Equals contribution per minute $2.00 $1.50 $1.67 2. $26 for CD-RW, $40 for DVD. Minutes required times $2 per minute = CM per unit Add variable cost Price required CD-RW 10 $20 6 $26 DVD 15 $30 10 $40

Note to the Instructor: This simple problem illustrates the principle stated in the title, that opportunity cost is relevant to making a pricing decision. The opportunity cost of using a scarce resource is the gain from its best (most profitable) alternative use. The best use here, making CD-R, yields $2 per minute, so the cost of using the resource is $2.

5-14

5-28 1.

Comprehensive Review of Short -Term Decisions $1,000,000

(20-25 minutes)

[($50 x 8,000) + ($120 x 3,000) + ($60 x 4,000)]

Note to the Instructor: In covering this requirement, it is important to emphasize that per-unit fixed (and total) costs and profit are valid only at the volume used to calculate them. Few, if any, students have trouble with this requirement, but many fail to recognize that point and so err in the subsequent requirements. 2. Profit will fall by $960,000. Volume Unit contribution margin ($600 - $360) Lost contribution margin and profit 4,000 $240 $960,000 $720,000 640,000 $ 80,000

3.

Profit will increase by $80,000. Increased contribution margin, sofas [(7,000 - 4,000) x $240] Decreased contribution margin, chairs [8,000 x ($120 - $40)] Net gain Profit will increase by $25,000. Current cost (4,000 x $60) New cost [$35,000 + ($45 x 4,000)] Savings $240,000 215,000 $ 25,000

4.

5. 6.

Profit will increase by $85,000 [1,000 x ($245 - $160)]. Profit will increase by $7,500. Contribution margin on order (1,500 x $85) Lost contribution margin (500 x $240) Net gain Using Per-Unit Data (15-20 minutes) $127,500 120,000 $ 7,500

5-29 1.

Profit will increase by $8,000. Contribution from special order [20,000 x ($8 - $6)] Contribution lost on regular sales [8,000 x ($10 - $6)] Net gain from special order $40,000 32,000 $ 8,000

Note to the Instructor: To reinforce the use of sensitivity analysis in making decisions, you might ask students how many units of regular sales would have to be lost to make accepting the order a bad decision. The answer is 10,000 units, the total contribution from the special order ($40,000) divided by the normal contribution margin on sales ($4). The company has nearly a 25% margin for error in its estimate of the potential loss in volume. 2. Profit will increase by $10,000. Total current cost (200,000 x $2.80) Cost to make the part [(200,000 x $2.25) + $100,000] Cost difference in favor of making the part $560,000 550,000 $ 10,000

3. $14. The simplest analysis involves recognizing that if variable cost per unit, fixed costs, and profit are to remain the same, but volume is to be cut in half, the selling price per unit must produce twice as much per-unit

5-15

contribution margin. The current margin is $4 and the selling price $10, so a price increase of $4 (to $14) will be needed. A longer, less thoughtful approach deals with the actual totals for profit, fixed costs, etc., as below. Current (and future) fixed costs, known to be $3 per unit at a volume of 200,000 units Desired profit (now $1 per unit at a volume of 200,000) Required total contribution margin Divided by no. of units to be sold Equals required per-unit contribution margin Plus variable cost per unit, the same as currently Required selling price 5-30 Just-in-Time, Costs of Activities (20 minutes) $600,000 200,000 $800,000 100,000 $ 8 6 $ 14

The memo should include a comparison of the costs under the old and new methods, such as shown below. Costs under old method Variable costs for 22,000 units: Materials ($2.90 x 22,000) Labor ($2.80 x 22,000) Overhead ($1.80 x 40% x 22,000) Avoidable fixed costs: Inspection Production scheduling Maintenance Total JIT costs--given Materials Labor Overhead, incremental only Total Difference in costs

$63,800 61,600 15,840 4,000 2,500 3,600 $151,340 $55,000 67,000 9,000 131,000 $ 20,340

The memo should also include the following factors. (1) Workers in a JIT environment take on additional responsibilities, so some overhead costs, such as those enumerated in the problem, are reduced. (2) Because more costs are direct to products under JIT, products might appear to be relatively more costly when compared with the manufacturing costs identified as direct to product using conventional methods. The increase in cost identified directly with products is, however, offset by the decrease in total overhead costs viewed as indirect.

5-16

5-31

Choosing a Product

(15-20 minutes)

1. Mashed is the best choice. Carrots are a resource in short supply, and the contribution margin per processed pound of carrots is the highest for mashed. Selling price per case Variable processing cost per case Processing margin per case Pounds of raw carrots per case Processing margin per pound Sliced $7.50 2.50 $5.00 5 $1.00 Mashed $6.00 2.75 $3.25 2.5 $1.30 Pickled $8.25 4.00 $4.25 5 $0.85

Including the cost of carrots yields the same answer. Processing margin per case, as above Cost of carrots (lbs. x $0.25) Net contribution Pounds per case Contribution per pound An alternative is to use totals. Sliced Sales, 100,000 x $7.50, 200,000 x $6, 100,000 x $8.25 Carrot cost Variable processing costs Contribution margin 2. $445,000 Sales [$6.00 x (500,000/2.5 = 200,000 cases)] Variable processing costs ($2.75 x 200,000) Carrots (500,000 x $0.25) Fixed production costs Profit $1,200,000 $550,000 125,000 80,000 $ 755,000 445,000 $750,000 (125,000) (250,000) $375,000 Mashed $1,200,000 ( 125,000) ( 550,000) $ 525,000 Pickled $825,000 (125,000) (400,000) $300,000 Sliced $5.00 1.25 $3.75 5 $0.75 Mashed $3.25 0.625 $2.625 2.5 $1.050 Pickled $4.25 1.25 $3.00 5 $0.60

3. 3.85 pounds, suggesting that the managers hope is forlorn because the reduction is extremely large. The simplest way to solve is to determine what number of pounds would turn the $5.00 per case processing margin for sliced carrots into the $1.30 per pound that mashed carrots earn. Thus, $5.00 processing margin for sliced carrots divided by X lbs. = $1.30 X = 3.85 lbs. 4. The most obvious factor is that the quantity of the product the customer buys is smaller, which could create problems if customers do not respond favorably. The value of the purchase is less, so customers might go to other brands. An ethical question is whether the company should take such a course without disclosing the action to customers. Product PricingOff-Peak Hours

5-32

(20-25 minutes)

The shown in hours is $46, for

special luncheon price would be unprofitable to the restaurant, as the analysis below. The current incremental profit for the luncheon $280 while the new price would produce a loss during the period of a $326 disadvantage ($46 + $280).

5-17

Sales: Pizza (250 x $5.00) Beverages* ($150/150) x 250 Total sales Variable costs: Pizza* [($450/150) x 110% x 300] Beverages** ($60/$150) x 250 Total variable costs Contribution margin Avoidable fixed costs $380 x 120% Loss

$1,250 250 1,500 990 100 1,090 410 ($ 456 46)

* $1 per customer, from $150 prior sales to 150 customers **$250 new expected sales times the variable cost ratio ($60/$150) for beverages. Or, 250 customers is 1.67 times the 150 now served, so 1.67 x $60 = $100. The problem is that the precipitously. Under the old ($1,020/150) and the variable margin. Now the contribution Price $5.00 Variable cost per pizza, $3 x 1.1 $3.30 Ratio of pizzas to customers, 300/250 1.20 Variable cost per customer Contribution margin per customer from pizza 3.96 $1.04 contribution margin per customer falls arrangement, the average price was $6.80 cost $3 ($450/150) for a $3.80 contribution margin on pizza is only $1.04 per customer.

The increased volume of customers and of beverages is not enough to make up the drop in contribution margin. Note to the Instructor: You might ask the class what factors might prompt the owner to accept the proposal even though it is unprofitable. One possibility is the prospect of gaining business at other hours from the new customers who patronize the business at lunch. That gain might more than offset the loss from these customers at lunch. Angelo might also consider trying to reduce costs on the special by not allowing each customer to order any combination of the toppings. For example, the luncheon special might be a buffet, with pizzas of particular combinations of toppings. (A buffet might also reduce the need for part-time help.) Car PoolB Relevant Costs

5-33

(5-10 minutes)

1. The possibilities range from $2 per day, the cost of the alternative of taking the bus, to about $0.56 per day, the incremental cost of the extra four miles (4 x $.14).

5-18

Variable costs ($1,350 + $450 + $300) Miles Variable cost per mile

$2,100 15,000 $ 0.14

Between the extremes fall the sharing of full cost, or of variable cost, for 14 miles (or even for 4 miles). Some plausible prices are: $.6533, based on a three-way sharing of the $1.96 total variable cost (14 x $0.14) * $0.98, a two-way share of total daily variable costs ($1.96/2) based on the driver's not having to share variable cost * $2.24, based on full cost of $0.48 per mile ($7,200/15,000) and a threeway share for 14 miles (14 x $0.48 = $6.72 per day) Maintenance cost is more likely to be step-variable than variable, which introduces the question whether the extra miles will take the car to one of the maintenance steps. Also, if the driver's time has a high opportunity cost, doubtful in this case, the price should reflect the value of that time. 2. The $0.56 incremental cost. However, the driver would then not be compensated for time and the aggravation of the extra four miles of traffic per day. No single price might be considered perfectly fair. The colleague might even feel that $2 or more per day is fair because the bus would not pick him up and drop him off at home. 5-34 Product-Line Analysis for Service Firm (30-35 minutes) *

1. The firm should continue doing residential work. Dropping residential work would lose the $10.0 thousand gross margin but not reduce the companysustaining costs. Office Buildings $69.0 26.4 $42.6 Public Buildings $56.2 30.6 $25.6 Residences $28.8 18.8 $10.0 Total $154.0 75.8 78.2 45.4 $32.8

Fee income Cost of fees Gross margin Company-sustaining costs Profit

2. It appears that the firm should concentrate on office buildings because their gross margin percentage is highest of the three. This is a tentative conclusion, but warranted given the information available. 5-35 Hours of Operation (15-20 minutes)

1. The $591 is probably the result of dividing the year's total operating expenses ($184,500) by 312 days (52 weeks x 6 days per week). The difference between the $910 sales figure and the $591 is $319, which is approximately 35% of $910. And 35% is also the ratio of cost of sales to sales for the year ($162,700/$464,900), so the gross margin is about 65%. Thus, the owner probably thought that sales on the extra day would need to bring in sufficient gross margin to cover what he computed as daily operating cost, because the $910 is the approximate result of dividing $591 by 65%. 2. Using only the quantitative information available, it almost certainly pays to stay open on Sunday, as the following calculation shows. Sales Cost of sales at 35% $860 301

5-19

Gross margin at 65% Payroll cost Profit

559 135 $424

The above analysis assumes that all operating expenses are essentially fixed, which might not be true. However, even if all the expenses other than salaries, rent, and insurance were variable with the number of operating days, Sunday operation appears to be profitable. Utilities and "other" expenses ($12,500 + $27,200) Divided by normal number of days (6 x 52 weeks) Equals cost per operating day $39,700 312 $127

The $424 profit shown above more than covers the $127 per operating-day cost of utilities, etc. And, if such cost is actually variable with the number of operating hours in the day, even the $127 overstates the costs for Sunday opening, since the per-day cost covers 12-hour days, while the store is expected to be open only six hours on Sunday. This conclusion rests on the premise that Sunday sales would not otherwise be made, i.e., that the Sunday sales are incremental. 3. Some items the memo might include are listed below.

(a) Data about the pattern of sales throughout the week are important, because the owner will want to know whether the Sunday hours produce an increase in total sales. That is, staying open on Sundays might be wise if total revenue increases but unwise if it simply shifts sales from other days of the week. The public as a whole is not likely to buy a lot more sationaery items just because of the opportunity to shop on Sunday. However, the Sunday hours might attract some customers who have been going to other stores during the week but would prefer to shop on Sunday. (b) Information about the behavior of the individual operating costs is important to the final decision. The owner will need to know which, if any, of the operating expenses are variable. (This matter is covered to some extent in the answer to requirement 2.) For example, the lease agreement might include a percentage-rental provision, and the cost of public liability insurance might relate in part to the number of operating hours or days. (c) Details of the payroll costs for the Sunday operation should be reviewed to assure that the full amount of such costs was considered in the preliminary analysis. For example, that analysis might not have included such things as payroll taxes and other wage-related expenses. Special OrderAlternative Volumes

5-36 1.

(20-25 minutes) $210,000 $135,000 7,500 142,500 $ 67,500

Yes, because income increases by $67,500. Additional revenue (15,000 x $14) Additional costs: Variable manufacturing costs at $9/unit* License fee at $0.50 Increase in income

* Total variable manufacturing costs of $2,070,000 ($2,760,000 $690,000) divided by 230,000 units. Alternatively, contribution margin on the special order is $4.50 per unit ($14 - $9.00 - $0.50), so the increase in profit is 15,000 x $4.50 = $67,500

5-20

2. Income will increase by $46,000; contribution margin on regular sales is $6.70 per unit. Total income will be $621,000 ($575,000 + $46,000). Selling price ($4,140,000/230,000) Variable costs: Manufacturing License fee Commission at 10% Contribution margin $18.00 $9.00 0.50 1.80

11.30 $ 6.70 $180,000 134,000 $ 46,000

Additional contribution margin--special order ($4.50 x 40,000) Lost contribution margin on regular sales (20,000 x $6.70) Increase in contribution margin and profit 3. 4. $9.50, the per-unit variable cost. About 26,866 shirts

Contribution margin on order (above) Divided by contribution margin on regular sales Volume to be lost to make order break-even rounded

$180,000 $6.70 26,866

This calculation is valuable when people might buy from the chain instead of from the company. (The assignment states that the chain deals in areas where Wilderness Products does not.) The 26,866 is a figure that the managers can examine and decide whether the risk is worthwhile. Managers might be reluctant to place a figure on the lost sales through leakage but would probably be willing to state the likelihood of a derived figure. Note to the Instructor: Although the text covers very early the idea that average total cost is not a useful number for decision making, the point is important enough to warrant mention again, especially since the problem specifically refers to the average cost per unit. To emphasize that comparing average total cost and price is not useful when one is dealing with special orders, you may wish to compute an average unit cost if the special order is accepted under the situation presented in requirement 1. The average cost is Total costs at 230,000 units ($2,760,000 + $805,000) $3,565,000 Incremental costs of special order (requirement 1) 142,500 Total costs for 245,000 units $3,707,500 Average cost ($3,707,500/245,000 units) $15.1327 The $14 selling price for the special order is still less than the average total cost, yet requirement 1 shows that the company will show an increase in profit if the special order is accepted. 5-37 1. Make or Buy (30-40 minutes)

Buying is the better alternative, costing $522,000 (36,000 x $14.50).

5-21

Materials (36,000 x $5.90) Direct labor (36,000 x $5.30) Rent of space Rent of machinery Other variable overhead (36,000 x $1.40**) Total cost to make

Cost to Make $212,400 190,800 48,000* 45,000 50,400 $546,600

* Rental on the new space, not on the space already leased. The incremental cost is $48,000 because that is the change in cost occasioned by the decision to make the motor. **$4.10 total less $2.70 fixed. 2. About 48,947 units. Equating the costs of making and buying, where Q = volume Cost to make = = Cost to buy = $14.5Q = Q = $48,000 + $45,000 + [Q x ($5.90 + $5.30 + $1.40)] $93,000 + $12.60Q $14.5Q $93,000 + $12.60Q 48,947

The estimate of volume would have to be off by some 12,947 units (48,947 - 36,000) or 36% (12,947/36,000) for the buy-decision to be unwise. 3. $12.60, the variable cost to produce a unit. Once the rentals have been incurred, the company's incremental cost to make the motor is unit variable cost. (This requirement underscores the importance of determining precisely what the decision is in a given case.) Dropping a ProductOpportunity Costs

5-38

(20 minutes)

If the liquidation of receivables and inventory could take place within a relatively short time, we might simply compare the lost product margin (if the apparel line is discontinued) with the savings in interest. Lost product margin Savings in interest ($320,000 investment that is covered by debt carrying a 14% interest rate) $320,000 x 14% Savings if line is dropped $35,000 44,800 $ 9,800

Because the company's stated intention is to pay off the debt if cash is released from the investment in inventories and receivables, the interest savings appear to be relevant. Even if the cash from liquidating the working capital items were used for some other purpose, there must be some cost (an opportunity cost) to tying up cash in an investment in working capital items. The measurement of that opportunity cost depends on what alternative uses are available from the cash freed by liquidation of the working capital items. Note to the Instructor: The opportunity cost of cash is more directly related to the subject of capital budgeting, but it is not too early to emphasize the point that there is some cost associated with the use of cash. It's possible that paying off debt, even when it carries an interest rate of 14%, is not a good use of the cash available to the firm. (Perhaps the company could expand one of its other lines, or put the cash into productive investment in product lines not now being covered at all, and earn a return in excess of 14%.)

5-22

One other matter warrants discussion. Though some cash flow will result from the liquidation of receivables and inventories, there's no assurance that the liquidation will produce cash equal to the recorded (book) investments. Recovery of book value on the investment in receivables is not unreasonable. The amount recoverable from the investment in inventories depends on the market for the product and the approach the company takes to liquidating the inventories. An orderly liquidation may well produce cash inflows in excess of recorded costs, but, of course, any delay in the cash inflows (such as might be caused by effecting an orderly liquidation) reduces the savings in interest payments. 5-39 Joint Process (Extension of 5-8 and 5-9) (15 minutes)

Westlake should continue to operate the joint process. Ignoring the costs of operating the joint process, the monthly profit that comes from producing the joint products and processing further one of those products (Frazinine) is $808,000 (from 5-9), and the costs saved by not operating the joint process are only $604,000 (avoidable costs of $220,000 + variable costs of $320 per batch for 1,200 batches, or $384,000). The advantage to operating the joint process is $204,000 ($808,000 - $604,000). The same answer can be determined by comparing total income (loss) depending on whether the process is operated. Operate the Process and Further Process Frazinine Margin before costs of joint process, from 5-9 $808,000 Costs of joint process: Variable, 1,200 batches x $320 per batch (384,000) Fixed, avoidable (220,000) Fixed, unavoidable (180,000) Profit (loss) $ 24,000 Drop the Joint Process ($180,000) ($180,000)

The difference between a profit of $24,000 and a loss of $180,000 is the $204,000 computed earlier. 5-40 Salesperson's Time as Scarce Resource (15-20 minutes)

1. On the basis of the averages alone, the sales force should concentrate on retailers. Number of wholesalers called on in one week (8 x 5) Average order per wholesaler, at wholesale price Average weekly wholesale sales, per salesperson Variable cost of sales at 75% Weekly gross margin from calling on wholesalers at 25% Number of retailers called on in one week (14 x 5) Average order per retailer, at retail prices Average weekly retail sales, per salesperson Variable cost of retail sales at 60% Weekly gross margin from calling on retailers at 40% 40 $500 $20,000 15,000 $ 5,000 70 $300 $21,000 12,600 $ 8,400

2. If there were other variable costs applicable to any sales, the emphasis on retailers is still appropriate. That is, so long as the same products are sold to both retailers and wholesalers, an increase or decrease in variable cost still makes retailers the more profitable. However, the memo might

5-23

raise questions such as the following about costs associated with selling to retailers being higher than they are for sales to wholesalers. An ABC analysis should provide useful information about the relative costs of servicing the two channels of distribution. (a) With more separate orders to retailers, such costs as shipping, making up orders, and packaging could well be higher for retailers. (b) Clerical work is likely to be higher with retailers, leading to higher costs for credit-checking, administration of receivables, and collections. The larger number of orders means more bookkeeping (recording and posting orders and payments) and more monthly statements to prepare and mail. (c) It is probable that retailers are generally less credit-worthy, which could result in higher bad debts, though nothing in the facts suggests this. One other factor that might be mentioned is the advantage to the company to have wholesalers handle its products. Wholesalers could fill orders between visits of salespeople and perform other services that could favorably affect sales. For example, some wholesalers might sponsor regional advertising ("We proudly stock Lombard products."). Special OrderCapacity Limitation

5-41

(25 minutes)

1. Income will not change (a gain of $480,000 on the order itself, less a loss of $480,000 from lost sales). The per-unit contribution margin on special order is $6 ($34 - $24 - $4). Contribution Margin Special Order Lost Sales 80,000 24,000* $6 $20 $480,000 $480,000 320,000 80,000 240,000 300,000 60,000 24,000

Volume Contribution margin per tire Contribution margin * Maximum production Less special order Available for regular sales Expected regular sales Lost sales for month Net lost sales, 40% x 60,000 2. $34.00

Contribution margin on lost sales, required on order Divided by units in special order Equals contribution margin per unit Add variable cost per unit Equals required price

$480,000 80,000 $ 6.00 28.00 $34.00

3. Income would fall by $440,000 per month ($800,000 drop from lost sales less $360,000 increased profit from special order). Volume Contribution margin per tire Contribution margin *Production Special Order 60,000 $6 $360,000 320,000 Lost Sales 40,000* $20 $800,000

5-24

Special order Available for regular sales Expected regular sales Lost sales at regular prices

60,000 260,000 300,000 40,000

The lowest acceptable price is $41.33. Dividing the $800,000 contribution margin on lost sales by the 60,000 units on the special order gives a required contribution margin per unit of $13.33. Adding the $28 variable cost to the desired contribution margin gives a price of $41.33. Note to the Instructor: Besides negotiating on price, the company could negotiate on the size of the special order. You might ask the students how many units the special order must be to make the company indifferent. Obviously, at some price, and some monthly volume, the order becomes desirable. The analysis above gets at the pricing issue. For the volume issue, the following is the simplest. Overall loss on 60,000 unit order Divided by difference in CMs, $20 - $6 Required reduction in special order, rounded Maximum order, 60,000 - 31,429 $440,000 $14 31,429 28,571

The idea here is that the company trades $6 margin for $20 margin on every unit that it takes from the special order and sells at the regular price. To make up the $440,000 loss requires nearly 31,429 such exchanges. Such a calculation is helpful if Southland has some reason for wanting the business. Perhaps the chain sells in a geographical area Southland would like to move into, or perhaps is contemplating expansion and would like some private brand business to provide a base of volume. Southland might not want a $440,000 monthly decline in income, but it might undertake the business at a slight profit or loss to fulfill some other strategic need. 4. The purpose of this requirement is to stress the importance of materiality. The company expects the following monthly income without the order. Contribution margin, 300,000 x $20 Fixed costs Profit $6,000,000 4,800,000 $1,200,000

We would certainly not accept the order, with whatever disruption it might cause, for no increase in a $1,200,000 profit for one month.

5-25

5-42 1.

Production and Market Constraints $2,000 Selling price Raw material 1 Raw material 2 Raw material 3 Throughput units Fixed costs Profit Alpha $180 40 50 $ 90 50 $4,500

(20-25 minutes) Beta $180 50 30 $100 25 $2,500 Total

$7,000 5,000 $2,000 Machine 4

2. Machine 1 Alpha A 30 A 20 B 30 B 10 20 Beta B 30 B 10 C 20 C 30 10 Total 50 50 50 50 50 25 25 25 25 25 1,500 1,000 1,500 500 1,000 750 250 500 . 2,000 . 2,250 750 . 2,500 250 1,250 Machine 2 Machine 3

Available time (40 hrs 60) Load factor

2,400 83%

2,400 94%

2,400 104%

2,400 52%

The production constraint is Machine 3 with a load factor greater than 100%. 3. Alpha: 50 units, Beta: 22 units. Alpha requires 30 minutes on Machine 3 while Beta requires 40 minutes. A single Alpha yields $90/30 = $3 per minute; a single Beta yields $100/40 = $2.50 per minute. Thus, Alphas should be produced first. Producing all 50 Alphas will require 50 30 minutes, or 1,500 minutes, leaving 2,400 1,500 = 900 minutes to produce Betas. With this available time, 900/40 = 22 Betas can be produced. 5-43 Production and Market Constraints with Changing Conditions (extension of 5-42) (30 minutes) 1. Option 1: $1,625; Option 2: $1,235; Option 3: $(1,130)

5-26

Option 1 Selling price Raw material 1 Raw material 2 Raw material 3 Throughput units fixed costs profit

Alpha $180 40 55 $ 85 50 $4,250

Beta $180 55 30 $ 95 25 $2,375

Total

$6,625 5,000 $1,625

Under this option, there would be no production constraint, only marketing constraints. Machine 3 would have a load factor of 2,000/2,400 = 83%. (Alpha: 50 units (16 + 8 minutes) = 1,200 and Beta: 25 units (8 + 24 minutes) = 800) Option 2 Selling price Raw material 1 Raw material 2 Raw material 3 Throughput units fixed costs profit Alpha $165 40 50 $ 75 49 $3,675 Beta $200 50 30 $120 23 $2,760 Total

$6,435 5,200 $1,235

Under this option, the production constraint still exists at machine 3. Beta is now the more desirable product, yielding $120/40 = $3/minute on machine 3 while Alpha now yields $75/30 = $2.50/minute. The entire demand for Beta should be produced, using 23 40 minutes = 920 minutes, leaving 1,480 minutes available to produce Alpha. A total of 1,480/30 = 49 Alpha can be produced. Option 3 Selling price Raw material 1 Raw material 2 Raw material 3 Throughput units fixed costs loss Alpha $180 40 50 $ 90 43 $3,870 Beta $180 50 30 $100 0 $ 0 Total

$ 3,870 5,000 $(1,130)

This option focuses improvement on a non-bottleneck machine to the detriment of the bottleneck machine. The load factor of machine 3 actually increases (25 minutes 50 + 25 minutes 25 = 1,875 additional minutes) to (2,500 + 1,875)/2,400 = 182% while the load factor for machine 2 drops to [2,250 (10 50 + 10 25)]/2,400 = 2,250 750 / 2,400 = 63%. A unit of Alpha will now take (20 + 25 + 10) = 55 minutes to produce. A total of 2,400/55 = 43 units of Alpha can be produced. No Beta units are possible. 2. None of the options is preferable to the original. If none of the options where chosen, profits would be 50 90 + 22 100 5,000 = $1,700. 5-44 Special Orders and Qualitative Factors (15 minutes)

5-27

1.

$1,257,100

Revenue from order $4,000,000 Order value at regular price ($4,000,000/70%) Variable cost of order [60% - 20%(60%) x $5,714,285] 2,742,900 Additional contribution $1,257,100 2.

$5,714,285

Factors that might be included in the memo include the following.

(a) SuperFi's current distributors are likely to be unhappy with private brand sales. (b) Demand for SuperFi's high quality equipment could increase, in which case the company would have to expand to meet such demand because of the capacity it devotes to the private brand. (c) The strong desire to maintain the company's reputation suggests the need for SuperFi's managers to look beyond their own business practices to the business practices of those to whom they sell. SuperFi's managers should be concerned about the discounter's confidence that buyers will be aware of the maker's name. Perhaps that confidence is based on some plan to make this fact known; and perhaps the plan does not include making buyers aware that the products are of a lower quality than SuperFi's regular products. (d) Customers purchasing the discounted products and aware of the manufacturer may, because of the lower quality, become disenchanted with SuperFi products in general. The company's long-lived reputation for high quality could be irreparably damaged. (e) SuperFi's managers must face the difficult problem of determining the acceptable magnitude of the quality difference between SuperFi's regular products and the special-order item. If regular buyers of SuperFi products are really devoted seekers of the highest quality, regular sales should not suffer from the introduction of the discounted product. However, some buyers attracted by the price of the discounted product might find their needs satisfied with its quality and conclude that the extent of their earlier interest in products well-known for quality was excessive. If growth is a problem for SuperFi, the company might wish to consider producing, under its own name, high-quality products sufficient to meet the demands of a less discerning buyer. Alternatively, SuperFi might establish a subsidiary to sell equipment of lesser quality. 5-45 Cost of Being Your Own Boss (15 minutes)

If the Taylors consider only the monetary aspects of the decision, and if the most recent year's results can be assumed to be representative of future years, they would be better off selling the business and going back to work as employees. Their income would be Salaries ($40,000 + $45,000) Interest ($150,000 x 10%) Total income $ 85,000 15,000 $100,000 The

The opportunity cost of their being in business for themselves is $100,000, which is $5,200 greater than their current income of $94,800.

5-28

business is also likely to be much riskier than their working as employees and earning interest on their capital, which increases the advantage of selling the business. There are, however, a number of qualitative factors to be considered. One is the satisfaction of owning (as opposed to being an employee), which could be worth a great deal. The Taylors work long hours, but they are together during working hours, which has both good and bad points. They may also have worked long hours at their other jobs. They cannot be fired if they work for themselves. The future of the bistro is more critical than its past, as are the salaries the Taylors could earn now, as opposed to the salaries they used to earn; so some quantitative issues remain unresolved. They might also have incurred other job-related expenses (as reflected in Ellen's remark about "fighting traffic") that they do not now incurr. Whatever the Taylors' attitude about working for themselves as opposed to working for someone else, the financial consequences of their choices are important and they should be aware of those consequences. Note to the Instructor: We deliberately made the income level high enough that another issue can be raised: the diminishing marginal utility of income. It's one thing to be in business for yourself at $94,800 and sacrifice $5,200; it's quite another to do so when the income from the business is, say, $26,800. The Taylors might have tastes, personal goals, and priorities that can be satisfied on much less income than they previously earned; but they need some minimum level of income for basic necessities. 5-46 Pricing Policy and Excess Capacity (15 minutes)

First, assume that the KwH sold in the summer months will not increase as a result of conversion to electric heat. That is, assume that those users who are expected to convert already use as much electricity as they need in the summer. With this assumption, summer consumption per month will not exceed capacity, and the following analysis is appropriate. Additional revenue from additional KwH sales at new rate (44 million KwH x $72 per 1,000 KwH) Less: Loss of revenue due to reduced price for all KwH sales already being made to customers who would convert and be entitled to the lower rate for all their consumption 60 million KwH x $15 decrease per 1,000 KwH Variable costs of additional KwH sales 44 million KwH x $46 per 1,000 Kwh Loss of revenue from lower rate to customers already using electrical heating equipment 20 million KwH x $15 decrease per 1,000 KwH Net loss from the new plan $3,168,000

$900,000 2,024,000 300,000 3,224,000 $ 56,000

From a strictly monetary standpoint, the proposed reduction is inadvisable. Removing the original assumption, it's possible that, in the past, the users who would convert to electric heat have been conservative with their use of electricity in the summer. Conversion and the lower rate may cause them to be less conservative, so that summer sales may increase. The additional demand is good for the company so long as the increase doesn't exceed available capacity. The added summer demand would help to offset the

5-29

monetary disadvantage of the new plan. 5-47 Processing Decisions (20-25 minutes)

1. Ayers should sell bark and shavings because the revenues of $3,000 cover the avoidable costs of $520, leaving an incremental profit of $2,480. The costs of the logs and of cutting them up are joint to the products. 2. More than $3,980. Ayers must earn $2,480, the current incremental profit, plus the additional processing costs of $1,500 to be indifferent to the two choices. Current incremental profit, sell at split-off Additional processing costs Required revenue $2,480 1,500 $3,980

Note to the Instructor: Another dimension is added to the assignment when you ask students whether they would accept the offer if the revenue were to be, say $4,000, giving only a $20 increase in profit. The answer is likely to be no, and exploring the reasons therefore should be useful. Some will suggest that the actual additional cost could turn out to be higher than the estimated $1,500. Some will recognize that Ayers would be accepting some risk if he rented equipment and hired additional help. The assignment does not say whether there is a fixed term or whether a month's notice (or enough for Ayers to eliminate the $1,500 additional processing costs) would be required to terminate the agreement. Most managers would not increase the size of an operation for a small additional profit. The role of expectations is also important, both here and in requirement 3. The assignment says that Ayers expects about the same results in the future. But he cannot know that the price of bark and shavings will continue at the current level. Accepting the offer could turn out to be unwise if the price of bark and shavings rose. If, however, Ayers could get a firm contract for, say, six months, he would be eliminating the risk that the price might fall. 3. Ayers should not accept the offer unless he is offered $35,530 or more. Essentially, Ayers now has the opportunity to sell the grade B lumber at the split-off point rather than process it further. Revenue after further processing Less further processing costs: Trimming Sanding Shipping Margin from further processing Plus new shipping costs Minimum price at split-off $41,000 $ 860 3,380 2,430

6,670 34,330 1,200 $35,530

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5-48

Evaluating a DecisionCosts of Activities

(15 minutes)

Sales Variable cost of sales* Gross margin Incremental operating expenses** Profit

$320,000 199,000 121,000 45,000 $ 76,000

* Variable cost of sales = $86,000 + $41,000 + $72,000. The $72,000 is 60% of $120,000 **Incremental operating expenses = $27,000 + $12,000 + $6,000. The $6,000 is $22,000 less the $16,000 administrative charge. The $27,000 salary seems incremental as the person spends 80% of her time on this account. The $12,000 is for a part-time clerk who works only on this account, which is clearly incremental. The administrative charge is almost certainly not incremental. There is room for disagreement about some items. There is also some question whether the company could lose regular sales in the future. It has operated close to capacity in the past six months, so might reach capacity in the next six. Before making a decision, the sales manager should inquire further about the needs for meeting regular sales. 5-49 1. Relevant Range (30 minutes)

Yes. Income will increase by $200,000 if the order is accepted. Selling price $60 Variable costs: Materials ($900,000/45,000) $20 Direct labor ($810,000/45,000) 18 Overhead ($540,000/45,000) 12 50 Unit contribution margin $ 10 Volume 20,000 Total additional contribution margin $200,000 Contribution margin falls $ 10.00 6.00 $ 4.00 20,000 $80,000 $1,000,000 $50 10 $60 600,000 (400,000) 200,000 $ (200,000)

2. Yes. Ipswick will earn $80,000 on the order. to $4 per unit. Original contribution margin (above) Commission at 10% of $60 Contribution margin Volume Increase in contribution margin 3.

No. The company will lose $200,000. Lost regular sales (10,000 x $100) Variable costs saved on 10,000 units: Manufacturing costs (above) Selling ($100 x 10%) Total unit variable cost Total costs saved for 10,000 units ($60 x 10,000) Lost contribution margin Contribution margin on special order (requirement 1) Net loss in contribution margin

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4. Yes. The company will gain $93,000. Sales (20,000 x $60) $1,200,000 Costs: Basic costs, requirement 1 (20,000 x $50) Premium labor and overhead costs* 1,060,000 Additional contribution 140,000 Additional fixed costs 47,000 Additional profit 93,000

$1,000,000 60,000

$ $18 12 $30 $ 6 10,000 $60,000

* Direct labor cost Variable overhead cost Total Premium at 20% Units at premium cost (45,000 + 20,000 - 55,000) Total premium cost Value of New ProductsComplementary Effects (a) (b) $12,000 $ 6,000 ($40,000 x 60%) - $12,000 ($60,000 x 40%) - $18,000

5-50 1.

(25 minutes)

2. The beer and wine department should be added because, as shown below, it would contribute more to the company than does the hardware department, despite the higher incremental segment profit from the latter. With With Beer Hardware and Wine Grocery sales $630,000* $648,000** Cost of sales 252,000 259,200 Gross profit 378,000 388,800 Other variable costs, 20% 126,000 129,600 Contribution margin 252,000 259,200 Fixed costs 140,000 140,000 Income 112,000 119,200 Incremental profit, added department (requirement 1) 12,000 6,000 Income for store $124,000 $125,200 * $600,000 x 105% **$600,000 x 108% 3. The major lesson is that a decision will often affect segments of the company other than the one being considered. The effects of an action on the entire company must be considered, not just those directly associated with the segment. The problem also shows that the product with the higher gross profit rate is not always the most profitable or the one most important to maintain. Special OrdersEffects on Existing Sales

5-51

(25 minutes)

1. Accepting the order brings additional contribution margin of $300,000 [30,000 x ($30 - $20)].

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2. The order should still be accepted, as it will increase profit by $30,000. Lost sales (90,000 units x 10%) 9,000 Contribution per unit ($50 - $20) $30 Contribution lost $270,000 Gain from accepting the order (requirement 1) 300,000 Net gain $ 30,000 3. Regular sales must decline more than $500,000, or 10,000 units ($500,000/$50 per unit), before acceptance of the order would be unwise. Gain in contribution from the order (requirement 1) Contribution percentage on regular sales $2,700,000/$4,500,000 60% Regular sales with contribution margin of $300,000 that can be earned on the special order ($300,000/60%) $300,000

$500,000

4. The special order is for only one year. Suppose some of the regular customers buy from the discounter, and the discounter stocks another brand in the future. If the regular customer is satisfied with his purchase from the discounter, he may return a second year. Hence, future sales by Hunt will be hurt, since the regular customer will be lost for more than a year. Some customers might, at the lower price offered by the discounter, buy more units than might ordinarily be the case. If so, again, the possibility exists that future sales will suffer. 5-52 Alternative Uses of Product (35 minutes)

1. 7,000 jars ($5,600 avoidable fixed costs divided by $0.80 contribution margin per jar). Contribution margin per jar: Selling price Cost of Grit 337 ($1.60/4) Other variable production costs Variable selling costs Contribution margin per jar $4.00 $0.40 2.50 0.30 3.20 $0.80

2. 8,000 jars. One way to approach this requirement is as a further processing decision. The additional fixed processing costs are $5,600 and the advantage to further processing is $0.70 per jar, as computed below. Dividing the $5,600 fixed processing costs by the $0.70 advantage for further processing yields 8,000 jars. Sales value of Grit 337 per 1/4 pound ($2.00/4) Additional processing costs per jar Additional selling costs Total Advantage of further processing, per jar ($4.00 - $3.30) $0.50 2.50 0.30 $3.30 $0.70

The following schedule shows that at 8,000 jars the company is indifferent between the alternatives. The cost of Grit 337 is ignored because it is the same under both alternatives. Revenue from polish (8,000 x $4.00) Variable costs, excluding cost of Grit 337 ($2.50 + $0.30) x 8,000 Avoidable fixed costs $32,000 $22,400 5,600 28,000

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Net revenue from polish Lost sales of Grit 337 [(8,000/4) x $2.00]

$ 4,000 $ 4,000

Thus, the loss of 2,000 pounds of Grit 337 at $2.00 per pound equals the net revenue from 8,000 jars of polish. 5-53 Processing Decision (35 minutes)

1. This requirement presents a further-processing decision, though not obviously so. Each new month is a split-off point, with another month on the lot being the further processing. The following analysis shows that three months is the optimal holding period. Holding period in months 1 2 3 4 Revenue at $0.50/lb. $320 385 445 495 Cost $260 + ($52 x months held) $312 364 416 468

Weight 640 770 890 990

Profit $ 8 21 29 27

2. This requirement is a capacity problem. The lot can be kept full every month, so the question is how best to use it. As shown in the schedule below, the animals should be kept for two months. Contribution margin per unit of capacity One Month Total number of animals per year 12 months/months held Times contribution margin per animal (from requirement 1) Equals total contribution per unit of capacity 12 $ 8 $96 Holding Periods Two Months Three Months 6 $ 21 $126 4 $ 29 $116

An alternative approach is to use totals, working with the annual results from each holding period. Holding Periods One Month Two Months Three Months Animals per year: 5,000 x 12 60,000 5,000 x 6 30,000 5,000 x 4 20,000 Contribution margins $8 $21 $29 Total annual contribution margin $480,000 $630,000 $580,000 5-54 Special Order (35 minutes) Critical to the analysis is determining the

1. Income will fall by $4,500. lost sales at the normal price.

Lost regular sales: Maximum capacity for two-month period (7,500 x 2 x 2) Special order Available for regular sales Expected sales (6,000 x 2 x 2) Lost regular sales if order accepted

30,000 cases 10,000 20,000 24,000 4,000 cases

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The analysis proceeds as follows. Materials Direct labor Variable overhead (1/2 hour x $1.50) Total variable cost

Variable cost is $6.25 per case. $2.50 3.00 0.75 $6.25

Contribution margin on the special order is therefore $1.25 ($7.50 - $6.25) and $4.25 on regular sales ($10.50 - $6.25). Contribution margin on special order (10,000 x $1.25) Contribution margin on lost regular sales (4,000 x $4.25) Net loss on special order An alternative is Gain in revenue from special order: Revenue from special order (10,000 x $7.50) Lost revenue from 4,000 cases (4,000 x $10.50) Net gain in revenue Incremental costs of special order: Cost of operating at capacity for two months 15,000 cases x 2 months x $6.25 per case Cost of operating at expected sales level 12,000 cases x 2 months x $6.25 Net additional cost Net loss ($33,000 - $37,500) $75,000 42,000 33,000 $187,500 150,000 37,500 $ 4,500 $12,500 17,000 ($ 4,500)

2. $7.95. A simple way to find this is to divide the loss of $4,500 by the 10,000 units of the special order and add the $0.45 ($4,500/10,000) to the original price of $7.50. Another approach uses the basic idea of target pricing from Chapter 2. Required contribution margin [4,000 x ($10.50 - $6.25)] Divided by volume on special order Equals per-unit required contribution margin Plus variable cost per case Equals required price Services of an AthleteJumping Leagues $17,000 10,000 $1.70 6.25 $7.95

5-55

(50-60 minutes)

Note to the Instructor: There is no single, best answer for either requirement of this case. What individual owners will consider a fair way to share the cost of attracting Jones to the CCSL, or keeping Jones in the NSL, depends on the risk-aversion preferences of the owners. The additional confounding factor in requirement 2 is that sold-out games could be either home or away games for Jones' team, so the potential loss for individual teams other than Jones' is not determinable even if the home-away split of gate receipts were known (which it is not) and unequal. Nevertheless, the preliminary calculations for each requirement permit some conclusions about proposals that are unreasonable. You can also conclude that proposals failing to address the potential impact of an injury that sidelines Jones are deficient. Moreover, you can assess the reasonableness of any assumptions students make to deal with missing information and determine whether students recognize that their proposals incorporate assumptions. You might want to point out that the two requirements underscore the idea that someone facing a decision always has a

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starting point. In requirement 1, none of the teams currently risks losing if Jones misses a game. In requirement 2, all of the teams currently face that risk. 1. Preliminary calculations--potential gain for CCSL Potential Gain for League Total additional admissions (10,000 persons x 10 games) Contribution margin per admission ($20 - $4) Additional contribution for 10 games Potential for the Titans Contribution from home games: Contribution, per admission at home ($20 - $6 - $4) Additional admissions expected per home game Additional contribution expected per home game Number of home games Total added contribution from home games Contribution from away games: Visiting team's receipt for each admission Additional admissions expected per away game Additional contribution expected per away game Number of away games Total additional contribution from away games Total additional contribution from all games $10 10,000 $100,000 5 $500,000 $6 10,000 $60,000 5 300,000 $800,000 100,000 $16 $1,600,000

The potential for the CCSL is $1,600,000 and for the Titans is $800,000, so the other five teams have the potential for $800,000, or $160,000 each on average. The Titans will not try to sign Jones without help from the other teams because his $1,000,000 salary demand exceeds the additional contribution. Moreover, the entire analysis depends on Jones being able to play in every game. Any injury that temporarily sidelines him, if the fans know about it prior to the game, could reduce the contribution. The potential to the Titans is five times that to each of the other teams, so the owners might believe it fair for the Titans to pay half of the salary ($500,000) and the others to split the remainder equally ($100,000 each). The Titans then stand to gain $300,000 ($800,000 - $500,000) and the others $60,000 ($160,000 - $100,000). The Titans take more risk because they are exposed to Jones being sidelined for all of their games, while each of the other teams is exposed only twice. Note, however, that each team's paying in proportion to its potential gain appears fair only if Jones will play every game. If he misses a game, only one other team is affected. The Titans do not care which other team is affected, but the other teams do. For the affected team, a $60,000 gain turns into a $40,000 loss for a home game or breakeven for an away game. The other owners probably would not consider such a split fair because of that risk. One possible solution is for the teams to share the risk, so that if Jones misses a game, all of the other teams share the loss. Thus, if Jones misses a Titan's home game, costing the other team $60,000, each of the others pays $12,000 toward Jones salary. If Jones misses a Titan's away game, the others share $100,000, or $20,000 each. Such a plan is a starting point for discussions. Because everyone can benefit from acquiring Jones, the incentive is to find a solution.

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2. Preliminary calculations--potential loss to NSL Lost contribution on games not sold out: Contribution margin per admission No. of admissions lost per game Contribution lost per game Average number of games not sold out Lost admissions for 6 games Lost contribution on games sold out: Contribution margin per admission No. of admissions lost per game No. of lost ticket requests 8,000 No. of unfilled ticket requests for sellout games 3,000 No. of actual ticket sales lost Contribution lost per game Average number of games sold out Lost admissions for 6 games Total lost contribution ($960,000 + $600,000) Savings if Jones leaves--his salary Net decline in profits for league

$20 8,000 $160,000 6 $960,000 $20

5,000 $100,000 6 $600,000 $1,560,000 600,000 $960,000

As with the analysis for the CCSL, this one does not consider injuries. Because the sell-outs could be any combination of home and away games, we cannot determine the potential loss to any given team from Jones being hurt. The NSL can match the $1,000,000 offer because it stands to lose $1,560,000 before considering his salary, leaving $560,000 ($1,560,000 - $1,000,000) net if the league keeps Jones at $1,000,000. The question of sharing the salary depends on the split of revenues. If the teams split contribution margin equally, then the Lumberjacks stand to lose $780,000 ($1,560,000 x 50%) and the others $780,000, or an average of $130,000. Working in the sell-outs complicates matters because the other teams could lose $160,000 (from two non-sell-outs) to $100,000 (two sell-outs). (Jones contribution for a non-sell-out is $160,000 per game, split 50-50, so it is $80,000 for each of the two games and similarly for non-sell-outs.) The Lumberjacks stand to lose $180,000 ($780,000 - $600,000 salary) if Jones moves, the others $130,000 each. So a split of the $400,000 increase in salary along the lines of the relative losses is not unreasonable. Potential Loss Lumberjacks Others Total $180,000 780,000 $960,000 Percentage of Total 18.75% 81.25% Added Salary Payment $ 75,000 325,000 $400,000

It appears that the $1,000,000 salary is only a starting point. Both leagues have incentives to sign Jones, with the CCSL being able to pay up to $1,600,000 and the NSL $1,560,000. Because these amounts are close, and because of all of the estimates and nonquantifiable factors, it is difficult to predict which league will win. Civic pride and other factors could also become involved. 5-56 Dropping a Segment (30 minutes)

It will cost Mr. Johnson $18,930 to act in accordance with his views about smoking. Tobacco Drugs Sundries Total Lost sales $31,000 $8,960* $3,600** $43,560

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Cost of sales 10,500 Lost gross profit $20,500 Less: Gross profit gained on greeting card sales Reduced carrying costs Clerk's salary Total operating expenses Net reduction in profit before taxes

3,780* $5,180

1,050** $2,550

15,330 28,230 5,000 300 4,000 9,300 $18,930

* 7% reduction in sales of prior periods (5% due to dropping tobacco and 2% due to the pharmacist's having to handle greeting card sales) **10% reduction The above analysis does not recognize the positive effects either (a) for persons who might benefit from being unable to obtain tobacco products or (b) of the example provided by Mr. Johnson. Nor does it include a measurement of Mr. Johnson's satisfaction in having abided by his convictions. Note to the Instructor: In addition to raising the problem of quantifying the factors mentioned above, the case is interesting in that the owner's decision will be heavily affected by nonquantitative factors, and that the concepts introduced in managerial accounting can be used to present the owner with some quantified implications of the decision. We're not suggesting that owners and other managers should make decisions based solely on quantifiable considerations, or even that there is (or should be) a limit to how far they will (or should) go in exercising their convictions. We suggest only that owners and other managers are better off with this information than without it. In any event, we've found that the case generates lively class discussion when students are prompted to suggest other personal beliefs that might present a problem to the owners and/or managers of other businesses. For example, one might have convictions about the morality of lotteries or birth control or be dedicated to the preservation of the environment. Each opportunity to act on these convictions is likely to have financial implications, and it is true that one cannot do everything one might want to do. The question of value hierarchies comes into play here. What is Mr. Johnson willing to have his family forgo to exercise his convictions? (Will the expected drop in income mean not being able to fulfil a desire to send his children to college? Will it mean reducing financial assistance he provides to his parents or to charitable organizations he regularly supports?) It may not be possible to measure the degree of one's convictions on various issues, but it is true that there are different degrees. Would Mr. Johnson be willing to change his line of business altogether in order to abide by his conviction with respect to tobacco? (Would the country tolerate the expenditures and consequent taxation required to ensure that no traffic deaths could be attributed to faulty roads?)

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5-57

Alternative Uses of Space

(45 minutes)

The analysis involves comparing the incremental profit that can be expected from the two alternatives for using the space now occupied by the boutique with the revenue expected if the lease with the boutique chain were renewed. The expected revenue if the lease is renewed follows. Revenue, first ten months this year Expected revenue, last two months [($400,000/10) x 2 x 2] Boutique sales, current year (estimated) Sales increase expected next year, 10% Sales expected for boutique next year Percentage rental expected from lease, 5% Base rental provided in contract Expected revenue from leased department $400,000 160,000 560,000 56,000 $616,000 $ 30,800 36,000 $ 66,800

The expected incremental profits from the two alternatives are computed below. In-House Operation Expanded Shoe of Boutique Department Sales: Projected sales of $380,000 x 90% $342,000 Projected sales of $200,000 $200,000 Variable costs: Cost of goods sold ($171,000/$380,000) x $342,000 (153,900) (100% - 45%) x $200,000 (110,000) Sales commissions ($200,000 x 10%) ( 20,000) Expected contribution from sales 188,100 70,000 Fixed costs (given) (104,000) Lost contribution margin Customers coming especially to Clothes Horse $616,000 x 40% x 20% x (45% - 8%) ( 18,234) ( 18,234) Regular customers of the store $616,000 x 60% x 2 x 10% x (45% - 8%) ( 27,350) ( 27,350) Incremental profit $ 38,516 $ 24,416 Some students will probably approach the analysis by computing the cost of abandoning the leased department. That cost is $112,384, the expected rental fee ($66,800) plus the cost of the lost sales $45,584 ($18,234 + $27,350). For an in-house use of the space to be advisable, the promised profit would have to exceed $112,384, and neither of the available alternatives promises that level of return. One could conclude that the most profitable use of the space now occupied by the leased department (Clothes Horse) would be to renew the lease. Revenues from the lease would be $66,800, while the most profitable of the alternative use would be an in-house operation of the boutique, which could result in a return of only $38,516. The estimates made of the shopping habits of customers now frequenting the boutique must be carefully considered. Were the observed habits typical? Without regard to the lost contribution margins (computed as a result of the firm's observations of shopping habits of boutique customers), the in-house operation of the boutique would produce an incremental profit of $84,100 ($188,100 - $104,000). Of some importance also is management's conclusion that the sales estimate for the in-house boutique is overly optimistic. If Rausch's estimate is correct, the incremental profit produced by an in-house

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boutique operation is $59,416 [($380,000 x 55%) - fixed costs of $104,000 lost contribution margin of $45,584]; and once again, the estimate of lost contribution margin becomes critically important. 5-58 Product Processing (45 minutes)

Note to the Instructor: This is a difficult case because it seems to be a simple question of product profitability but is actually a further processing question, though it reverses the usual joint-products problem. The managers' past insistence on viewing the company as a paneling manufacturer has caused it to forgo profits. The company operates three processes, plywood, veneer, and gluing. It can make three products, plywood, veneer, and paneling. The special feature of the operation is that the third product is the result of combining the other two. The schedule below shows the contribution margins of each product and process. Per 1,000 square foot Product & Process Product Plywood Veneer Total Paneling $81 $74 $155 $178 18 25 20 63 $18 1,200 1,000 16 20 16 52 $22 1,000 1,000 34 45 36 115 $ 40 34 55 44 133 $ 45 1,000*** 1,000 Process Gluing $23 0 10 8 18 $ 5 1,300 1,000

Selling prices Variable costs: Materials Direct labor Variable overhead* Total variable costs Contribution margin Capacity ** Used

* 80% of direct labor ** in thousands of square feet *** Capacity in veneer limits paneling capacity. The company was right to process veneer and plywood into paneling; the incremental revenue of $23 exceeded the incremental cost of $18. But the company gave up $36,000 by not making another 200,000 feet of plywood and whatever it might have made using the 300,000 feet of unused gluing capacity. The managers appear to be realizing that changes in operations might be desirable. But their responses to complaints from workers and from the manager of the gluing process suggest a lack of understanding of the company's cost structure. The schedule draws attention to the gluing operation as a potentially profitable further-processing opportunity. The managers need to understand the break points in prices where it becomes more profitable to sell the two products separately. A $5 increase in the price of either intermediate product or decline in the price of paneling makes the company indifferent between paneling and the two intermediate products. Thus a drop of $12 in the price of paneling, to $164, as Chen mentioned, makes the company better off selling the products separately. A complete evaluation of the CEO's proposal requires knowing the cost of obtaining additional capacity. (The $2,000 figure was the authorization, not a statement about the cost.) We can, however, determine how much the company could pay for additional capacity at various product prices. At prevailing prices, adding capacity to plywood, which already has excess capacity, adds $18 contribution margin per 1,000 square feet of

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capacity. So additional capacity is desirable if it costs less than $18 per 1,000 feet. Increasing veneer capacity is profitable if it costs less than $27 per 1,000 feet. Gain, contribution margin on 1,000 feet of paneling Loss, contribution margin on 1,000 feet of plywood Net gain $45 18 $27

Of course, the loss applies only when veneer capacity exceeds 1,200,000 feet, the current capacity in plywood. 5-59 Product Mix with Production Constraints (40 minutes)

1. 40 units of X and 70 units of Y. Step 1 of the theory of constraints is to identify the constraint. This can be accomplished most readily by calculating the load factors for each station as follows: time per unit X Y total for product X (40 units) Y (80 units) Total available time Load factor A 28+6=34 A 0 2,720 2,720 2,400 113% B 4+5+15=24 4+5=9 B 960 720 1,680 2,400 70% C 15+18=33 9+6=15 C 1,320 1,200 2,520 2,400 105% D 20 18 D 800 1,440 2,240 2,400 93% E 8 8+8+9=25 E 320 2,000 2,320 2,400 97%

The question becomes which station is the constraint, A or C, since both have load factors in excess of 100%. Station A can support a maximum production of 2,400/34 = 70 units of Y while Station C can support 2,400/15 = 160 units of Y. Station A is the constraint. Notice that Station A is not a constraining factor on product X, so 70 units of Y can be produced. This will use 15 70 = 1,050 minutes on Station C, leaving 2,400 1,050 minutes = 1,350 minutes for production of X. A total of 1,350/33 = 40 units of X can be produced. 2. Station A should serve as the drum of the production process. Buffers should be maintained immediately prior to this station so that there is no downtime due to lack of product. Management cannot be complacent about the other workstations, however. Notice that the load factors for station C at the actual product mix is also at 99%. Management will need to maintain a buffer before this station as well, as any shortage would cause station C to become the constraint. Stations D and E have load factors of 86%. There is little margin of error at these stations so management must be diligent. total for product X (40 units) Y (70 units) Total available time Load factor A 0 2,380 2,380 2,400 99% B 960 630 1,590 2,400 66% C 1,320 1,050 2,370 2,400 99% D 800 1,260 2,060 2,400 86% E 320 1,750 2,070 2,400 86%

Note to Instructor This problem can be used to illustrate Goldratts concept of a critically constrained resource, one that has the potential to become the constraint if care is not taken. Any downtime at station C would cause the constraint to shift from station A. Any prolonged problems at either stations D or E could also cause the constraint to shift.

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