CHAPTER 18

ACTIVITY RESOURCE USAGE MODEL AND

TACTICAL DECISION MAKING
QUESTIONS FOR WRITING AND DISCUSSION
1. Tactical decision making is choosing among alternatives with an immediate or limited end in mind.
2. Tactical decisions should support the overall strategic objectives of an organization. Often, the
strategic objectives are served by small-scale actions. For example, making a part instead of buying
it may lower costs of production and thus serve the strategic cost leadership objective. Or it may
serve the
objective of differentiation by helping to produce a higher-quality final product than
produced by competitors.
3. Tactical cost analysis is the use of relevant cost data to identify the alternative that provides the
greatest benefit to the organization. Steps 35 are the major components of tactical cost analysis:
predicting costs, comparing relevant costs, and selecting the lowest cost alternative (or alternative
with the greatest benefit).
4. Answers will vary. I (second author) have used this as a writing assignment for several years. It has
been very successful; students enjoy analyzing their own decisions, whether it is buying a car,
moving from the dorm into an apartment, or buying a puppy. Sometimes, the application of the
model leads to new insights into their problems.
5. Relevant costs and revenues are future costs and revenues that differ across alternatives.
Depreciation on an existing asset represents an allocation of a past cost. Past costs are sunk costs
and therefore seldom relevant.
6. A future cost that is not relevant is a future cost that does not differ across the alternatives being
considered. For example, rent on a factory in a keep-or-drop decision is a future cost, but it will be
there whether one of the factorys products is dropped or kept.
7. Disagree. Relevant costs are just part of the overall tactical decision model. Strategic effects and
other qualitative factors may affect the decision. The effect may be such that a higher-cost
alternative may be chosen.
8. Yes, direct materials can be irrelevant. In a make-or-buy decision, any direct materials already in
inventory are irrelevant. In a make-or-buy decision, the salary of the production supervisor would be
fixed but relevant to the decision. Leasing equipment is relevant if it is a future cost that differs
across alternatives. In most cases, this would not be a factor because it entails the acquisition of
multiperiod capacity and really belongs to the capital expenditure decision domain.
9. The only role of past costs is predictive. They can be used to help predict future costs.
10.

Flexible resources are relevant whenever the demand for an activity changes across alternatives.
Resource spending will differ across alternatives, making the cost of the activity relevant.

11.

Typically, committed resources acquired through implicit contracting are acquired in lumpy amounts
and are not formal commitments. Thus, if changes in demand across alternatives produce a change
in resource supply, then resource spending will also change, making the cost relevant. Usually, the
cost of committed resources is a sunk cost (since they are acquired in advance). Reductions in
demand typically do not lead to reductions in resource spending. Increases in demand beyond the
activity
capacity usually mean a major resource expenditur e a decision that is outside the
domain of tactical decision making and more in the domain of strategic analysis.

12.

A functional-based make-or-buy analysis focuses on unit-level activities and directly attributable

fixed cost and assumes that the costs of all other non-unit-level activities are irrelevant. An activitybased analysis exploits activity cost behavior to identify relevant costs.

147

13.

Activity-based segmented reports trace costs to segments using activity drivers and provide a more
accurate assessment of profitability. Additionally, the use of the activity resource usage model allows
a manager to more fully assess the changes in resource spending that will occur if a segment is
dropped.

14.

Joint costs are present whether the product is processed further or sold at split-off and are not
relevant.

15.

If a firm has unused production capacity and sufficient unused activity capacity, a 1-time special
order may bring in more revenues than the increase in resource spending needed to fill the order. In
this case, short-term profits will increase.

148

EXERCISES
181
1.

Problem: How to obtain additional space needed for warehousing, offices,

and the production of plastic moldings.

2.

Alternatives identified by Renslens managers:

a.

Build its own facility with sufficient capacity to handle current and
immediate foreseeable needs.

b.

Lease a larger facility and sublease its current facility.

c.

Lease an additional, similar facility.

d.

Lease an additional building that would be used for warehousing only,

thereby freeing up space for expanded production.

e.

Buy shafts and bushings externally and use the space made available
(previously used for producing these parts) to solve the space problem.

Not feasible:
a.

Investment too risky at this stage of companys development.

b.

Subleasing too difficult.

c.

Production level doesnt justify another facility; overkill solution.

Feasible: d and e
3.

Potential costs: lease payment, cost of materials and labor to produce the
parts, materials handling, inspection of shafts and bushings, cost of
purchasing shafts and bushings, depreciation on equipment used to produce
shafts and bushings, revenue from selling the equipment if shafts and
bushings are purchased, etc. Of these costs and benefits, probably all those
listed, except depreciation, would be relevant.

182
1.

Flexible resources: Forms, postage, and other supplies

Committed resources: Clerks, PC system

2.

Activity availability =
+
32,000
=

Activity
Unused activity
29,320
+

149

usage
2,680

182
3.

Concluded

Activity costa =
$135,858
=

Cost of activity used +

$126,076
+

Cost of unused activityb

$9,782

[4($27,400 + $1,800)] + [($20,800/32,000) 29,320].

[4($27,400 + $1,800)] 2,680/32,000.

4.

a.

Since demand changes for the flexible resources, the cost of supplies
increases by $650 ($0.65 1,000). For the committed resources, there is
sufficient excess capacity (2,680 purchase orders = 32,000 29,320) to
handle the special order.

b.

If the special order requires 4,500 purchase orders, there is not sufficient
excess capacity to handle it. An additional clerk must be hired (at
$27,400) and an additional PC system must be obtained (annual
depreciation of $1,800). The extra flexible resource cost of the additional
purchase orders is $2,925 (4,500 $0.65). This all seems excessive for a
1-time special order. There may be other options for dealing with the
excess capacity requiremente.g., using a temporary agency to hire a
clerk and having this clerk work outside the normal shift to avoid the
need to invest in a new PC system. However, the important point here is
that additional resources are needed and are relevant to the decision.

183
1.

The money already spent on the LeBaron is not relevant. The purchase price
and the repair costs are sunk costs; they are the same whether Kelly restores
the LeBaron or buys the RAV4.

2.

All future costs that differ across alternatives are relevant. The alternatives
facing Kelly are restoration and buying the RAV4. Thus, all costs of
restoration, the sales price of the LeBaron, and the purchase price of the
RAV4 are relevant.
The costs of restoration are $2,700. The net purchase cost of the RAV4 is
$6,400 ($10,000 $3,600). If all other things are equal, Kelly should choose
the restoration alternative. (However, all things are seldom equal. If the
unreliability of the LeBaron, the hassle of having it in the shop, and the
lowered desirability of the convertible top are sufficiently important to Kelly,
it might be worth it to her to spend the extra money and get the RAV4.)

150

184
1.

The company should accept the offer as the additional revenue is greater
than the additional costs (assuming fixed overhead is allocated and will not
increase with the special order):
Incremental revenue per croquet set.................
Incremental cost per croquet set.......................
Incremental income per croquet set............

$21.00
18.05*
$ 2.95

Total additional income: $2.95 4,000 = $11,800

*$7.90 + $5.40 + $4.75 = $18.05.
2.

If the idle capacity is viewed as a temporary state, then accepting an order

that shows a loss in order to maintain labor stability and community image
may be justifiable. Qualitative factors often outweigh quantitative (at least in
the short run).

185
1.
Direct materials.................
Direct labor........................
Variable overhead.............
Fixed overhead.................
Purchase cost...................
Total relevant costs....

Make
$1,050,000
300,000
45,000
12,000
0
$ 1,407,000

Buy
$

0
0
0
0
1,410,000 ($94 15,000)
$ 1,410,000

Darim Company should continue manufacturing the part.

2.

Maximum price = $1,407,000/15,000 = $93.80

186
1.
Direct materials.................
Direct labor........................
Variable overhead.............
Purchase cost...................

Make
$140,000
60,000
20,000
0
$ 220,000

Buy
$

0
0
0
230,000
$ 230,000

The offer would be rejected, and the company would continue to produce
internally.

186
2.

Concluded
Make
151

Buy

Direct materials...................
Direct labor..........................
Variable overhead................
Setups...................................
Inspections...........................
Materials handling...............
Purchase cost......................

$140,000
60,000
20,000
3,600
12,300
8,000
0
$ 243,900

0
0
0
0
0
0
230,000
$ 230,000

The outcome now favors the purchase option.

3.

In making this decision Golf-2-Go should consider such qualitative factors as

the quality of the part, the reliability of the supplier, the effect of labor
reductions on employee morale, the possibility of price increases in the
future, and the effect on the overall strategic position of the firm. The
strategic implications are particularly important. Does Golf-2-Go really want
to reduce the level of backward integration? If Golf-2-Go is pursuing a cost
leadership strategy, is purchasing the part the best way of reducing costs?
Or should it first examine ways of reducing costs internally before making a
purchase decision? It may be possible to reduce waste and inefficiency to
the point where internal production is much better (from a cost reduction
point of view) than external purchase.

4.

The controller does have a point. Purchasing the part will affect a number of
other activities such as purchasing, receiving, and paying bills. If these
activities do not have unused capacity that can absorb the increased
demands associated with the new part, then resource spending could
increase and this should be factored into the analysis. An ABC system would
tend to make this focus a natural outcome and thus avoid the likelihood of
missing any incremental costs.

152

187
1.

Income effect:
Revenues ($35 14,000).....................................
Direct materials ($20 14,000)...........................
Direct labor ($15 10,500)..................................
Setups ($175 25) + ($8 50).............................
Inspection ($1 400)............................................
Machining ($20 2,500) + ($3 7,000)...............
Income change..............................................

$ 490,000
(280,000)
(157,500)
(4,775)
(400)
(71,000)
$ (23,675)

The initial analysis favors rejecting the order because income decreases by
$23,675.
2.

If machining had 7,500 hours of unused capacity, it would be unnecessary to

acquire the additional 2,500 hours to deal with the order. This makes the
fixed activity component irrelevant. The only increase in resource spending
for the machining activity would be the variable amount of $21,000 ($3
7,000 hours). Thus, income would increase by $26,325 ($50,000 $23,675),
making the special order profitable.

3.

The setup activitys 80 hours of unused capacity increases the benefit of

accepting the order by $4,375 ($175 25). However, the unused machining
capacity is still not sufficient to cover the orders requirements and so the
additional capacity must be acquired by leasing another machinefor
$50,000 per year ($20 2,500). The order is still unacceptable, but with a loss
of $19,300 instead of $23,675. (23,675 4,375 = 19,300)

153

188
1.

Functional-based statement:
Smooth
Crunchy
Revenues........................................ $ 5,000,000
$ 800,000
Variable expenses:
Direct materials....................... (2,500,000)
(480,000)
Direct labor..............................
(500,000)
(80,000)
Variable overheada..................
(360,000)
(90,000)
Contribution margin...................... $ 1,640,000
$ 150,000
Less: Direct fixed expenses.........
200,000
60,000
Product margin........................ $ 1,440,000
$ 90,000
Common fixed expensesb.................................................................
Income before taxes....................................................................

Total
$ 5,800,000
(2,980,000)
(580,000)
(450,000)
$ 1,790,000
260,000
$ 1,530,000
567,500
$ 962,500

Only direct labor benefits and machine costs vary with direct labor hours.
Why direct labor hours as driver for machine costs? Use two overhead
rates as follows:

Direct Labor Benefits $200,000 / 50,000 hours = $4/hr; $160,000 to Smooth,

$40,000 to Crunchy
Machining: $250,000 / 12,500 machine hours = $20 per machine hour;
$200,000 to Smooth, $50,000 to Crunchy
Total Var OH allocated to Smooth is still $360,000 and $90,000 to Crunchy
All other overhead costs are fixed with respect to this driver. Thus, Variable
overhead rate = $450,000/50,000 direct labor hours = $9 per direct labor
hour.
Smooth: $9 40,000 = $360,000
Crunchy: $9 10,000 = $90,000
b

$567,500 = $500,000 + $22,500 + $45,000.

Activity-based statement:
Revenues........................................
Variable costsa................................
Contribution margin...............
Traceable expenses:
Advertising:
Direct fixed.......................
Receiving:b
Activity fixed....................
Non-unit variable.............
Packing:c
Activity fixed....................
Non-unit variable.............

Smooth
$5,000,000
3,360,000
$1,640,000

Crunchy
$800,000
650,000
$150,000

Total
$ 5,800,000
4,010,000
$ 1,790,000

(200,000)

(60,000)

(260,000)

(100,000)
(15,000)

(50,000)
(7,500)

(150,000)
(22,500)

(50,000)
(30,000)

(25,000)
(15,000)

(75,000)
(45,000)

154

Product margin.............................. $ 1,245,000

$ (7,500)
$ 1,237,500
d
Unused activity expenses:
Receiving.....................................................................................
(50,000)
Packing........................................................................................
(25,000)
Common fixed expenses (machine depreciation)..........................
(200,000)
Income before taxes................................................................... $ 962,500
See functional-based statement for detail.
Fixed activity rate = $200,000/1,000 = $200/receiving order; Variable activity
rate = $22,500/750 = $30/receiving order
Activity fixed = ($200 500) and ($200 250); Non-unit variable = $30 500
and $30 250
c
Fixed activity rate = $100,000/2,000 = $50/packing order; Variable activity rate
= $45,000/1,500 = $30/packing order; Activity fixed = ($50 1,000) and ($50
500); Non-unit variable = ($30 1,000) and ($30 500)
d
$200 250; $50 500.
a

2.

In a functional-based analysis, the segment margin will signal how much

profits will change if a line is dropped. Thus, for the Crunchy line, the
analysis indicates that profits will drop by $90,000 and the line should be
kept.

3.

ABC keep-or-drop analysis (Crunchy line):

Contribution margin
Advertising:
Direct fixed
Receiving:a
Nonunit variable
Traceable fixed
Unused capacity
Packing:b
Nonunit variable
Traceable fixed
Total
a

188

Keep Alternative
$150,000

Drop Alternative
$
0

(60,000)

(7,500)
(50,000)
(50,000)

0
0
0

(15,000)
(25,000)
$ (57,500)

0
0
$0

($22,500/750) 250; $200 250 (traceable fixed); $200 250 (unused

capacity needed to achieve the entire step). One step can be saved by
dropping the Crunchy line (250 orders used by that line plus 250 orders of
current permanent unused capacity). The savings from eliminating one step
of capacity are broken down into these two sources and listed as traceable
fixed and unused capacity.

Concluded

155

($45,000/1,500) 500; ($100,000/2,000) 500 (Two steps can be reduced by

dropping the Crunchy line; the permanent unused packing capacity can
produce more savings but these are possible whether or not this line is
dropped and so are not relevant.)

The ABC analysis favors dropping the Crunchy line, producing a savings of
$57,500.

189
1.

Sales........................................
Cost of goods sold................
Gross profit......................

$168,000
138,000
$ 30,000

Revenues.................................
Further processing cost........
Gross profit......................

Split-Off
$15,000
0
$15,000

2.

Process Further
$ 58,500
39,675
$ 18,825

Difference
$ 43,500
39,675
$ 3,825

Further processing will increase profit by $3,825. Joint costs are irrelevant;
they will be incurred whether or not the organ meats are processed further.

PROBLEMS
1810
1.
Sales........................................
Variable expenses.................
Contribution margin........
Direct fixed expenses..........
Segment margin...............

Keep
$16,200,000
13,430,000
$ 2,770,000
900,000
$ 1,870,000

Drop
$10,200,000
8,160,000
$ 2,040,000
500,000
$ 1,540,000

If the company stops selling auto insurance, income will decrease by

$330,000 ($1,870,000 $1,540,000). Therefore, the company should continue
to sell automobile insurance.

1810 Concluded
2.
Sales...........................................

Automobile
Insurance
$ 4,620,000

156

Life
Insurance
$12,360,000

Total
$16,980,000

Less: Variable costs.................

4,213,000
9,888,000
Contribution margin........... $ 407,000
$ 2,472,000
Less: Direct fixed expenses....
400,000
500,000
Segment margin................. $
7,000
$ 1,972,000
Less: Common fixed costs...............................................................
Net income....................................................................................

14,101,000
$ 2,879,000
900,000
$ 1,979,000
350,000
$ 1,629,000

The advertising should be increased as income would increase by $59,000

($1,629,000 $1,570,000).

1811
1.

Creemy
Shiney
Revenue.................................
$1,728,000
$1,872,000
Variable expenses................
1,008,000
432,000
Contribution margin.......
$ 720,000
$ 1,440,000
Joint cost...........................................................................................
Operating income.......................................................................

2.

If the order is accepted, Lancaster must manufacture two additional standard

production runs (2 240,000 gallons = 480,000 gallons requested). The two
added production runs will also generate 720,000 gallons of Creemy.
Creemy
Shiney
Revenue.................................
$2,304,000
$3,504,000
Variable expenses...............
2,016,000
816,000
Contribution margin.......
$ 288,000
$ 2,688,000
Joint cost...........................................................................................
Operating income (loss).............................................................
Yes, the special order will result in a $1,296,000 profit.

1812
1.

The company would save $49,625 per year by making the blades:
Prime costs.....................
Setupsa............................
Machiningb......................

Make
$ 500,000
145,000
155,000
157

Buy
$

0
0
0

Total
$3,600,000
1,440,000
$2,160,000
840,000
$1,320,000

Total
$5,808,000
2,832,000
$2,976,000
1,680,000
$1,296,000

Purchasingc....................
Materials handlingd........
Purchase cost................
Total.........................

0
375
0
$ 800,375

50,000
0
800,000
$ 850,000

($200 100) + ($500 250). (Another whole unit of activity capacity needs to
be purchased.)
b
(2 $40,000) + ($1.50 50,000). (Since each line is capable of producing
80,000 sets, two lines will be needed, calling for two supervisors and 50,000
machine hours.)
c
The unused activity capacity increases by 2,500 orders (6,500 4,000). Thus,
the total unused capacity would increase from 3,000 to 5,500 orders. Since
the step size for purchasing is 5,000 orders, resource spending can drop by
$10 5,000, or $50,000. This $50,000 can be interpreted as a benefit for the
make alternative or an opportunity cost for the buy alternative.
d
The demands on materials handling increase by a net 250 moves (650 400).
Since there are 300 moves of unused capacity, the company does not need
to expand handling capacityfixed resource spending does not change.
Only variable materials handling is relevant. Inspection cost is not relevant
because resource spending remains unchanged. There are 2,000 hours of
unused capacity, and demand for this resource, if the blades are produced
internally, is only 1,500 hours.
a

2.

The ABC resource usage model provides insight concerning activity supply,
activity excess capacity, and the need to acquire more capacity. ABC offers a
more complete assessment of how activities are affected by decisions. A
conventional approach would probably have viewed setups, purchasing,
inspection, and material handling as part of fixed overhead and, therefore,
would have ignored their effect. At best, a special study may have revealed
the consequences. It seems more desirable to have the information system
structured to provide this kind of information on a regular basis.

1813
1.

Cost Item
Raw materialsa.....................
Direct laborb.........................
Variable overheadc...............
Fixed overheadd...................
Purchase coste.....................

Make
$180,000
50,000
12,500
50,000
0
$ 292,500

($60 1,500) + ($90 1,000).

158

Buy
$

0
0
0
0
282,000
$ 282,000

b
c

($5 2,500).

d
e

($20 2,500).
($30,000 + $20,000).

($100 1,500) + ($132 1,000).

Net savings = $10,500; Gray should purchase the crowns.

2.

Quality of crowns, reliability and promptness of producer, reduction of

workforce

3.

It reduces the cost of making the crowns to $272,500, which is less than the
cost of buying.

4.

Cost Item
Raw materials......................
Direct labor..........................
Variable overhead................
Fixed overhead....................
Purchase cost......................

Make
$360,000
100,000
25,000
50,000
0
$ 535,000

Buy
$

0
0
0
0
564,000
$ 564,000

Gray should produce its own crowns if demand increases to this level, as the
fixed overhead is spread over more units.

1814
1.

@ 1,000 gals.
Process Further
a
Revenues ...............
$ 85,000
Containersb.............
0
Shippingc.................
(4,000)
Processingd............
(5,000)
Packaginge..............
(48,600)
$ 27,400
1,000 10 $8.50 = $85,000; $25 1,000.
$1.65 (1,000/5).

159

Sell
$ 25,000
(330)
(40)
0
0
$ 24,630

Difference
$ 60,000
330
(3,960)
(5,000)
(48,600)
$ 2,770

[(10 1,000)] $0.40; $0.20 200.

$5.00 1,000.
e
10 1,000 $4.86.
c

Chemco should process the suppressant further.

2.

$2,770/1,000 = $2.77 additional income per gallon

$2.77 360,000 = $997,200 (additional income)

160

1815
1.

First year (in thousands):

Cost Item
Materials............................
Labor..................................
Pension expense..............
Cost of buying...................

Make
$12,000
20,000
4,000
0
$36,000

Following years (in thousands):

Cost Item
Make
Materials............................ $12,000
Labor..................................
20,000
Pension expense..............
4,000
Cost of buying..............
0
Total recurring........... $36,000

Buy
$ 1,800 (penalty)
1,000
3,000
30,000
$35,800
Buy
$

0
0
3,000
30,000
$33,000

The salaries of Pam and her staff are irrelevant; they continue whether or not
the Denver plant closes. Nonrecurring costs (first year): $2,800,000. If these
nonrecurring costs are removed, there is a $3 million annual difference in
favor of buying. The annual opportunity cost associated with the
nonrecurring cost of $2,800,000 is surely less than $3 million. For example, if
we assume that the $2,800,000 could have been invested to earn as much as
50%, the amount foregone would be $1,400,000 per year.
2.

Qualitative factors include the quality of purchased parts, reliability of the

supplier, GianAutos responsibility to society (the employees losing their
jobs), and the effect it could have on the feeling of job security of other
GianAuto employees. The annual savings could easily disappear if the
supplier increases its selling prices. (A 10% increase in the purchase price is
all that is needed.) I would not close the plant unless I was certain that quality
and reliability were assured and unless I had a long-term contract providing
some confidence that the price advantage would continue in the future.

161

1816
1.

Cost Item
Purchase cost......................................
Variable manufacturing costs............
Lease expenses...................................
Supervisor salary.................................
Total relevant costs......................

Lease and Make

$
0
14,000*
27,000
10,000
$51,000

Buy
$50,000
0
0
0
$50,000

*$7 2,000.
Purchase cost......................................
Variable manufacturing costs............
Lost contribution margin....................
Total relevant costs......................

Drop Thickness Gauge and Make

$
0
14,000
34,000
$ 48,000

Note: The direct fixed expenses are the same across all alternatives.
Best alternative: Drop the thickness gauge and make the subassembly.
2.

Analysis with complementary effect:

Loss in sales for density gauge .............
Cost of making componentb....................
Reduction of other variable costs c..........
Loss in contribution margin for
thickness gauge...................................
Cost to purchased.....................................
Total relevant cost.............................
a

Make
$15,000
12,600
(3,000)
34,000
0
$58,600

Buy
$

0
0
0

0
50,000
$50,000

0.10 $150,000.

0.90 2,000 $7.00.

0.10($80,000 $50,000); since sales decrease by 10% if the component is

manufactured, other variable costs (those other than the cost of the
component) will reduce proportionately.

If the buy alternative is chosen, then there is no reduction in sales and the
same number of components will be needed.

The correct decision now is to keep the thickness gauge and buy the
component.

162

1816

Concluded

3.

Lease and Make

$19,600
27,000
10,000
0
$56,600

Variable manufacturing costs

Lease
Salary (supervisor)
Purchase cost*
Total relevant costs

Buy
$

0
0
0
70,000
$70,000

*$25 2,800.
Lost sales from density gauge...................
Variable cost of manufacturinga.................
Reduction of other variable costs b............
Loss in contribution margin (thickness)...
Purchase cost..............................................
Total relevant costs..............................

Drop Thickness Gauge and Make

$ 15,000
17,640
(1,000)
34,000
0
$ 65,640

0.90 2,800 $7.00.

0.10 ($80,000 $70,000).

The correct decision now is to lease and make the component.

1817
1.

Committed resources: Sonogram equipment and technicians

Flexible resources: Supplies and power, verification

2.

Activity costs:
Technician salaries....................
Depreciation...............................
Supplies and power...................
Verification..................................
Total expected costs..........
Practical capacity..............................
Activity rate........................................

$ 180,000
30,000
10,000
50,000
$ 270,000
5,000 tests
$
54

Fixed activity rate = ($180,000 + $30,000)/5,000 = $42 per test

Variable activity rate = ($10,000 + $50,000)/5,000 = $12 per test
Relevant: Supplies and power and physician verification. These are flexible
resources; if activity demand changes, then they are relevant. In this case,
the demand for tests increases by 500 units.
Irrelevant: Depreciation (sunk cost); technician salaries (demand increase is
less than unused capacity).

1817 Concluded

163

3.

If the offer is accepted, PMC receives $35 per test and will spend $12 per test,
for a net per test benefit of $23. In total, the benefit is $11,500 ($23 500). The
offer should be accepted since it reduces the hospitals operating costs by
$11,500.

4.

Harry is thinking about the long-term effects. If demand for sonogram testing
remains at 4,200 units, then the current charge of $65 will not cover the
hospitals full cost. To provide the same revenues, the charge per test must
now be $77.38 [($65 5,000)/4,200)]. The ability to charge this amount
depends on what competitors are charging, the loyalty of physicians who
refer patients, and the insurance companies payment policies. Harry has a
good point about word getting out to user physicians; their reaction affects
long-term demand for the hospitals services. A short-term benefit that
adversely affects the strategic position of the hospital is unwise.

5.

Elaine has been able to change units of purchase of the sonogram activity
from 1,000 to 1,050. Thus, in one stroke, the unused activity capacity for the
short-term technician resource has been wiped out. PMC now has the
capability of offering only 4,200 tests per year. Accepting the HMO offer
would require an increase in resource spending probably equivalent to
hiring another technicianat least for a year. If $36,000 is required to hire
another technician to provide 500 tests, this is $72 per test ($36,000/500)a
cost well in excess of the $35 price offered by the HMO, not even considering
the $12 variable cost per test. The offer should be rejected.

6.

The charge to receive the same revenues as before, less the resource
spending reduction, is computed as follows:
Price = [($65 5,000) $28,000*]/4,200 = $70.71
*$36,000 4($2,000) = $28,000.

164

1818
1.
Sales revenues.......................
Variable costs:
Commissions..................
Materials...........................
Power...............................
Contribution margin...............
Traceable expenses:
Activity fixed:
Scheduling................
Personnel..................
Cafeteria...................
Non-unit variable:
Cafeteria...................
Direct fixed:
Labor.........................
Depreciation.............
Advertising...............
Segment margin.....................

Regular
$9,000,000

Heavy Duty
$ 3,500,000

Total
$ 12,500,000

(180,000)
(3,500,000)
(250,000)
$5,070,000

(70,000)
(1,000,000)
(100,000)
$ 2,330,000

(250,000)
(4,500,000)
(350,000)
$ 7,400,000

(120,000)
(75,000)
(36,000)

(120,000)
(18,750)
(9,000)

(240,000)
(93,750)
(45,000)

(15,200)

(3,800)

(19,000)

(900,000)
(800,000)
(400,000)
$ 2,723,800

(315,000)
(300,000)
(200,000)
$ 1,363,450

(1,215,000)
(1,100,000)
(600,000)
$ 4,087,250

Unused activity costs:

Scheduling.................................................................................
(60,000)
Cafeteria.....................................................................................
(36,000)
Personnel...................................................................................
(56,250)
Common fixed costs:
Plant depreciation.......................................................................
(900,000)
Administrative.............................................................................
(500,000)
Income before taxes.......................................................................... $ 2,535,000
Two activities, scheduling and cafeteria, have unused activity that can be
exploited to reduce resource spending. Scheduling can be reduced by
$60,000 (50 $1,200). This is possible because the resource must be
acquired in increments of 25 and there are 50 units of excess capacity.
Cafeteria can be reduced by $27,000 ($1,800 15). This resource is acquired
in increments of 15 and there are 20 units of excess capacity. Personnel has
15 units of excess capacity but must be acquired in increments of 20 so no
reduction is possible.

165

1818 Continued
2.

Profits will decrease by the segment margin adjusted for the lumpy nature of
activity fixed expenses.
Adjustments:
Scheduling: $120,000/$1,200 per run = 100 runs
100/25 = 4 lumpy units
Conclusion: Resource spending for scheduling can be reduced by exactly
$120,000; thus, no adjustment is needed for this activity.
Personnel: $18,750/$3,750 per cell worker = 5 workers
The unused capacity of 15 workers (40 supplied 25 used) plus the 5
workers released by eliminating the Heavy Duty line equals 20 workers,
exactly equal to the lumpy quantity for personnel. Therefore, one step
($75,000 = 20 $3,750) can be saved.
Conclusion: Resource spending for personnel can be reduced if the Heavy
Duty Model is dropped. Adjust segment income by adding back the
additional $56,250 ($75,000 $18,750).
Cafeteria: $9,000/$1,800 = 5 workers
Since the company could already reduce spending on cafeteria by 15
workers, or $27,000 (see answer to Requirement 1), the additional reduction
in workers by dropping the Heavy Duty line does not enable the company to
save enough for still another lumpy amount. Therefore, the spending on
cafeteria workers remains.
Conclusion: Resource spending of $9,000 remains, and segment income
must be adjusted by $9,000.
Change in profits:
Lost segment margin...................
Adjustments:
Personnel...............................
Cafeteria.................................
Total change..................................

166

$(1,363,450)
56,250
(9,000)
$(1,316,200)

1818 Concluded
3.

No, the president is not correct. The Regular Model cell is operating at 80%
capacity and can produce the special order without displacing any current
production (150,000/0.8 = 187,500 units); thus, the cell is capable of
producing an additional 37,500 units. Incremental revenues and costs of the
order are as follows:
Revenues ($30 30,000)........................
Direct materials ($23.33 30,000).........
Power ($1.67 30,000)...........................
Incremental benefit.........................

$ 900,000
(699,900)
(50,100)
$ 150,000

The other costs remain unchanged if the order is accepted. It is assumed that
the number of cell workers is constant (even if production fluctuates within
some reasonable range) because cell laborers can be employed in other
tasks besides production. Thus, labor costs and the non-unit-based costs
(cafeteria and personnel) are not affected by additional production. Also,
scheduling has excess capacity so no incremental cost is required for this
activity as shown:
Units per run = 150,000/100 = 1,500
Runs required = 30,000/1,500 = 20
Excess scheduling capacity: 250 200 = 50
4.

This information casts an entirely different light on the decision. The sale
could place the low-end competitor in direct competition with Emerys
regular customers. This could have two adverse effects: (1) the special order
could displace some of the regular sales by decreasing demand by Emerys
regular customers; (2) if Emerys regular customers should learn of the
special sale, they may turn to alternative sources, and Emery could suffer a
further reduction in demand. Both possibilities could be permanent effects,
significantly reducing Emerys profitability.

167

1819
MEMO
TO:
FROM:
SUBJECT:

Central University President

Dean, College of Business Administration
Decentralization of Continuing Education

In recommending whether to centralize or decentralize continuing education (CE),

I have first focused on the economic implications. The income statements,
showing a favorable trend for CE, are misleading. Tuition revenues will be
present whether we centralize or decentralize and, therefore, are not relevant to
the decision. Department heads are already heavily involved in scheduling and
staffing off-campus and evening courses, and individual faculty are largely
responsible for generating our noncredit offerings. Thus, it would be difficult to
argue that decentralizing CE would have any adverse impact on the level of
tuition revenues.
One can also argue that the operating costs for evening and noncredit courses
and the direct costs for off-campus offerings are also irrelevant. These costs,
which consist of instructional wages, rental of facilities, and supplies, will be
incurred regardless of whether CE is centralized or decentralized.
This leaves two categories of costs, indirect costs and administration, which
affect the decision. These categories include advertising, secretaries, assistants,
and other support personnel. If we choose to decentralize, all of these costs, with
the exception of the directors salary and advertising, can be avoided.
Furthermore, because the director will be teaching in her department, some of
her salary is avoidable as well ($20,000). The total avoidable costs are outlined as
follows:
Administrationa..........
Indirectb.......................
Total.....................

$ 82,000
410,000
$ 492,000

[$112,000 ($50,000 $20,000)] = $82,000.

Indirect costs Advertising = $440,000 $30,000.

I have retained the advertising budget and would recommend that this amount be
allocated to the individual colleges in proportion to the evening and off-campus
revenues generated by each college.
As you can see, the savings from decentralization are significant. This assumes
that the overhead of the individual units will not increase because of the added
responsibilities. I have discussed this matter with my department heads and with
the other deans. All feel that the additional administrative work can be absorbed
by existing staff.

168

1819 Concluded
In choosing to decentralize, however, we do lose some intangible benefits. First,
we no longer have one individual who can be contacted by outside parties.
Instead, we have numerous individuals involved. This may prove to be frustrating
for some of those whom we serve, and it is possible that they will perceive a drop
in service quality.
Also, some units may not exert the effort needed to provide good service.
Accountability is more diverse, and some department heads may feel that they
have more than enough to do without continuing education. This problem can be
alleviated to some extent by localizing the CE responsibility at the college level,
rather than at the departmental level.
I am convinced that a decentralized CE will work at least as well as our current
arrangement. Given our current budgetary crisis, I would rather risk reducing the
quality of service for CE than risk reducing the quality of service for our main
programs. Therefore, I strongly recommend that CE be decentralized and that the
savings from this action be used to maintain the quality of our on-campus
programs.

COLLABORATIVE LEARNING EXERCISE

1820
1.

Kate has already suggested the basis of the analysis. Both activity-based
costing and the concept of flexible and committed costing will bear on the
problem. The overhead assigned to Component A56 contains some
avoidable costs (e.g., electricity to power the welding equipment) as well as
unavoidable costs (e.g., the depreciation connected with the space the
production line occupies, the lines share of general factory costs). Activitybased costing would give a much better indication of the actual usage of
overhead activities by the A56 production line and would enable the
controller to figure out the incremental cost of producing A56. Future
(opportunity) costs associated with potential layoffssuch as increased
unemployment insurance ratesshould also be considered.

2.

Lauren depends on the accounting department for accurate costing

information and has no reason to believe that such information is either
incomplete or inaccurate. In addition, it is possible that there is some
empire building going on. As head of the purchasing department, she is
well aware of benefits associated with purchasing and believes in the
importance of her job and her department. Additional outsourcing would
decrease the relative value of production and increase the relative value of
purchasing.

169

1820 Concluded
James is obligated by standard I-1 to maintain an appropriate level of
professional competence by ongoing development of their knowledge and
skills. Rick had already suggested that he learn about activity-based
costing. Actually, it is outrageous that the plant manager has to tell the
controller about new developments in accounting. James should be aware of
these and have sufficient knowledge to adequately evaluate them. ABC is not
a fad. In addition, James has a problem with the integrity section of the
standards of ethical conduct. For example, III-5 points out the need to
recognize and communicate professional limitations that would make it
difficult to do an adequate job.
3.

Yes, I think he should fire James. Bringing in a new person at a level lower
than James would make it impossible for the new person to do a good job.
James may not be up to date in management accounting, but he is surely
intelligent enough to recognize that the new person was being hired to
remedy his own (Jamess) deficiencies. The people issues involved could
well paralyze the accounting office. To hire the new person at a level higher
than James would simply give the new hire deadwood in the officeagain,
people issues would cause problems. The cleanest option is to fire James
and hire a new controller.
Ricks loyalties should lie with the company and the rest of the employees,
not just one person. Rick is under pressure to reduce costs and improve
productivity. He does not have the luxury of retaining someone who cannot
contribute.

CYBER RESEARCH CASE

1821
Answers will vary.

170