Exercise 13-2 (30 Minutes) : Difference: Net Operating Income Increase or (Decrease)

Exercise 13-2 (30 minutes)
1. No, production and sale of the racing bikes should not be

discontinued. If the racing bikes were discontinued, then the
net operating income for the company as a whole would
decrease by $11,000 each quarter:
Lost contribution margin.......................... $(27,000)
Fixed costs that can be avoided:
$
Advertising, traceable........................... 6,000
10,00
Salary of the product line manager....... 0 16,000
Decrease in net operating income for the
company as a whole..................... ......... $(11,000)
The depreciation of the special equipment is a sunk cost and is
not relevant to the decision. The common costs are allocated
and will continue regardless of whether or not the racing bikes
are discontinued; thus, they are not relevant to the decision.
Alternative Solution:
Difference
: Net
Operating
Total If Income
Racing Increase
Bikes or
Current Are (Decrease
Total Dropped )
$300,00
Sales 0 $240,000 $(60,000)
120,00
Less variable expenses 0 87,000 33,000
180,00
Contribution margin 0 153,000 (27,000)
Less fixed expenses:
Advertising, traceable 30,000 24,000 6,000
Depreciation on special
equipment* 23,000 23,000 0
Salaries of product 35,000 25,000 10,000
© The McGraw-Hill Companies, Inc., 2008. All rights reserved.
Solutions Manual, Chapter 15 1
managers
60,00
Common allocated costs 0 60,000 0
148,00
Total fixed expenses 0 132,000 16,000
$ 32,00
Net operating income 0 $ 21,000 $ (11,000)
*Includes pro-rated loss on the special equipment if it is
disposed of.

Exercise 13-2 (continued)
2. The segmented report can be improved by eliminating the

allocation of the common fixed expenses. Following the format
introduced in Chapter 12 for a segmented income statement, a
better report would be:
Dirt Mountai Racing
Total Bikes n Bikes Bikes
$300,00 $90,00 $150,00
Sales 0 0 0 $60,000
Less variable
manufacturing and 120,00
selling expenses 0 27,000 60,000 33,000
180,00
Contribution margin 0 63,000 90,000 27,000
Less traceable fixed
expenses:
Advertising 30,000 10,000 14,000 6,000
Depreciation of special
equipment 23,000 6,000 9,000 8,000
Salaries of the product 35,00
line managers 0 12,000 13,000 10,000
Total traceable fixed 88,00
expenses 0 28,000 36,000 24,000
Product line segment $35,00 $
margin 92,000 0 54,000 $ 3,000
Less common fixed 60,00
expenses 0
$
Net operating income 32,000

1. Per Unit
Differenti
al Costs 15,000 units
M
ake Buy Make Buy
$525,00
Cost of purchasing................. $35 0
$210,00
Direct materials..................... $14 0
Direct labor........................... 10 150,000
Variable manufacturing
overhead......................... .... 3 45,000
Fixed manufacturing
overhead, traceable1........... 2 30,000
Fixed manufacturing
overhead, common.............
$435,00 $525,00
Total costs............................. $29 $35 0 0
Difference in favor of
continuing to make the
carburetors......................... $6 $90,000
Only the supervisory salaries can be avoided if the
carburetors are purchased. The remaining book value of the
special equipment is a sunk cost; hence, the $4 per unit
depreciation expense is not relevant to this decision. Based
on these data, the company should reject the offer and
should continue to produce the carburetors internally.
2. Make Buy
$525,00
Cost of purchasing (part 1)..................... 0
$435,00
Cost of making (part 1).......................... 0
Opportunity cost—segment margin
foregone on a potential new product
line.................................................. ..... 150,000
Total cost............................. ................... $585,00 $525,00

0 0
Difference in favor of purchasing from $60,00
the outside supplier............................. 0
Thus, the company should accept the offer and purchase the
carburetors from the outside supplier.

Only the incremental costs and benefits are relevant. In particular,

only the variable manufacturing overhead and the cost of the
special tool are relevant overhead costs in this situation. The
other manufacturing overhead costs are fixed and are not
affected by the decision.
Total
Per for 20
Unit Bracelets
$169.9 $3,399.0
Incremental revenue..................... .. 5 0
Incremental costs:
Variable costs:
Direct materials......................... $ 84.00 1,680.00
Direct labor................................ 45.00 900.00
Variable manufacturing
overhead................................. 4.00 80.00
Special filigree........................... 2.00 40.00
$135.0
Total variable cost........................ 0 2,700.00
Fixed costs:
Purchase of special tool............. 250.00
Total incremental cost..................... 2,950.00
Incremental net operating income.. $ 449.00
Even though the price for the special order is below the
company's regular price for such an item, the special order would
add to the company's net operating income and should be
accepted. This conclusion would not necessarily follow if the
special order affected the regular selling price of bracelets or if it
required the use of a constrained resource.

1. A B C
(1) Contribution margin per unit.................... $54 $108 $60
(2) Direct material cost per unit..................... $24 $72 $32
(3) Direct material cost per pound................. $8 $8 $8
Pounds of material required per unit (2)
(4) ÷ (3)......................... ............................. 3 9 4
(5) Contribution margin per pound (1) ÷ (4). . $18 $12 $15
2. The company should concentrate its available material on

product A:
A B C
Contribution margin per pound
(above)......................................... $ 18 $
15 12 $
×
Pounds of material available............ × 5,000 × 5,000 5,000
$75,00
Total contribution margin................. $90,000 $60,000 0
Although product A has the lowest contribution margin per unit
and the second lowest contribution margin ratio, it is preferred
over the other two products since it has the greatest amount of
contribution margin per pound of material, and material is the
company’s constrained resource.
3. The price Barlow Company would be willing to pay per pound

for additional raw materials depends on how the materials
would be used. If there are unfilled orders for all of the
products, Barlow would presumably use the additional raw
materials to make more of product A. Each pound of raw
materials used in product A generates $18 of contribution
margin over and above the usual cost of raw materials.
Therefore, Barlow should be willing to pay up to $26 per pound
($8 usual price plus $18 contribution margin per pound) for the
additional raw material, but would of course prefer to pay far
less. The upper limit of $26 per pound to manufacture more
product A signals to managers how valuable additional raw
materials are to the company.
If all of the orders for product A have been filled, Barlow
Company would then use additional raw materials to
manufacture product C. The company should be willing to pay
up to $23 per pound ($8 usual price plus $15 contribution
margin per pound) for the additional raw materials to
manufacture more product C, and up to $20 per pound ($8
usual price plus $12 contribution margin per pound) to
manufacture more product B if all of the orders for product C
have been filled as well.

Problem 13-19 (60 minutes)
1. The $90,000 in fixed overhead costs charged to the new

product is a common cost that will be the same whether the
tubes are produced internally or purchased from the outside.
Hence, they are not relevant. The variable manufacturing
overhead per box of Chap-Off would be $0.50, as shown below:
Total manufacturing overhead cost per box of
Chap-Off........................ ..................................... $1.40
Less fixed portion ($90,000 ÷ 100,000 boxes)...... 0.90
Variable overhead cost per box............................. $0.50
The total variable costs of producing one box of Chap-Off would
be:
Direct materials............................................. ........ $3.60
Direct labor........................................................... 2.00
Variable manufacturing overhead......................... 0.50
Total variable cost per box.................................. ... $6.10
If the tubes for the Chap-Off are purchased from the outside
supplier, then the variable cost per box of Chap-Off would be:
Direct materials ($3.60 × 75%)............................ $2.70
Direct labor ($2.00 × 90%)................................... 1.80
Variable manufacturing overhead ($0.50 × 90%). 0.45
Cost of tube from outside..................................... 1.35
Total variable cost per box.................................... $6.30
Therefore, the company should reject the outside supplier’s
offer. A savings of $0.20 per box of Chap-Off will be realized by
producing the tubes internally.

Problem 13-19 (continued)
Another approach to the solution would be:

Cost avoided by purchasing the tubes:
Direct materials ($3.60 × 25%)................... $0.90
Direct labor ($2.00 × 10%).......................... 0.20
Variable manufacturing overhead ($0.50 ×
10%)................................................... ....... 0.05
Total costs avoided....................... .................. $1.15 *
Cost of purchasing the tubes from the

outside............................................... .......... $1.35
Cost savings per box by making internally..... $0.20

* This $1.15 is the cost of making one box of tubes
internally, since it represents the overall cost savings
that will be realized per box of Chap-Off by purchasing
the tubes from the outside.
2. The maximum purchase price would be $1.15 per box. The

company would not be willing to pay more than this amount,
since the $1.15 represents the cost of producing one box of
tubes internally, as shown in Part 1. To make purchasing the
tubes attractive, however, the purchase price should be less
than $1.15 per box.

3. At a volume of 120,000 boxes, the company should buy the

tubes. The computations are:
Cost of making 120,000 boxes:
$138,00
120,000 boxes × $1.15 per box............. 0
Rental cost of equipment...................... . 40,000
$178,00
Total cost................................................. 0
Cost of buying 120,000 boxes:
$162,00
120,000 boxes × $1.35 per box............. 0
Or, on a total cost basis, the
computations are:
Cost of making 120,000 boxes:
$732,00
120,000 boxes × $6.10 per box............. 0
Rental cost of equipment...................... . 40,000
$772,00
Total cost................................................. 0
Cost of buying 120,000 boxes:
$756,00
120,000 boxes × $6.30 per box............. 0
Thus, buying the boxes will save the company $16,000 per
year.

4. Under these circumstances, the company should make the

100,000 boxes of tubes and purchase the remaining 20,000
boxes from the outside supplier. The costs would:
Cost of making: 100,000 boxes × $1.15 per $115,00
box............................................................ ... 0
Cost of buying: 20,000 boxes × $1.35 per
box............................................................ ... 27,000
$142,00
Total cost....................................... ................. 0
Or, on a total cost basis, the computation would be:
Cost of making: 100,000 boxes × $6.10 per
box............................................................ ... $610,000
Cost of buying: 20,000 boxes × $6.30 per
box............................................................ ... 126,000
Total cost....................................... ................. $736,000
Since the amount of cost under this alternative is $20,000 less
than the best alternative in Part 3, the company should make
as many tubes as possible with the current equipment and buy
the remaining tubes from the outside supplier.
5. Management should take into account at least the following

additional factors:
a) The ability of the supplier to meet required delivery
schedules.
b) The quality of the tubes purchased from the supplier.
c) Alternative uses of the capacity that would be used to
make the tubes.
d) The ability of the supplier to supply tubes if volume
increases in future years.
e) The problem of alternative sources of supply if the supplier
proves undependable.

1. Since the fixed costs will not change as a result of the order,
they are not relevant to the decision. The cost of the new
machine is relevant, and this cost will have to be recovered by
the current order since there is no assurance of future business
from the retail chain.
Total—
U 5,000
nit units
Revenue from the order ($50 × 84%).......... $42 $210,000
Less costs associated with the order:
Direct materials................................ ......... 15 75,000
Direct labor............................................... 8 40,000
Variable manufacturing overhead.............. 3 15,000
Variable selling expense ($4 × 25%)......... 1 5,000
Special machine ($10,000 ÷ 5,000 units).. 2 10,000
Total costs........................................... ......... 29 145,000
Net increase in profits....................... ........... $13 $ 65,000
2. Revenue from the order:

Reimbursement for costs of production
(variable production costs of $26, plus fixed
manufacturing overhead cost of $9 = $35
per unit; $35 per unit × 5,000 units).............. $175,000
Fixed fee ($1.80 per unit × 5,000 units)............ 9,000
Total revenue................................................... .... 184,000
Less incremental costs—variable production
costs
($26 per unit × 5,000 units)............................. . 130,000
Net increase in profits......................................... $ 54,000
3. Sales revenue:
From the U.S. Army (above).............................. $184,000
From regular channels ($50 per unit × 5,000
units)........................................... ................... 250,000
Net decrease in revenue..................................... (66,000)
Less variable selling expenses avoided if the
Army’s order is accepted ($4 per unit × 5,000
units)........................... ..................................... 20,000
Net decrease in profits if the Army’s order is
accepted........................................... ................ $(46,000)

1. A product should be processed further so long as the

incremental revenue from the further processing exceeds the
incremental costs. The incremental revenue from further
processing of the Grit 337 is:
Selling price of the silver polish, per jar......... $4.00
Selling price of 1/4 pound of Grit 337 ($2.00
÷ 4)............................................................ 0.50
Incremental revenue per jar.......................... $3.50
The incremental variable costs are:
Other ingredients.......................................... $0.65
Direct labor................................................... 1.48
Variable manufacturing overhead (25% ×
$1.48)............................... .......................... 0.37
Variable selling costs (7.5% × $4)................. 0.30
Incremental variable cost per jar................... $2.80
Therefore, the incremental contribution margin is $0.70 per jar
($3.50 – $2.80). The $1.60 cost per pound ($0.40 per 1/4
pound) required to produce the Grit 337 would not be relevant
in this computation, since it is incurred regardless of whether
the Grit 337 is further processed into silver polish or sold
outright.

2. Only the cost of advertising and the cost of the production

supervisor are avoidable if production of the silver polish is
discontinued. Therefore, the number of jars of silver polish that
must be sold each month to justify continued processing of the
Grit 337 into silver polish is:
Production supervisor.................................. $3,000
Advertising—direct................................ ....... 4,000
Avoidable fixed costs................................... $7,000
Avoidable fixed costs $7,000

= = 10,000 jars per
Incremental CM per jar $0.70 per jar
month
Therefore, if 10,000 jars of silver polish can be sold each

month, the company would be indifferent between selling it or
selling all of the Grit 337 as a cleaning powder. If the sales of
the silver polish are greater than 10,000 jars per month, then
continued processing of the Grit 337 into silver polish would be
advisable since the company’s total profits will be increased. If
the company can’t sell at least 10,000 jars of silver polish each
month, then production of the silver polish should be
discontinued. To verify this, we show on the next page the total
contribution to profits of sales of 9,000, 10,000 and 11,000 jars
of silver polish, contrasted to sales of equivalent amounts of
Grit 337 sold outright (i.e., 10,000 jars of silver polish would
require the use of 2,500 pounds of Grit 337 that otherwise
could be sold outright as cleaning powder, etc.):

9,000 10,000 11,000

Jars of Jars of Jars of
Polish; Polish; Polish;
or or or
2,250 2,500 2,750
pounds pounds pounds
of Grit of Grit of Grit
337 337 337
Sales of Silver Polish:
Sales @ $4.00 per jar................... $36,000 $40,000 $44,000
Less variable expenses:
Production cost of Grit 337 @
$1.60 per pound........................ 3,600 * 4,000 * 4,400 *
Further processing and selling
costs of the polish @ $2.80 per
jar.............................................. 25,200 28,000 30,800
Total variable expenses.................. 28,800 32,000 35,200
Contribution margin........................ 7,200 8,000 8,800
Less avoidable fixed costs:
Production supervisor................... 3,000 3,000 3,000
Advertising................................... 4,000 4,000 4,000
Total avoidable fixed costs.............. 7,000 7,000 7,000
Total contribution to common fixed
costs and to profits....................... $ 200 $ 1,000 $ 1,800
Sales of Grit 337:
Sales @ $2.00 per pound $ 4,500 $ 5,000 $ 5,500
Less variable expenses:
Production cost of Grit 337 @
$1.60 per pound........................ 3,600 * 4,000 * 4,400 *
Contribution to common fixed
costs and to profits....................... $ 900 $ 1,000 $ 1,100
* This cost will be incurred regardless of whether the Grit 337 is
further processed into silver polish or sold outright as cleaning
powder; therefore, it is not relevant to the decision, as stated
earlier. It is included in the computation above for the specific
purpose of showing that it will be incurred under either
alternative. The same thing could have been done with the

depreciation on the mixing equipment.

Amount of 14% Present

Cash Facto Value of
Item Year(s) Inflows r Cash Flows
Project A:
Cost of
equipment........ Now $(100,000) 1.000 $(100,000)
Annual cash
inflows.............. 1-6 $21,000 3.889 81,669
Salvage value of
the equipment. . 6 $8,000 0.456 3,648
Net present value $ (14,683)
Project B:
Working capital
investment....... Now $(100,000) 1.000 $(100,000)
Annual cash
inflows.............. 1-6 $16,000 3.889 62,224
Working capital
released............ 6 $100,000 0.456 45,600
Net present value $ 7,824
The $100,000 should be invested in Project B rather than in

Project A. Project B has a positive net present value whereas
Project A has a negative net present value.

1. Computation of the annual cash inflow associated with the new

pinball machines:
Net operating income......................... ........... $40,000
Add noncash deduction for depreciation....... 35,000
Net annual cash inflow.................................. $75,000
The payback computation would be:
Investment required
Payback period =
Net annual cash inflow
$300,000
= = 4.0 years
$75,000 per year
Yes, the pinball machines would be purchased. The payback
period is less than the maximum 5 years required by the
company.
2. The simple rate of return would be:
Annual incremental - Annual incremental expenses,

Simple rate = revenues including depreciation
of return Initial investment
Annual incremental net income
=
Initial investment
$40,000
= = 13.3%
$300,000
Yes, the pinball machines would be purchased. The 13.3%

return exceeds 12%.
Present
Amount 20% Value of
Year(s of Cash Facto Cash
Item ) Flows r Flows
R(275,000 R(275,000
Cost of new equipment...... Now ) 1.000 )
R(100,000
Working capital required.... Now ) 1.000 (100,000)
Net annual cash receipts. . . 1-4 R120,000 2.589 310,680
Cost to construct new
roads............................... 3 R(40,000) 0.579 (23,160)
Salvage value of
equipment....................... 4 R65,000 0.482 31,330
Working capital released. . . 4 R100,000 0.482 48,200
Net present value.............. R (7,950)
No, the project should not be accepted; it has a negative net

present value at a 20% discount rate. This means that the rate of
return on the investment is less than the company’s required rate
of return of 20%.

1. The formula for the project profitability index is:

Net present value of the project
Project profitability index =
Investment required by the project
The indexes for the projects under consideration would be:
Project 1: $66,140 ÷ $270,000 = 0.24
Project 2: $72,970 ÷ $450,000 = 0.16
Project 3: -$20,240 ÷ $400,000 = -0.05
Project 4: $73,400 ÷ $360,000 = 0.20
Project 5: $87,270 ÷ $480,000 = 0.18
2. a., b., and c.

Net Project Internal
Present Profitabilit Rate of
Value y Index Return
First preference..... 5 1 2
Second preference 4 4 1
Third preference.... 2 5 5
Fourth preference.. 1 2 4
Fifth preference..... 3 3 3

3. Which ranking is best will depend on Revco Products’

opportunities for reinvesting funds as they are released from
the project. The internal rate of return method assumes that
any released funds are reinvested at the internal rate of return.
This means that funds released from project #2 would have to
be reinvested in another project yielding a rate of return of
19%. Another project yielding such a high rate of return might
be difficult to find.
The project profitability index approach assumes that funds
released from a project are reinvested in other projects at a
rate of return equal to the discount rate, which in this case is
only 10%. On balance, the project profitability index is the most
dependable method of ranking competing projects.
The net present value is inferior to the project profitability
index as a ranking device, since it looks only at the total
amount of net present value from a project and does not
consider the amount of investment required. For example, it
ranks project #1 as fourth in terms of preference because of its
low net present value; yet this project is the best available in
terms of the amount of cash inflow generated for each dollar of
investment (as shown by the profitability index).

1. and 2. Rusco Products

Statement of Cash Flows
For the Year Ended July 31, 2009
Operating activities:
Net income............................................. ... $ 30,000
Adjustments to convert net income to cash
basis:
Depreciation charges.............................. $20,000
Increase in accounts receivable.............. (40,000)
Increase in inventory.............................. (50,000)
Decrease in prepaid expenses................ 4,000
Increase in accounts payable.................. 63,000
Decrease in accrued liabilities................ (9,000)
Gain on sale of investments.................... (10,000)
Loss on sale of equipment...................... 2,000
Increase in deferred income taxes.......... 8,000 (12,000)
Net cash provided by operating activities. 18,000
Investing activities:
Proceeds from sale investments................ 30,000
Proceeds from sale of equipment.............. 8,000
(150,000
Additions to plant and equipment............. )
(112,000
Net cash used for investing activities........ )
Financing activities:
Increase in bonds payable......................... 70,000
Increase in common stock......................... 20,000
Cash dividends.............................. ............ (9,000)
Net cash provided by financing activities. . 81,000
Net decrease in cash................................. (13,000)
Cash balance, August 1, 2008................... 21,000
$
Cash balance, July 31, 2009...................... 8,000
Schedule of noncash investing and
financing activities:
Preferred stock converted into common $
stock.................................................... 16,000

3. Although the company reported a large net income for the

year, a relatively small amount of cash was provided by
operations due to increases in both accounts receivable and
inventory. The cash provided by operations, when added to the
cash provided by the sale of investments, the issue of bonds,
and the sale of common stock, was not sufficient to cover the
purchase of plant and equipment during the year. Note that the
company increased its investment in plant and equipment by
almost 50%. More care should have been taken in planning for
this major investment in plant assets. Also, the company
should get better control over its accounts receivable and
inventory.

Note to the instructor: Although it is not a requirement, a worksheet may be helpful.

Cash
Source Flow Adjust- Adjusted Classi-
Change or use? Effect ments Effect fication
Assets (except cash and cash equivalents)
Current assets:
Accounts receivable..... +40 Use –40 –40 Operating
Inventory...................... +50 Use –50 –50 Operating
Prepaid expenses......... –4 Source +4 +4 Operating
Noncurrent assets:
Long-term investments –20 Source +20 –20 0 Investing
Plant and equipment.... +130 Use –130 –20 –150 Investing
Liabilities, Contra-assets, and Stockholders’

Equity
Contra-assets:
Accumulated
depreciation............... +10 Source +10 +10 +20 Operating
Current liabilities:
Accounts payable......... +63 Source +63 +63 Operating
Accrued liabilities......... –9 Use –9 –9 Operating

Cash
Source Flow Adjust- Adjusted Classi-
Change or use? Effect ments Effect fication
Noncurrent liabilities:
Bonds payable............. +70 Source +70 +70 Financing
Deferred income taxes. +8 Source +8 +8 Operating
Stockholders’ equity:
Preferred stock............. –16 Use +16 0
Common stock............. +36 Source +36 –16 +20 Financing
Retained earnings:
Net income................ +30 Source +30 +30 Operating
Dividends................... –9 Use –9 –9 Financing
Additional entries
Proceeds from sale of
investments................. +30 +30 Investing
Gain on sale of
investments................. –10 –10 Operating
Proceeds from sale of
equipment.................... +8 +8 Investing
Loss on sale of
equipment.................... +2 +2 Operating
Total............................. ... –13 –13

This Year Last Year

1. a. Current assets.................................. $1,520,000 $1,090,000
Current liabilities.............................. 800,000 430,000
Working capital................................. $ 720,000 $ 660,000
b. Current assets (a)............................. $1,520,000 $1,090,000

Current liabilities (b)......................... $800,000 $430,000
Current ratio (a) ÷ (b)...................... 1.90 2.53
c. Quick assets (a).......................... ...... $550,000 $468,000

Current liabilities (b)......................... $800,000 $430,000
Acid-test ratio (a) ÷ (b).................... 0.69 1.09
d. Sales on account (a)......................... $5,000,000 $4,350,000

Average receivables (b).................... $390,000 $275,000
Accounts receivables turnover (a) ÷
(b)................................... ............... 12.8 15.8
Average collection period:
365 days ÷ turnover...................... 28.5 days 23.1 days
e. Cost of goods sold (a)....................... $3,875,000 $3,450,000

Average inventory (b)....................... $775,000 $550,000
Inventory turnover (a) ÷ (b)............. 5.0 6.3
Average sales period:
365 days ÷ turnover...................... 73 days 58 days
f. Total liabilities (a)............................. $1,400,000 $1,030,000

Stockholders’ equity (b)................... $1,600,000 $1,430,000
Debt-to-equity ratio (a) ÷ (b)........... 0.875 0.720
Net income before interest and

g. taxes (a)......................................... $472,000 $352,000
Interest expense (b)......................... $72,000 $72,000
Times interest earned (a) ÷ (b)........ 6.6 4.9

2. a. Sabin Electronics
Common-Size Balance Sheets
This Last
Year Year
Current assets:
Cash........................................... ..... 2.3% 6.1%
Marketable securities...................... 0.0 0.7
Accounts receivable, net................. 16.0 12.2
Inventory........................................ 31.7 24.4
Prepaid expenses............................ 0.7 0.9
Total current assets........................... 50.7 44.3
Plant and equipment, net.................. 49.3 55.7
Total assets....................................... . 100.0% 100.0%
Current liabilities............................... 26.7% 17.5%

Bonds payable, 12%.......................... 20.0 24.4
Total liabilities................................. 46.7 41.9
Preferred stock, $25 par, 8%........... 8.3 10.2
Common stock, $10 par.................. 16.7 20.3
Retained earnings........................... 28.3 27.6
Total stockholders’ equity.................. 53.3 58.1
Total liabilities and equity.................. 100.0% 100.0%

b. Sabin Electronics
Common-Size Income Statements
This Last
Year Year
Sales.............................. ................. 100.0% 100.0 %
Less cost of goods sold................... 77.5 79.3
Gross margin.................................. 22.5 20.7
Less operating expenses................. 13.1 12.6
Net operating income..................... 9.4 8.1
Less interest expense..................... 1.4 1.7
Net income before taxes................. 8.0 6.4
Less income taxes.......................... . 2.4 1.9
Net income..................................... 5.6% 4.5 %
3. The following points can be made from the analytical work in

parts (1) and (2) above:
a. The company has improved its profit margin from last
year. This is attributable primarily to an increase in gross
margin, which is offset somewhat by a small increase in
operating expenses. Overall, the company’s income
statement looks very good.
b. The company’s current position has deteriorated
significantly since last year. Both the current ratio and the
acid-test ratio are well below the industry average and are
trending downward. At the present rate, it will soon be
impossible for the company to pay its bills as they come due.
c. The drain on the cash account seems to be a result mostly
of a large buildup in accounts receivable and inventory.
Notice that the average age of the receivables has increased
by five days since last year, and now is 10 days over the
industry average. Many of the company’s customers are not
taking their discounts, since the average collection period is
28 days and collections terms are 2/10, n/30. This suggests
financial weakness on the part of these customers, or sales
to customers who are poor credit risks.

d. The inventory turned only five times this year as compared

to over six times last year. It takes nearly two weeks longer
for the company to turn its inventory than the average for
the industry (73 days as compared to 60 days for the
industry). This suggests that inventory stocks are higher than
they need to be.
e. In the authors’ opinion, the loan should be approved only if
the company gets its accounts receivable and inventory back
under control. If the accounts receivable collection period is
reduced to about 20 days, and if the inventory is pared down
enough to reduce the turnover time to about 60 days,
enough funds could be released to substantially improve the
company’s cash position. Then a loan might not even be
needed.

Problem 16-19 (60 minutes or longer)
Pepper Industries
Income Statement
For the Year Ended March 31
Key to
Computatio
n
Sales.......................................... $4,200,000
Less cost of goods sold.............. 2,730,000 (h)
Gross margin.......................... .... 1,470,000 (i)
Less operating expenses............ 930,000 (j)
Net operating income................ 540,000 (a)
Less interest expense................ 80,000
Net income before taxes............ 460,000 (b)
Less income taxes (30%)........... 138,000 (c)
Net income................................ $ 322,000 (d)
Peppers Industries
Balance Sheet
March 31
Current assets:
Cash........................................ $ 70,000 (f)
Accounts receivable, net.......... 330,000 (e)
Inventory................................. 480,000 (g)
Total current assets.................... 880,000 (g)
Plant and equipment.................. 1,520,000 (q)
Total assets................................ $2,400,000 (p)
Current liabilities........................ $ 320,000
Bonds payable, 10%.................. 800,000 (k)
Total liabilities............................ 1,120,000 (l)
Common stock, $5 par value.. . 700,000 (m)
Retained earnings.................... 580,000 (o)
Total stockholders’ equity........... 1,280,000 (n)
Total liabilities and equity........... $2,400,000 (p)

Computation of missing amounts:
a. Earnings before interest and taxes

Times interest earned =
Interest expense
Earnings before interest and taxes
=
$80,000
= 6.75
Therefore, the earnings before interest and taxes for the year
must be $540,000.
b. $540,000 – $80,000 = $460,000.
c. Income tax expense = $460,000 × 30% tax rate = $138,000.
d. $460,000 – $138,000 = $322,000.
e. Accounts receivable = Sales on account

turnover Average accounts receivable balance
$4,200,000
=
Average accounts receivable balance
= 14.0
Therefore, the average accounts receivable balance for the
year must have been $300,000. Since the beginning balance
was $270,000, the ending balance must have been $330,000.
f. Cash + Marketable securities + Current receivables

Acid-test ratio=
Current liabilities
Cash + Marketable securities + Current receivables

=
$320,000
= 1.25

Therefore, the total quick assets must be $400,000. Since there

are no marketable securities and since the accounts receivable
are $330,000, the cash must be $70,000.
g. Current assets
Current ratio =
Current liabilities
Current assets
=
$320,000
= 2.75
Therefore, the current assets must total $880,000. Since the
quick assets (cash and accounts receivable) total $400,000 of
this amount, the inventory must be $480,000.
h. Cost of goods sold

Inventory turnover =
Average inventory
Cost of goods sold

=
1/2($360,000+$480,000)
Cost of goods sold

=
$420,000
= 6.5
Therefore, the cost of goods sold for the year must be
$2,730,000.
i. Gross margin = $4,200,000 – $2,730,000 = $1,470,000.
j. Net operating income = Gross margin - Operating expenses
Operating expenses = Gross margin - Net operating income
= $1,470,000 - $540,000
= $930,000

k. Since the interest expense for the year was $80,000 and the
interest rate was 10%, the bonds payable must total $800,000.
l. $320,000 + $800,000 = $1,120,000.
Net income - Preferred dividends

m Earnings per share =
Average number of common shares outstanding
.
$322,000
=
Average number of common shares outstanding
= $2.30
Therefore, there must be 140,000 common shares outstanding.
Since the stock is $5 par value per share, the total common
stock must be $700,000.
n. Total liabilities
Debt-to-equity ratio =
Stockholders' equity
$1,120,000
=
Stockholders' equity
= 0.875
Therefore, the total stockholders’ equity must be $1,280,000.
o. Total stockholders' equity = Common stock + Retained earnings
Retained earnings = Total stockholders' equity - Common Stock
= $1,280,000 - $700,000 = $580,000

p. Total assets = Liabilities + Stockholders' equity
= $1,120,000 + $1,280,000 = $2,400,000
This answer can also be obtained using the return on total

assets:
Return on = Net income + [Interest expense × (1 - Tax rate)]

total assets Average total assets
$322,000 + [$80,000 × (1 - 0.30)]

=
Average total assets
$378,000
=
Average total assets
= 18.0%
Therefore the average total assets must be $2,100,000. Since
the total assets at the beginning of the year were $1,800,000,
the total assets at the end of the year must have been
$2,400,000 (which would also equal the total of the liabilities
and the stockholders’ equity).
q. Total assets = Current assets + Plant and equipment
$2,400,000 = $880,000 + Plant and equipment

Plant and equipment = $2,400,000 - $880,000
= $1,520,000


Exercise 13-2 (30 Minutes) : Difference: Net Operating Income Increase or (Decrease)

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Exercise 13-2 (30 Minutes) : Difference: Net Operating Income Increase or (Decrease)

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Exercise 13-2 (30 minutes)

1. No, production and sale of the racing bikes should not be

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2. The segmented report can be improved by eliminating the

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Only the incremental costs and benefits are relevant. In particular,

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2. The company should concentrate its available material on

3. The price Barlow Company would be willing to pay per pound

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1. The $90,000 in fixed overhead costs charged to the new

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Another approach to the solution would be:

Cost of purchasing the tubes from the

Cost savings per box by making internally..... $0.20

2. The maximum purchase price would be $1.15 per box. The

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3. At a volume of 120,000 boxes, the company should buy the

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4. Under these circumstances, the company should make the

5. Management should take into account at least the following

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2. Revenue from the order:

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1. A product should be processed further so long as the

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2. Only the cost of advertising and the cost of the production

Avoidable fixed costs $7,000

Therefore, if 10,000 jars of silver polish can be sold each

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9,000 10,000 11,000

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Amount of 14% Present

The $100,000 should be invested in Project B rather than in

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1. Computation of the annual cash inflow associated with the new

2. The simple rate of return would be:

Annual incremental - Annual incremental expenses,

Yes, the pinball machines would be purchased. The 13.3%

No, the project should not be accepted; it has a negative net

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1. The formula for the project profitability index is:

2. a., b., and c.

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3. Which ranking is best will depend on Revco Products’

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1. and 2. Rusco Products

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3. Although the company reported a large net income for the

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Note to the instructor: Although it is not a requirement, a worksheet may be helpful.

Liabilities, Contra-assets, and Stockholders’

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This Year Last Year

b. Current assets (a)............................. $1,520,000 $1,090,000

c. Quick assets (a).......................... ...... $550,000 $468,000

d. Sales on account (a)......................... $5,000,000 $4,350,000

e. Cost of goods sold (a)....................... $3,875,000 $3,450,000