Chap 009

CHAPTER 9: DECISION MAKING WITH RELEVANT COSTS AND A STRATEGIC EMPHASIS QUESTIONS 9-1

Relevant costs are costs to be incurred at some future time and differ for each option available to the decision maker. Relevant costs in replacing equipment would include the cost of purchasing and installing the new equipment, the operating costs of the new equipment, and the disposal costs of the old equipment, the cost of repair of the old equipment, and so on. The purchase price of the old equipment would not be relevant to the decision.

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When a firm chooses to have a basic service function provided by a subcontractor outside the firm, it is called outsourcing. Relevant cost analysis is used to identify the relevant costs in the decision to outsource or to retain the production or service activity within the firm. An example of a non-relevant cost in this context is a cost which would not differ between the options. For example, if there is no alternative use for the space occupied by the internal production, then the costs of the space is not relevant since these costs will continue whether the production is retained or outsourced.

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Decisions where relevant cost analysis might be used effectively include: 1. The special order decision 2. Make, lease, or buy 3. Outsourcing 4. Sale before or after additional processing 5. Keep or drop products or services 6. Profitability analysis: evaluating programs

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Relevant cost analysis is applied in the same way for manufacturing and for service firms. Both types of firms are subject to the types of decisions outlined in Question 9-3. 9-5 Contract manufacturing is the type of manufacturing when another manufacturer (some-times a direct competitor) manufactures a portion of the firm's products. Users of contract manufacturing include IBM, Texas Instruments, and Digital Equipment.

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Strategic factors include: 1. The level of capacity usage of the plant 2. The time value of money 3. Quality 4. Functionality 5. Timeliness of delivery 6. Reliability in shipping 7. Service after the sale

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Not relevant, or sunk costs are costs which are irrelevant in decision making because they are committed and therefore there is no longer any discretion regarding these costs. Examples include the purchase price of equipment already owned and all related costs of installing the equipment.

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Variable costs are usually more relevant in decision making than fixed costs because they are more likely to be discretionary, not yet incurred. In contrast, many times fixed costs are sunk because they relate to assets which have been purchased some time ago.

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A firm can decrease variable costs by increasing fixed costs by, for example, purchasing new equipment that has lower operating costs. For example, a more technologically advanced and therefore more expensive machine will likely have lower variable operating costs, but a higher purchase cost.

9-10 A firm can decrease fixed cost by increasing variable costs, by for example, purchasing less technologically advanced equipment (see Question 9-9). Generally, the amount of fixed costs as compared with variable costs can be reduced by replacing equipment with labor, to become a more labor-intensive operation. 9-11 A well-known problem in business today is the tendency of managers to focus on short-term goals and neglect the longer-term strategic goals, because their compensation is based upon short-term accounting measures such as net income. This issue has been raised by many critics of relevant cost analysis. As noted throughout the chapter, it is critical that the relevant cost analysis be supplemented by a careful consideration of the long-term, strategic concerns of the firm. Without strategic considerations, management could improperly use relevant cost analysis to achieve a short-term benefit and potentially suffer a significant long-term loss. For example, a firm might choose to accept a special order because of a positive relevant cost analysis, without properly considering that the nature of the special order will have a significant negative impact on the firm's image in the marketplace, and perhaps a negative effect on sales of the other products. The important message for managers is to keep the strategic concerns in mind, and to start with the strategic objectives in any decision situation. 9-12 The limitations of relevant cost analysis include: 1. Excessive focus on short-term decisions (see Question 9-11) Blocher,Chen,Cokins,Lin: Cost Management 3e

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2. Tendency to focus on quantitative factors only, and to not include the important strategic factors (see Question 9-6) 3. Managers’ tendency to include irrelevant costs, such as sunk costs, in the decision making 4. Tendency to focus on a single product or department in isolation of others, and there to perhaps not find the strategically correct analysis 9-13 Strategic management principles require a more integrative focus, as noted in the chapter: RELEVANT COST ANALYSIS

STRATEGIC COST ANALYSIS

Financial Focus

Customer Focus

Not Linked to Strategy

Linked to the Firm's Strategy

Precise and Quantitative

Broad and Subjective

Focused on Individual Product or Decision Situation

Integrative; Considers all Customer-related Factors

Short-term Focus

Long-term Focus

9-14 Some of the behavioral, implementation, and legal issues in using relevant cost analysis include: 1. The tendency of managers to focus on short term goals, and to not attend satisfactorily to longer-term strategic goals of the firm. The techniques described in relevant cost analysis can have the effect of encouraging this bias, unless specific steps are taken, such as to use the balanced scorecard in management evaluation (see chapter 18). 2. If variable costs are given too much focus, as suggested in relevant cost analysis, managers can tend to ignore fixed costs. Moreover, some managers might replace variable costs with fixed costs where possible, to improve the evaluation of their unit. The result might be higher overall costs for the firm. 3. Researchers have shown a strong human tendency to rely upon and use irrelevant factors such as sunk costs in decision making. Thus, the proper use of relevant cost analysis requires the management accountant to carefully explain the techniques and to carefully present the relevant cost reports to management. 4. Predatory pricing, the lowering of prices to where the effect may be to substantially damage the competition in an industry is unlawful under the provisions of the Robinson Patman Act.

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9-15 When there is only one production constraint and excess demand it is generally best to produce only one of products to maximize income, and that is the product with the highest contribution per unit of scarce resource. When the production process requires two or more production activities, the choice of sales mix involves a more complex analysis, and in contrast to the case of one production constraint, the solution can include both products. The determination of best product mix in this case involves mathematical programming techniques, which are employed using either a graphical analysis or a computer-based solution technique. 9-16 Relevant cost analysis and cost-volume-profit analysis (Chapter 8) are similar in that they both rely on the distinction of variable versus fixed costs and they both use the contribution margin (price less unit variable cost) as the focal point of the analysis. Both cost-volume-profit analysis and relevant cost analysis focus on the relationship of profit to volume, and therefore on the unit contribution margin for the product or service. 9-17 Depreciation is a not relevant cost because it is a sunk cost. The purchase cost of plant or equipment is irrelevant, as well as the depreciation charges which are used to expense the purchase cost over time.

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EXERCISES 9-18 Special Order Analysis (10 min) Since there are no marketing costs for the special order, the only relevant cost is the variable manufacturing cost of $13 per unit. Revenue for special order less variable manufacturing cost = (1.35 x $13 - $13) x 4,000 = ($13 x .35) x 4,000 = $18,200 The special order should be accepted, since the revenue of $18,200 exceeds the retooling costs of $12,000.

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9-19 Special Order (15 min) 1. Revenue per unit Variable costs per unit: Direct materials Direct labor Variable factory overhead Variable nonmanufacturing costs Contribution margin per unit $ Contribution margin for 5,000 units

Current $ 45 $ 9 $ 8 $ 4 $ 8 16

29

Special Order $ 35

$

$9 $8 $4 $4 10

$ 80,000

25

$ 50,000

The difference in favor of continuing with current production and turning down the special order is $30,000 ($80,000 - $50,000). Note that because Alton, Inc. is at full capacity, the decision whether or not to produce the special order is based on the comparison of current and special order production. If there were additional capacity, the proper decision would be to accept the special order since it has a positive contribution of $50,000. The minimum price for the order would be the relevant total variable costs of $25. 2. The minimum price would be $28.20. At 16,000 units of output, Alton does not have enough capacity to produce the entire order for SHC. Further, the contribution on regular sales ($16) exceeds the contribution on sales to SHC ($10), so Alton should try to reduce or delay 1,000 units of the SHC order to get an order for 4,000 units. Then the special order could be done without a loss of regular sales. If SHC insists on the full order of 5,000 units, then Alton must figure the costs of lost sales ($16 x 1,000 = $16,000). This loss is less than the contribution of the special order ($30,000), so the special order would still be accepted at the $35 price. The minimum price would be the total variable cost per unit ($25) plus the per unit cost of lost sales ($3.20 = $16,000/5,000): $25 + $3.20 = $28.20.

9-20 Profitability Analysis: Discontinuing a Division (10 min) Blocher,Chen,Cokins,Lin: Cost Management 3e

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Division's contribution Less overhead that can be eliminated Increase in Pretax income if division is discontinued

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$20,000 30,000 $ 10,000

9-21 Special Order (15 min) 1. The costs fall from $11 to $10 because of the fixed overhead costs which are the same at each level of production, so that the unit fixed costs decrease as production level increases. 2. The relevant costs are: Materials Labor Variable Overhead Total

$2 3 3 $8

($80,000/40,000) ($120,000/40,000) ($300,000-$240,000)/20,000

Alternatively: ($600,000 - $440,000)/20,000 = $8 The relevant costs are $8 per unit, so the bid price should be any price above $8. The sales manger’s price will produce a contribution of 20,000 ($9-$8) = $20,000 3. Other factors to consider • Is the order likely to lead to further regular business with this customer? • Is the order in the strategic best interest of the firm, for example, will it support or undermine Grant Industries’ desired image in the market? • While Grant has enough capacity to complete the special order, will there be other costs in addition to the variable manufacturing costs in order to complete the order, that is, special tooling or set up costs, etc. Also, are there alternative uses of the capacity which will produce a greater contribution?

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9-22 Profitability Analysis (15 min) 1. RAM Last year's contribution = $180,000 - $70,000 - $18,000 = $ 92,000 Last year's contribution margin ratio = $92,000/$180,000 = 51.11% ROM Last year's contribution = $260,000 - $130,000 - $50,000 = $80,000 Last year's contribution margin ratio = $80,000/$260,000 = 30.77% Incremental contribution margin from RAM if ROM is dropped = $92,000 x .1 = $ 9,200 The effect of discontinuing ROM is the contribution margin less variable selling costs less the incremental contribution for RAM: Net loss on discontinuing ROM = $130,000 - $50,000 - $9,200 = $70,800 2. The following strategic factors should be considered. What will be the effect on the firm’s image if ROM is dropped? Will this result in an unfavorable reaction from key customers of RAM and of other product lines? Can the production capacity released by ROM be used for new products?

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9-23 Relevant Cost Problems (5-10 min, each part) a. Make or Buy The total costs for producing the product are as follows: Direct Materials Direct Labor Var. Overhead Total

Costs Per Unit: $ 28 18 6 $ 52

($52 x 2,000) + $8,000 = $112,000. The total cost to purchase the units is $124,000. Since the purchase price is greater than the production price, Murray Inc. should make the units. Since there is some urgency to the order Mr. Walters may opt for the alternative which will allow him to deliver the product as quickly as possible. Quality, reliability, and capacity utilization are other considerations. b. Disposal of Assets Future Revenues Deduct future costs Margin

Remachine $30,000 25,000 $ 5,000

Scrap $2,500 $2,500

The difference is in favor of remachining. The $50,000 inventory cost is irrelevant. c. Replacement of Asset

Replace New boat $92,000 Deduct current disposal price$ 9,000 Rebuild of existing boat Margin $83,000

Rebuild $75,000 $75,000

The difference is in favor of rebuilding. The $90,000 purchase cost is irrelevant.

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Exercise 9-23 (continued) d. Profit from Processing Further Additional costs if processed further Increase in sales value if processed further Differential benefit (cost)

A $28,000

B 20,000

C 12,000

40,000 $12,000

20,000 $0

20,000 $8,000

Almond Corp. Is indifferent about the further processing for B since the net benefit is zero. There would be a positive benefit for further processing of A ($12,000) and C ($8,000). e. Make or Buy The relevant fixed overhead is $10 per unit ($20 x 50%) because that amount could be avoided by buying the part from McMillan. All variable costs are relevant ($65=$35+$11+$19). The relevant cost per unit is $75 ($65+$10). The total relevant cost is $1,500,000 (20,000 x $75). Strawn should make the part. When you compare the cost to make of $75 to the cost to buy of $85; there is a $10 per unit savings. f. Selection of most Profitable Product Selling price per unit Variable cost per unit Contribution margin per unit Relative use of labor hours (GASH requires ½ as many as Bash) Contribution margin per labor hr.

BASH $200.00 164.00 $ 36.00 ÷ 2

GASH $140.00 121.00 $ 19.00 ÷ 1

$ 18.00

$ 19.00

Since GASH requires ½ the labor time, and since labor capacity is a constraint, and since GASH’s relative contribution per labor hour is greater, as much production as possible should be devoted to GASH.

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Exercise 9-23 (continued) g. Special Order Pricing The total cost of each meal is variable plus fixed cost or $2.00 + $1,200/600 = $4.00 per meal. This is a reasonable cost basis for long term pricing, and Barry is getting a $1.00 margin on each meal. However, in a special order situation the fixed costs are irrelevant, and Barry should be willing to do business for any price above variable cost of $2.00. Thus, the tour operator’s deal is a good one for Barry. As long as there is space for the additional meals, and since daily fixed costs are unaffected by the additional patrons, any price above $2.00 should be acceptable. The idea of agreeing to serve 200 patrons on any given day presents a problem with limited capacity. In this case, 100 of the regular customers would have to look elsewhere for lunch on these days, at a loss of $3.00 ($5.00-$2.00 variable cost) per meal or a total of $300 per day. The additional new patrons at $3.00 each would bring in a contribution of only $1.00 ($3.00-2.00) per meal or a total of $200. It turns out the single bus load is a better deal.

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9.24 Make or Buy (15 min) Relevant Cost to Make (per unit): Direct Materials Direct Labor Variable Overhead Fixed Overhead Avoidable

$ 35 50 10 5 $100

Outside Purchase Cost = ($55,000 / 500) = $110 Three Stars Inc. should continue making the doors. The savings are $10 per unit ($110 - $100) when they are manufactured by Three Stars.

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PROBLEMS 9.25 Special Order (25 min) 1.

Price of special order $100 Relevant Cost = ($375,000+262,500)/7,500 = 85 Contribution on special order $15 per unit $15 x 2,500 = $37,500 total contribution

Positive contribution: Accept the Special Order 2. Other considerations a. Is the order likely to lead to further regular business with this customer b. Is the order in the strategic best interest of the firm, for example, will it support or undermine Award Plus’ desired image in the market? c. While Award Plus has just enough capacity to complete the special order, will there be other costs in addition to the variable manufacturing costs in order to complete the order, that is, special tooling or set up costs, etc d. See part 3. below 3. Obviously the controller, LePenn has a conflict of interest in the sourcing of raw materials for the firm. Cathy has the ethical responsibility under the IMA code to bring this matter to the attention of the appropriate person in the firm. Since LePenn is the controller, the appropriate person for Cathy to contact is likely to be the Vice President of Finance, Chief Financial Officer, a member of top management, or the audit committee if Award Plus has one.

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9-26 Special Order Analysis (15 min) 1. Net income with the special order will increase by $14,000 = 2,000 x ($28 - $21). The relevant Variable costs are the $21 manufacturing variable costs since marketing costs are not charged for the special order. Note that this answer relies on the availability of production capacity. The answer might be different if is at full capacity and the sale of the special order would require Jordan to lose some amount of current sales. For a good in-class assignment, ask the class to answer the question again, assuming Jordan is at full capacity. We now assume that a total of 10,000 units will be produced (full capacity). The variable marketing costs will be relevant for regular sales. Contribution of special order 2,000 x ($28 - $21) Less: Lost contribution on loss of regular sales: 2,000 x ($68 - $21 - $8) Net loss on the special order under full capacity

$14,000 78,000 $64,000

2. The special order has the strategic advantage of helping Jordan smooth the seasonal and cyclical changes in the business. If special orders such as this can be planned and scheduled carefully, the production rate at Jordan’s plant can be smoothed to improve scheduling and lower overall costs. Lower overall costs can help Jordan to become more cost competitive. This is especially important, since price competition is an important aspect of this industry. Also, smoothed production levels will help to most efficiently utilize the plant and thus minimize fixed plant costs. Moreover, special orders can help Jordan grow the business by developing new customers and helping the firm to learn new markets, perhaps for other interior finish items for cars and trucks. Special orders such as the one to JepCo can lead to additional orders for existing and new products.

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9.27 Special Order; ABC Costing (25 min) 1. First, determine relevant batch related costs: The special order would cause one new batch, so the relevant batch related cost is the cost per batch of $10,000. [Note: Total fixed costs are $25 x 10,000 = $250,000, composed of.. Batch related costs = $10 x 10,000 units = $100,000 Facilities related fixed costs = $15 x 10,000 150,000 Total Fixed costs = $25 x 10,000 $ 250,000 Relevant costs for the special order Variable manufacturing Batch related costs $10,000/2,000 Total unit relevant costs for the special order

$21

]

5 $26

Total relevant cost for the special order = 2,000 x $26 = $54,000 2. The special order price exceeds the relevant cost of $26, so Jordan should accept the JepCo offer since there is available capacity. Profit will increase by ($28-$26) x 2,000 = $4,000. Alternatively, ($28-$21) x 2,000 - $10,000 = $4,000 Notice that the increase in profits calculated here is less than in Problem 9-26 because we are taking into account the batch related costs. 3. If the JepCo order is reduced from, 2,000 to 1,000 units, then the batch related costs are the same in total, but the unit cost of batch level costs increases to $10 (=$10,000 per batch/1,000units). The relevant costs are now:

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Problem 9-27 (continued) Relevant costs for the special order Variable manufacturing $21 Batch related costs $10,000/2,000 10 Total unit relevant costs for the special order $31 Total relevant cost for the special order = 1,000 x $31 = $31,000 Now, the JepCo special order should not be accepted because the unit cost ($31) is greater than the special order price ($28).

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9-28 Special Order (25 min) 1. Relevant Cost Data (per sheet): Direct Materials $ Direct Labor Variable Overhead $

1.20 .20 .40 1.80

There are 4 sets in each sheet (132 /33) and 25,000 sets being ordered. BallCards Inc. will need to manufacture 6,250 sheets (25,000 /4). Total costs = ($1.80 x 6,250) + $2,000 +$5,500 = $18,750. Total costs per set = ($18,750 /25,000) = $0.75 Total price per set = ($23,750 /25,000) = $0.95 BallCards Inc. should accept the special order from Pennock Cereal, since the price per set ($.95) exceeds the relevant cost per set ($.75). 2. BallCards succeeds by developing new customers and keeping costs down. Also, a critical success factor is the firm’s ability to negotiate licensing agreements with the major leagues and the players. The special order with Pennock Cereal Inc is a competitively important decision because it will help BallCards to have its product distributed widely among its key customers. Promotion of the brand name is a key success factor for BallCards, and this special order is one important way to accomplish that.

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9-29 Special Order (25 min) 1. and 2. Net income with the special order will decrease by $15,000. The only relevant variable costs are the $15 manufacturing variable costs ($15 x 5,000 = $75,000 total) since marketing costs are not charged for the special order. Other relevant costs include the delivery cost of $2,000 and the cost of lost sales (since the 5,000 unit order would exceed GGI’s capacity. Currently, GGI has only 2,000 units of available capacity, and APAC requires the order to be filled in full). Contribution lost on 3,000 units of lost sales = price – variable manufacturing cost – variable selling cost = ($38 - $15 - $2) x 3,000 = $63,000 Summary of relevant costs Variable manufacturing costs Delivery costs Cost of lost sales Total relevant costs

$ 75,000

2,000 63,000 $140,000

Since the relevant costs of $140,000 exceed the price of the special order ($125,000), GGI should not accept the order. Note that if GGI had available capacity, the only relevant cost would be the variable manufacturing and the delivery costs of $77,000, and the special order would then be an acceptable one.

3. These are both ethical and strategic issues for GGI. From a strategic view, GGI would suffer severe damage to its reputation if APAC were to have any problems with the purity of the special order. One of the reasons APAC has requested the special order from GGI is because of its reputation for quality. It is clear that GGI competes on differentiation, with quality being a critical success factor. Also, there is an ethical issue. The use of a competitor’s materials would deceive APAC who is expecting the highest quality product from GGI. Problem 9-29 (continued)

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To take into account both strategic and ethical issues, GGI should make it clear to APAC that it will need to fill a portion of the order from competitor’s stock. GGI might request that the shipment be delayed until it can provide all of the product from its own stock. Or alternatively, it might offer to reduce the price, or to perform careful tests of its own on the competitor’s materials.

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9-30 Special Order; ABC Costing (25 min) 1. First, determine relevant batch related costs: The special order would cause two new batches at a cost of $5,000 each, so the relevant batch related cost is $10,000. [Note: Total fixed costs are $12 x 20,000 = $240,000, composed of: Batch related costs ($8 x 20,000 = $160,000) Costs per batch: 20 batches x $5,000 $100,000 Costs that do not vary with number of batches 60,000 Facilities related fixed costs = $4 x 20,000 80,000 Total Fixed costs $240,000 Relevant costs for the special order Variable manufacturing ($15 x 5,000) Batch related costs Delivery costs Cost of 3,000 units of lost sales* Total Relevant Costs

]

$75,000 10,000 2,000 48,000 $135,000

*The cost of lost sales is determined as follows: Sales ($38 x 3,000) Less: Variable Costs ($15 + $2) x 3,000 Less: Cost for 3 batches ($5,000 x 3) Net lost contribution

$114,000 51,000 15,000 $ 48,000

The total relevant cost of $135,000 is greater than the special order price of $125,000, so GGI should not accept.

2. Operating profit would decline by $10,000 = $135,000 $125,000

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9-31 Make or Buy; Special Order (25 min) 1. Compare the relevant cost to make a truss ($10,000/200 = $50 per truss) to the outside purchase cost of $55 per truss. The company should continue making the truss as this is lowest cost. 2. The following analysis finds the contribution margin for the additional beams vs. the truss production. Unit variable cost for beams: $48,000/600 = $80 per beam Trusses Sales Revenue $12,000 Less Var. Cost 10,000 Cont. Margin $2,000

Special order beams $40,000 (400 x $100) 32,000 (400 x $80) $8,000

Less opportunity cost

2,000 (loss of trusses) $ 6,000

The company should accept the special order as there is a net benefit of $6,000. The firm should also consider the impact of dropping the trusses; the company may lose customers that need to buy 2 or 3 different components, one being trusses. These customers may like the convenience of one-stop shopping.

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9-32 Profitability Analysis, Scarce Resources (25 min) 1. When there is no limit on production capacity, the super deluxe model should be manufactured since it has the highest contribution margin per unit.

Selling Price

No Frills Model $30.00

Direct Materials 9.00 Direct Labor ($10/hour) 5.00 Variable overhead 3.00 Total Variable Cost $17.00 Contribution Margin

$13.00

Standard Model $35.00

Super Model $50.00

11.00 10.00 6.00 $27.00

11.00 15.00 9.00 $35.00

$8.00

$15.00

2. When labor is in short supply, the No Frills Model should be manufactured since it has the highest contribution margin per direct labor hour. See below. Standard Super No Frills Options Deluxe Model Model Model Contribution Margin $ 13 $8 $15 Labor Hours Required .5 1 1.5 Contribution Margin/hr. $26.00 $8.00 $10

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Problem 9-32 (continued) Note: As an additional in-class assignment, the class can be asked to determine the best product mix when machine time rather than labor is the limited resource. Since fixed overhead is applied on the basis of machine hours, and fixed overhead per unit is given, it is possible to determine the relative proportion of machine time in each product. Since the fixed overhead in No Frills is $3 and in the Standard model is $6, we can infer that there is twice the amount of machine time in Standard as in No Frills. Similarly, there is twice the amount of machine time in the Super model relative to No Frills. The contribution per (relative) machine hour is again greatest for the No Frills model, as follows: No Frills Standard Super

Contribution

$13.00 8.00 15.00

Relative Machine Hours Contribution/ Rel. Hour

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$13.00 4.00 7.50

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9-33 Special Order Analysis; Strategy (20 min) To begin the analysis, the New Life CFO should recognize that the $2.50 full cost for its product includes $1.50 of irrelevant fixed overhead. Only the variable costs of $1.00 per unit are relevant. From this standpoint, the sales to SuperValue makes good sense, since there would be a contribution of $1.00 ($2.00 price less $1.00 relevant cost) per unit sold. Moreover, sales to SuperValue would utilize New Life’s available capacity. If these sales to were to continue for the long term, then average fixed costs would be reduced and New Life’s profitability would be improved in the long term as well. However, the sales to SuperValue could be a potentially serious strategic mistake for New Life. New Life’s reputation is built upon quality and product excellence, features which give it a clear differentiation in the market. To sell its products in a supermarket, even under another brand name, would cheapen the image of all New Life products, and cause it to lose market share in its usual distribution channels, the pharmacies and department stores. This is especially true given that SuperValue has the limited right to market the product as manufactured by New Life. How limited is that right? New Life could be trading a short-term gain for a potential longterm disaster in this deal with SuperValue. It should look for business partners that are more in line with its strategy.

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9-34 Project Analysis: Sales Promotions (30 min) 1. The relevant cost analysis follows: First contest: Gliders Per Unit Number of units (note 1) Sales Direct material Direct labor (note 2) Sales commission Contribution margin Cost of Prize Excess of CM over cost

$ 80.00 16.00 22.50 15.00 $26.50

Total 1,250 $100,000 20,000 28,125 18,750 $33,125 $8,800 $24,325

Second contest: Chair and Stool Per Unit Total 900 $ 61.00 11.00 30.88 10.00 $9.12

$ 54,900 9,900 27,792 9,000 $8,208 $4,685 $3,523

Notes: 1. 1,250 = 4,000 – 2,750; 900 = 8,000 – 7,100 2. $22.50 = 2.5 x $9.00; $30.88 = 3.25 x $9.50 Both contests have a substantially higher contribution relative to the cost of the prize: $24,325 and $3,523 net contribution for the first and second contests, respectively. Thus, the contests appear to be desirable. However, some additional strategic factors should also be considered: a. The contest appears to reward an increase of sales in units. However, the average sales price for each product has already fallen below budgeted levels. If the contest provides an expected incentive to reduce price in order to increase sales, then the result could be lower contributions than expected. Moreover, the price cutting could have adverse long term effects. Clear Lake should carefully consider its short and long term pricing strategy to make sure it is consistent with the firm’s overall strategy. While it appears that the firm’s overall strategy is cost leadership, so that lower prices are competitively advantageous, the pricing should be based on a longterm strategy with established profit targets.

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Problem 9-34 (continued) b. Clear Lake should evaluate the effectiveness of its advertising and promotional efforts. Are the targeted customers being reached? c. Since the products have a seasonal demand, are the lower sales the result of failure to meet sales delivery dates or to bad forecasts of the timing of demand? d. An unintended effect of the sales contests is that certain retail customers might buy unusually large orders, at the urging of sales people, and that some portion of these order might eventually be returned if not sold by the retailer by the end of the season. e. While sales of the table are over budget, why does the sales contest exclude the table? Perhaps this is one of Clear Lake’s most in-demand products, and overall profits would be improved through incentives on this product. f. Are Clear Lake’s products competitive? Have new competitors developed superior products, at lower prices? Perhaps this is time for a careful market research and competitive analysis for Clear Lake.

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9-35 Make or Buy (30 min) 1. GianAuto is in a high-growth, highly competitive industry. Auto makers are increasingly outsourcing the manufacture of parts and entire brake or seating systems to low-cost producers throughout the world. In North America, many of these plants are located in Mexico and throughout Latin America. To be competitive in this business, Gian must continue to be cost competitive and to also provide the customer service and reliability that is expected by the auto makers. Gian can also look for additional ways to be competitive by assisting the auto makers in improving the design of the parts, developing modular manufacturing systems, and improving the quality of the parts. Continuing to obtain covers from its own Denver Cover Plant would allow GianAuto to maintain its current level of control over the quality of the covers and the timing of their delivery. Keeping the Denver Cover Plant open also allows GianAuto more flexibility than purchasing the coverings from outside suppliers. GianAuto could more easily alter the coverings' design and change the quantities produced, especially if long term contracts are required with outside suppliers. GianAuto should also consider the economic impact that closing Denver Cover will have on the community and how this might affect GianAuto's other operations in the region. Other items that should be considered by GianAuto before making a decision include: • The disposal value or alternate uses of the plant. • Any income tax implications including tax rates applicable to gain/loss on sale of plant, depreciation tax shields, depreciation and investment tax credit recapture, etc. • Outside supplier's prices in future years. • Cost to manufacture coverings at the Denver Plant in future years • Ethical issues involved in the termination of 400 employees • Should GianAuto continue to manufacture the covers, but in a new, cost-efficient plant; the location could be anywhere in the world.

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Problem 9-35 (continued) 2. The following costs can be avoided by closing the plant and are therefore relevant. Materials Labor Direct $23,000 Supervisor 3,000 Indirect 4,000 Differential pension expenses ($4,000 - 3,000) Termination charges on cancelled material orders($32,000 x .15) Employment assistance Total

$32,000

30,000 1,000 $4,800 1,000 $68,800

The following costs are not relevant to the decision. Depreciation-equipment Depreciation-building Continuing pension expense ($4,000 - 1,000) Plant manager and staff Corporate allocation

$ 5,000

2,000

3,000 3,000

6,000 $ 19,000

The depreciation amounts are not relevant to the decision because they represent portions of sunk costs that are being written off during 2004. Three-fourths of the annual pension expense ($3,000) is not relevant because it would continue whether or not the plant is closed. The amount for plant manager and staff is not relevant because Vosilo and his staff would continue with GianAuto and administer three remaining plants. Corporate allocation is not relevant because this represents costs incurred outside Denver Cover and assigned to the plant.

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9-36

Make or Buy (25 min)

1. Current Materials $192 Labor 75 Variable overhead 150 Fixed overhead 150 Total cost for assembly $567

Savings to Buy $68.00 7.50 = 10% x $75 15.00 = 10% x $150 $90.50

The relevant cost to make (i.e., savings to buy) is $90.50 and the relevant cost to buy is $105, so the analysis favors to make, for a $14.50 (= $105 - $90.50) advantage. 2. Because the firm’s overall strategy is differentiation based on quality, the firm must be very sure that the decision to continue to make the part will best support the desired quality. Usually, by keeping manufacturing within the firm, as in this case, the firm can best maintain the desired quality levels. If, however, it can be shown that the outside supplier can provide the part at significantly higher quality than RSM can provide, then strategically it makes sense to forego the $14.50 advantage and buy the part outside, in order to improve overall quality. We put first priority on quality because of the differentiation strategy. Other considerations include whether or not the firm can develop successful cost reduction plans in other areas, and still maintain the desired quality. In addition to the need to maintain differentiation based on quality, the firm should consider other means to improve profitability and competitiveness. Some possible ideas include: 1. Get outside suppliers such as Performance Equipment, Inc. to help the firm improve the design of their product and also improve the quality of the product. That is, make the suppliers into partners in achieving the firm’s goals. That way both the firm and the suppliers succeed together. Probably some long-term supply agreements would be necessary. Problem 9-36 (continued) Blocher,Chen,Cokins,Lin: Cost Management 3e 2005

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2. Develop new product designs that improve quality while reducing cost. Avoid over-emphasis on getting the best out of the current technology. Look for ways to achieve the desired product differentiation in new ways – not just quality, but perhaps also in product innovation. 3. Has the firm developed appropriate means to “sell” its position as a high-quality manufacturer? Is this well understood in the market place? 4. The firm should continue to re-evaluate its strategy, as the demand in the industry changes, and as the nature of the competition changes.

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9-37 Make or Buy; Review of Learning Curves (50 min) 1. If the cylinders are manufactured by Henderson Equipment Company, the direct labor hour configurations would be as follows (see below): a. For the first 800 cylinders (including the pilot run) produced, the average direct labor hours per unit equal .117. b. For the first 800 cylinders (including the pilot run) produced, the total direct labor hours amount to 93.60. Cumulative Output 50 100 200 400 800

Average Direct Labor Hours Per Unit .285 (.8 X .285)=.228 (.8 X .228)=.182 (.8 X .182)=.146 (.8 X .146)=.117

Total Direct Labor Hours 14.25 22.80 36.40 58.40 93.60

2. The total manufacturing costs for Henderson to produce the additional 1,600 cylinders, assuming the first 800 cylinders produced (including the pilot run) required 100 direct labor hours and the 800th unit produced required .079 direct labor hours, amounts to $12,381.94, calculated as follows: Total units to be produced = 1,650 Additional units required = 1,600 (1,650 - Pilot Run of 50) Units available to meet the 1,600 requirement = 750 (800 - Pilot Run of 50) Add. production requirement = 850 (1,600 - 750)

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Problem 9-37 (continued) Manufacturing costs First 750 units Direct labor hours consumed

= 85.75 hours (100 hours, Pilot Run 14.25 hrs)

Direct labor = 85.75 hours X $12.00/hr $ 1,029.00 Variable overhead = 85.75 hrs X $10.00/hr = $ 857.50 Fixed overhead = 85.75 hrs X $16.60/hr = $ 1,423.45 Material = 750 units X $4.05/unit = $ 3,037.50 $ 6,347.45 Last 850 units Aggregate cost {850 units x .079 ($12.00 + $10.00 + $16.60) + 850 x $4.05)}

6,034.49

Total manufacturing costs for remaining 1,600 units $12,381.94 3. To maximize profits, Henderson Equipment Company should manufacture the additional 1,600 cylinders as the cost to manufacture is $2,156.20 less than the cost to purchase from Lytel Machine Company, calculated as shown below: Purchase cost (1,600 units @ $7.50 per unit) $12,000.00 Manufacturing cost: From Requirement (2). $12,381.94 Less: Fixed overhead 750 units (85.75 hrs. x $16.60) $1,423.45 850 units (850 X .079 x $16.60) 1,114.69 2,538.14 9,843.80 Savings by manufacturing

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$2,156.20

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9-38 Special Order; Strategy; International (50 min) 1.The standard direct labor hour per finished valve is ½ hour. Therefore, 30,000 units per month would require 15,000 direct labor hours. 2. The analysis of accepting the Glasgow Industries is presented below. Not Totals for Per unit 120,000 units Incremental revenue $21.00 $2,520,000 Incremental costs Variable Costs Direct materials 6.00 720,000 Direct labor 8.00 960,000 Variable overhead 3.00 360,000 Total variable costs $17.00 2,040,000 Fixed overhead Supervisory and clerical costs (4 months @ $12,000) 48,000 Total incremental costs 2,088,000 Incremental profit before tax $ 432,000 OR: 120,000 x ($21 - $17) - $48,000 = $ 432,000 3. The minimum unit price that Williams could accept without reducing net income must cover variable costs plus the additional fixed costs. Variable unit costs Direct materials $6.00 Direct labor 8.00 Variable overhead 3.00 $17.00 Additional fixed cost ($48,000 / 120,000) .40 Minimum unit price $17.40

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Problem 9-38 (continued) 4. Williams Company should consider the following factors before accepting the Glasgow Industries order: • The effect of the special order on Williams' sales at regular prices. • The possibility of future sales to Glasgow Industries and the effects of participating in the international marketplace. • The company's relevant range of activity and whether or not the special order will cause volume to exceed this range. • The impact on local, state, and federal taxes. • The effect on machinery or the scheduled maintenance of equipment. • The strategic advantage of the long-term commitment from Glasgow in recognition of Williams’ help. • Which firm handles warranty, repair, service, and the like. • The ethical and competitive issues of helping a competitor in distress. 5. The international issues Williams should consider include: • What customs duties and import/export restrictions might affect the special order and any future business with Glasgow? • While this special order will be completed in the relatively short time of a few months, foreign exchange rates might change significantly in this period. What does the special order agreement say regarding the sales price, in pounds or dollars? • Might the Glasgow special order introduce Williams to new markets in Scotland or elsewhere in Britain or Europe? If Williams is not now significantly involved in global sales, how might the firm use this opportunity to increase its exposure in foreign markets?

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9-39 Profitability Analysis; Review Master Budget; Strategy (50 min) 1. The dollar value of DimLok's present annual fixed costs is calculated as follows: Profit target based on 20% of annual fixed costs $800,000 Total fixed costs = $800,000 /.20 = $4,000,000 2. DimLok must sell 64,000 units in order to achieve both profit objectives of 20 percent return on fixed costs and $20 per unit sold. Supporting Calculations First: The solution must consider the following constraints: • 40,000 unit capacity for the current facility. • $1,000,000 additional fixed charge for production up to 80,000 units. • a sales discount of $20 per unit for sales beyond 40,000 units. • a variable cost decrease of $20 per unit after the production of 60,000 units. Second: The calculation with the current facility at the capacity level of 40,000 units will not meet the profit objectives. Contribution per unit below the 40,001 unit level = $200 selling price - ($80 variable cost per unit + $20 profit per unit) = $100 contribution per unit up to 40,000 Calculation of the number of units to achieve the desired profit objectives = (Fixed charges + Desired profit) / Contribution per unit. = ($4,000,000 + $800,000) / $100 per unit = 48,000 units 48,000 units exceeds capacity by 8,000 units.

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Problem 9-39 (continued) Third: In order to achieve the profit targets, DimLok must increase plant capacity, thus incurring an additional $1,000,000 in fixed costs. This in turn will increase the profit target based on fixed costs to $1,000,000 {.20($4,000,000 + $1,000,000)} The contribution for production in the 40,001 to 60,000 units range, with the selling price reduced to $180 per unit is as follows: = $180 selling price - ($80 variable cost per unit + $20 profit per unit) = $80 contribution per unit. Calculation of the number of units to achieve overall profit objectives = (Fixed charges + Desired profit) / Contribution per unit = ($5,000,000 + $1,000,000) /[ ($100 per unit x 40,000 units) + {$80(X - 40,000 Units)}] = 65,000 units 65,000 units exceeds the 60,000 unit constraint; variable costs are reduced by $20 per unit for production in excess of 60,000 units. Fourth: The contribution margin for production in the 60,000 to 80,000 units range, with the variable cost per unit reduced to $60 per unit is determined as follows: = $180 selling price - ($60 variable cost per unit + $20 profit per unit) = $100 contribution per unit Calculation of the number of units to achieve overall profit objectives = (Fixed charges + desired profit) / contribution per unit = ($5,000,000 + $1,000,000) / [($100 per unit x 40,000 units) + ($80 x 20,000 units) + {$100 (X - 60,000 units)}] = 64,000 units

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Problem 9-39 (continued) 3.

DimLok Division Pro Forma Income Statement

Revenue 40,000 units x $200 24,000 units x $180 Variable costs 60,000 units x $80 4,000 units x $60 Contribution Fixed costs Operating income

$8,000,000 4,320,000 4,800,000 240,000

$12,320,000 5,040,000 7,280,000 5,000,000 $ 2,280,000

The profit objectives {(20 percent of the annual fixed costs) + ($20 per unit produced)} are met as shown below. = (.20 x $5,000,000) + ($20 x 64,000 units produced) = $1,000,000 + $1,280,000 = $2,280,000 4. DimLok has a competitive strategy based on differentiation. The differentiation is based on the secret process that DimLok has developed and the advertising program stresses completely new products each year. Given the innovative nature of the firm’s products, this strategy seems to be a very appropriate one. 5. Critical success factors for DimLok include research and development to maintain the technological advantage of their unique products and strong advertising programs to stress the firm’s differentiation based on innovation. Other strategic success factors include quality of production and customer service to maintain product differentiation.

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9-40 Make or Buy; Strategy; Ethics (45 min) 1. An analysis of per unit and total costs for 32,000 units shows that the Midwest Division should purchase the parts for a saving of $15,440 ($575,040 - $559,600). Cost to purchase MTR-2000 from Marley Bid price from Marley Equipment lease penalty [($36,000/12)x2] Total cost to purchase Cost for Midwest to Make MTR-2000 Direct material ($195,000/30,000)x1.08 Direct labor ($120,000/30,000)x1.05 Factory space rental ($84,000/32,000) Equipment leasing costs($36,000/32,000) Variable manufacturing overhead Total cost to make

Cost per unit

Total Cost

$17.30

$553,600 6,000 $559,600

7.02 4.20 2.625 1.125 3.00 $17.97

$224,640 134,400 84,000 36,000 96,000 $575,040

2. At least three strategic factors that the Midwest Division and Paibec Corporation should consider before agreeing to purchase MTR-2000 from Marley Company include the following: • The quality of the Marley component should be equal to, or better than, the quality of the internally made component, or else the quality of the final product might be compromised and Paibec's reputation affected. • Marley's reliability as an on-time supplier is important, since late deliveries could hamper Paibec's production schedule and delivery dates for the final product. • Layoffs may result if the component Is outsourced to Marley, This could impact Midwest's and Paibec's other employees and cause labor problems or affect the company's position in the community, In addition, there may be termination costs which have not been factored into the analysis. • Giving up production capability risks dependence upon Marley’s future pricing.

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Problem 9-40 (continued) 3. Referring to the specific standards for ethical practice by a management accountant, Lynn Hardt should consider the ethical standards of competence, integrity, and objectivity: Competence • Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information. John has asked Lynn to adjust and falsify her report and leave out some manufacturing overhead costs. Integrity • Refrain from either actively or passively subverting the attainment of the organization's legitimate and ethical objectives, Paibec has a legitimate objective of trying to obtain the component at the lowest cost possible, regardless of whether it is manufactured by Midwest or outsourced to Marley. • Communicate unfavorable as well as favorable information and professional judgments. Hardt needs to communicate the proper and accurate results of the analysis, regardless of whether or not it is favorable to Midwest. • Refrain from engaging in or supporting any activity that would discredit the profession. Falsifying the analysis would discredit Hardt and the profession. Objectivity • Communicate information fairly and objectively. Hardt needs to perform an objective make-or-buy analysis and communicate the results objectively. • Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations presented. Hardt needs to fully disclose the analysis and the expected cost increases.

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9-41 Profitability Analysis; Excel 1. The profit report Hal is using is not contribution based, so the first step is to produce a contribution income statement for the three product lines, as shown below. Note that fixed costs are not allocated to the product lines since they are irrelevant to the short-term profitability analysis. Parker Virginian Weldon Total Per Unit Total Per Unit Total 150,000 335,000 165,000 459.00 68,850,000 365.00 122,275,000 248.00 40,920,000

Total

232,045,000

125.00 88.50 23.50 237.00

18,750,000 13,275,000 3,525,000 35,550,000

118.00 66.00 15.60 199.60

39,530,000 22,110,000 5,226,000 66,866,000

62.00 78.00 13.80 153.80

10,230,000 12,870,000 2,277,000 25,377,000

68,510,000 48,255,000 11,028,000 127,793,000

222.00

33,300,000

165.40

55,409,000

94.20

15,543,000

104,252,000

Per Unit Sales units Sales dollars Factory Costs Labor Raw Materials Power Variable Costs Contribution Fixed Costs Repairs Factory Equipment Other Costs Selling Expense Office Expense Office Depreciation Interest

7,962,500 21,775,000 8,473,750 22,935,000 10,920,000 17,875,000 4,225,000 94,166,250

Operating Profit

10,085,750

The analysis shows that all three lines are have a positive contribution, including the Weldon line. The short term effect of dropping the Weldon line would be the loss of $15,543,000 contribution. For a longer-term perspective, Hal should expect the Weldon product to cover the full operating costs, including the fixed costs. Thus, there should be a consideration of sales trends and alternative uses of the plant’s capacity. For example, if sales in the Weldon line are expected to fall and there are attractive alternative uses of the plant’s capacity, then the Weldon line might be discontinued now, suffering a short term loss as noted above, for the purpose of the longer-term gain. 2. Since the Weldon product has a positive contribution of $94.20 per unit, the total contribution will be positive irrespective of the level of sales, and the analysis in part one will continue to favor keeping the line. Hal and Joan might want to consider alternate uses of the plant facilities if Weldon sales continue to fall. Problem 9-41 (continued) Solutions Manual

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3. The 10% sales increase has total sales of 165,000 units for Parker and 368,500 units for Virginian. The analysis for dropping Weldon is as follows. The new total profit of $3,413,650 falls short of the profit with Weldon, $10,085,750, so in the short run it would be better to retain Weldon.

Parker Virginian Weldon Total Per Unit Total Per Unit Total 165,000 0 368,500 459.00 75,735,000 365.00 134,502,500 248.00

Total -

210,237,500

125.00 88.50 23.50 237.00

20,625,000 14,602,500 3,877,500 39,105,000

118.00 66.00 15.60 199.60

43,483,000 24,321,000 5,748,600 73,552,600

62.00 78.00 13.80 153.80

-

64,108,000 38,923,500 9,626,100 112,657,600

222.00

36,630,000

165.40

60,949,900

94.20

-

97,579,900

Per Unit Sales units Sales dollars Factory Costs Labor Raw Materials Power Variable Costs Contribution Fixed Costs Repairs Factory Equipment Other Costs Selling Expense Office Expense Office Depreciation Interest

7,962,500 21,775,000 8,473,750 22,935,000 10,920,000 17,875,000 4,225,000 94,166,250

Operating Profit

3,413,650

4. The most convenient way to solve this problem, once you have a spreadsheet, is to use Goal Seek in Excel. Goal Seek is available under the Tools menu. The dialog box that executes Goal Seek is illustrated below:

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Problem 9-41 (continued)

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Problem 9-41 (continued) The result of the Goal Seek is shown below Per Unit Sales units Sales dollars Factory Costs Labor Raw Materials Power Variable Costs Contribution

Parker Total

Per Unit

Virginian Total

Per Unit

Weldon Total

Total

459.00

220,014 100,986,203

365.00

335,000 122,275,000

248.00

-

223,261,203

125.00 88.50 23.50 237.00

27,501,689 19,471,196 5,170,318 52,143,203

118.00 66.00 15.60 199.60

39,530,000 22,110,000 5,226,000 66,866,000

62.00 78.00 13.80 153.80

-

67,031,689 41,581,196 10,396,318 119,009,203

222.00

48,843,000

165.40

55,409,000

94.20

-

104,252,000

Fixed Costs Repairs Factory Equipment Other Costs Selling Expense Office Expense Office Depreciation Interest

7,962,500 21,775,000 8,473,750 22,935,000 10,920,000 17,875,000 4,225,000 94,166,250

Operating Profit

10,085,750

The analysis shows that sales in the Parker line would have to increase to 220,014 units (a 70,014 unit or nearly 50% increase) in order to maintain operating income at $10,085,750 if Weldon is discontinued.

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9-42 Profitability Analysis; Linear programming (50 min) 1. Solve for all three constraints: The solution is 15 units of Premier and 30 units of Haute, as shown in Exhibit 9-42 B, cells B5 and B6. The Solver set up for this solution is shown in Exhibit 9-42 A, and the Answer report is shown in Exhibit 9-42 C. Exhibit 9-42 A

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Problem 9-42 (continued) Exhibit 9-42 B

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Problem 9-42 (continued) Exhibit 9-42 C

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Problem 9-42 (continued) 2. Solve with the preparation time constraint removed The solution is 45 units of Premier and 10 units of Haute, as shown in Exhibit 9-42 D, cells B5 and B6. The Solver Answer report is shown in Exhibit 9-42 E.

Exhibit 9-42 D

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Problem 9-42 (continued) Exhibit 9-42 E

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