CHAPTER 21

DISCUSSION QUESTIONS

Q21-1. Differential cost is the difference in the cost of will include the incremental element of fixed
alternative choices. The economist calls such cost reflected in the flexible budget.
costs marginal, and the engineer calls them Q21-6. Historical costs are usually irrelevant because
incremental. they have been created by a past decision
Q21-2. Marginal cost (or differential cost) is the cost that cannot be changed by a future decision.
incurred by increasing the present output. The Historical costs obtained from accounting
cost, therefore, would not have been incurred records often include arbitrarily allocated
if the additional units had not been made. fixed cost that may not be relevant to differen-
Marginal costing (or direct costing), on the tial cost analysis.
other hand, is a costing approach in which Q21-7. Variable cost is important because it can
only variable manufacturing costs are always be identified as a differential cost.
charged to products, and thus to inventory, However, differential costs may also include
while fixed manufacturing costs are treated as additional fixed costs.
period costs and are charged off without Q21-8. Sunk costs are irrecoverable costs that are
becoming part of inventory costs. not relevant to future decisions.
Q21-3. Incremental costs are important in decision Q21-9. A fixed cost would be relevant in deciding
making, because the least costly or most between alternatives if the fixed expenditure
profitable alternative cannot be determined is an out-of-pocket cost required in order to
unless incremental costs are known. undertake an alternative (e.g., the cost of
Incremental costs are the costs that must be renting equipment needed to provide suffi-
incurred in order to complete an activity that is cient capacity in deciding whether or not to
being considered. These costs must be accept an offer); or if a fixed expenditure can
known in order to compare each available be avoided by undertaking an alternative
alternative. (e.g., supervisory salaries that will be discon-
Q21-4. Differential costs do not correspond to any tinued in the event of a plant closing).
possible accounting category, because they Q21-10. Opportunity costs are the measurable value
are oriented toward the future rather than the of an opportunity bypassed by rejecting an
past and they treat product costs on a differ- alternative use of resources.
ential rather than a total cost basis. Q21-11. Appendix Linear programming is a mathe-
Furthermore, certain costs relevant for differ- matical technique designed to assist decision
ential cost analysis (e.g., opportunity cost and makers in determining the allocation of
imputed cost) are not recorded in the resources that would be required to maximize
accounts. Conversely, certain costs recorded or minimize the objective function; i.e., it is a
in the accounts (e.g., fixed costs that will tool that can be used by business managers
remain unchanged) are irrelevant for differen- to determine the mix of inputs necessary to
tial cost analysis. The differential cost concept maximize contribution margin or minimize
is a concept for cost analysis and not cost cost. Linear programming is an algorithm that
accumulation purposes. maximizes or minimizes a function of several
Q21-5. The flexible budget is useful in differential cost variables subject to one or more constraints.
analyses, because the increments between The function being optimized and the con-
each different level of output represent the cost straints are assumed to be linear with respect
that must be incurred if additional business is to production activity.
undertaken. As long as fixed costs remain con- Q21-12. Appendix The unit costs used in linear pro-
stant under all rates of output, variable costs gramming problems are the traceable variable
are always the differential costs. If fixed costs costs. Costs must be traceable to the product
change in the flexible budget, differential costs and variable with respect to production quantity

21-1
21-2 Chapter 21

in order to affect changes in total production point—and choosing the corner point
cost and total contribution margin when with the largest total contribution margin.
changes in production quantity and mix occur. Alternatively, a series of CM lines can be
Q21-13. Appendix constructed, which have a slope equal to
(a) The area bounded by the lines AB, BC, –1 multiplied by the unit contribution mar-
CD, and DA is called the solution space gin available from the product identified
because it represents those quantities by the horizontal axis, divided by the unit
and combinations of standard and deluxe contribution margin available from the
models that can be produced, given the product identified by the vertical axis. The
available capacity of the grinding and pol- profit line farthest from the origin, point A,
ishing machines. represents the greatest total contribution
(b) Triangle BCF represents those combina- margin, and in this case, it passes
tions of standard and deluxe models that through point C.
could be produced by the polishing Q21-14. Appendix The simplex method is an iterative
machines but not by the grinding process that finds the optimum solution to a
machines. Triangle CDE represents the linear programming problem. The simplex
level of production that the grinding method, which is based on matrix algebra, is
machines could attain, but not the polish- a systematic way of evaluating each corner
ing machines. point in the feasible area. The process begins
(c) Point C denotes the optimum solution at the zero level of production and systemati-
because any other level of attainable cally moves from one corner point to another
production will result in a smaller total until the optimal solution is found. Each move
contribution margin. It can be identified provides the largest per unit improvement in
by computing the total contribution mar- the objective function. The process continues
gin available from the production and until the objective function can no longer be
sale of the combination of standard and improved.
deluxe models—denoted by each comer
Chapter 21 21-3

EXERCISES

E21-1
Sales ($1.80 × 5 000 kg) ........................................ $9,000
Cost to manufacture:
Direct materials (($.60 + $.01) × 5 000 kg)........ $3,050
Direct labor ($.50 × 5 000 kg) ......................... 2,500
Factory overhead:
Indirect labor ($.20 × 5 000 kg) ................ 1,000
Power (($600 ÷ 30,000) × 5 000 kg) .......... 100
Supplies ($.02 × 5 000 kg) ........................ 100
Maintenance and repair ($.027 × 5 000 kg) 135
Depreciation ($3,000 ÷ 24 months).......... 125
Insurance ($.007 × 5 000 kg) .................... 35
Payroll taxes .............................................. $ 210
Cost of goods produced and sold....................... 7,255
Gross profit contribution ...................................... $1,745
Administrative expense ........................................ 150
Profit contribution from accepting new business $1,595

E21-2

(1) Estimated cost of the additional 100,000 units:

Materials (($150,000/150,000 units) × 100,000 units) ............. $100,000
Direct labor (($112,500/150,000 units) × 100,000 units)......... 75,000
Variable factory overhead
(($75,000/150,000 units) × 100,000 units) or
($125,000 at 100% capacity – $75,000 at 60% capacity) ..... 50,000
Fixed factory overhead
($125,000 at 100% capacity – $100,000 at 60% capacity)... 25,000
Total differential cost of manufacturing the additional
100,000 units..................................................................... $250,000

(2) Total cost of producing 250,000 units in January:

Budget for Differential Cost Total Cost for
150,000 Units for 100,000 Units 250,000 Units
Materials .............................. $150,000 $100,000 $250,000
Direct labor ............................ 112,500 75,000 187,500
Factory overhead:
Variable ......................... 75,000 50,000 125,000
Fixed.............................. 100,000 25,000 125,000
Total cost .............................. $437,500 $250,000 $687,500
21-4 Chapter 21

E21-2 (Concluded)

(3) Sales price required to achieve a 20% mark up on production cost:

Production cost per unit ($687,500 ÷ 250,000 units)........ $2.75

Plus 20% mark up on cost ($2.75 × 20%).......................... .55
Sales price required to achieve 20% mark up on cost .... $3.30

E21-3

Revenue from the special sale (15,000 units × $12.50 each) $187,500
Less differential costs:
Direct materials (($20,000 ÷ 10,000 units) ×
15,000 units) ..................................................... $30,000
Direct labor (($35,000 ÷ 10,000 units) ×
15,000 units) ..................................................... 52,500
Additional overtime premium on special order 10,000
Variable factory overhead
(($10,000 ÷ 10,000 units) × 15,000 units)........ 15,000
Additional fixed overhead from equipment
rental.................................................................. 5,000
Variable marketing expenses (($20,000 ÷
10,000 units) × 15,000 units) ........................ 30,000 142,500
Addition to annual company profit resulting
from special sale ............................................................ 45,000
Chapter 21 21-5

E21-4

No, Huntington should not accept Lufkin’s offer because it would be $5,000
cheaper to make the part.

Cost if purchased from Lufkin (10,000 × $18)................... $180,000

Cost if manufactured by Huntington:
Direct materials........................................................... $20,000
Direct labor.................................................................. 55,000
Variable factory overhead .......................................... 45,000
Rent from third party forgone if part
manufactured ........................................................ 15,000
Additional fixed factory overhead eliminated
if part purchased from Lufkin (10,000 × $4)....... 40,000 175,000
Savings if part manufactured by Huntington ..................................... $ 5,000

This solution assumes that a more profitable use of the facilities does not exist
than that derived from the saving of $5,000. Otherwise, it would be preferable to
buy Part M-1 from Lufkin and use Huntington’s facilities for the more profitable
activity.

E21-5

The company should purchase the pistons from the outside supplier because it
would cost $6,000 less than manufacturing them at the Tucson plant.

The differential cost of manufacturing pistons at the Tucson plant:

Direct materials........................................................... $160,000
Direct labor.................................................................. 80,000
Variable factory overhead (20% × $240,000) ............ 48,000
Incremental fixed cost for machinery rental ............ 30,000
Incremental fixed cost for additional
supervisor ............................................................. 40,000
Total differential cost to manufacture
80,000 pistons ....................................................... $358,000
Cost to purchase 80,000 pistons from Wichita
Machine Works ($4.40 per piston × 80,000
pistons) ........................................................................ 352,000
Cost savings available from purchasing the
pistons from the Wichita Machine Works rather
than manufacturing them at the Tucson plant $ 6,000
21-6 Chapter 21

E21-6

(1) Yes, the sales manager’s proposal to drop Tift from the product line and increase
the production of Mift should be accepted because it will increase the company’s
income by $4,000, determined as follows:

Contribution margin from sale of Tift:

Revenue from sale of Tift ($6 × 7,000 units) ............ $42,000
Less variable cost of manufacturing Tift:
Materials ($2 × 7,000 units) ............... $14,000
Labor ($1 × 7,000 units) ..................... 7,000
Variable factory overhead
($1 × 7,000 units) ............................ 7,000 28,000
Gross contribution margin from sale of Tift .................. $14,000
Less variable marketing expense from sale of
Tift ($1 × 7,000 units) .............................................. 7,000 $ 7,000

Contribution margin from sale of 4,000 additional units of Mift:

Revenue from sale of additional Mift

($10 × 4,000 units) ......................... $40,000
Less variable cost of manufacturing additional Mift:
Materials ($2 × 4,000 units) ................ $ 8,000
Labor ($2 × 4,000 units) ...................... 8,000
Variable factory overhead
($1 × 4,000 units) ........................... 4,000 20,000
Gross contribution margin from
sale of additional Mift ................... $20,000
Less variable marketing expense from
sale of additional Mift ($1 × 4,000 units) 4,000 16,000
Additional contribution margin from converting capacity
to production of 4,000 additional units of Mift..... $ 9,000
Additional advertising expense required to sell 4,000
additional units of Mift............................................ 5,000
Additional income from dropping Tift from product line
and converting capacity to production of
4,000 additional units of Mift ................................ $ 4,000
Chapter 21 21-7

E21-6 (Concluded)

(2) Montreal should consider whether dropping Tift from the product line will result
in decreased sales of Mift and Lift in the long run. For example, if the three prod-
ucts are complementary, customers may prefer to maintain only those sources
of supply from which the full product line is available. The present ability to sell
more Mift by dropping Tift may be a short-run condition. If this is a concern, the
cost of resuming Tift production at a later date should also be considered.

CGA-Canada (adapted). Reprint with permission.

E21-7

Silver Polish
per Jar
Sales price ........................................................................ $4.00
Grit 337 per jar (one fourth of $1.60).............................. $ .40
Other ingredients, labor, and variable factory overhead 2.50
Variable marketing cost................................................... .30
Total variable cost ................................................... $3.20
Contribution margin......................................................... $ .80
Opportunity cost from further processing rather than
selling Grit 337 (1/4 × ($2.00 – $1.60)) ...................... .10
Net contribution margin per unit .................................... $ .70

$5,600 avoidable fixed cost ÷ $.70 = 8,000, the minimum number of jars of silver
polish that must be sold to justify further processing of Grit 337.

E21-8
(1) Direct labor hours (DLH) = 1,000,000 doses to be packaged
required for the job 1,000 doses per DLH
= 1,000 DLH

Direct labor ($5 × 1,000 hours) ....................................... $5,000

Variable factory overhead ($2 × 1,000 DLH) .................. 2,000
Administrative expense................................................... 1,000
Total traceable out-of-pocket costs................................ $8,000

Minimum price per dose = Total traceable out-of-pocket costs

1,000,000 doses
$8,000 = $.008
=
1,000,000
21-8 Chapter 21

E21-8 (Concluded)

(2) Maximum allowable = Maximum return after taxes

return before taxes (1 – Tax Rate)

.09 .09
= = = .15 or 15%
1− .40 .60
= 2, 500 units
Total traceable out-of-pocket costs (from requirement (1)).... $ 8,000
Fixed factory overhead ($5 × 1,000 DLH) ................................. 5,000
Total full cost............................................................................... $13,000
Maximum allowable return (15% × $13,000)............................. 1,950
Total bid price.............................................................................. $14,950

Total bid price

Bid price per dose =
1,000,000 doses
$14,950 = $.01495
=
1,000,000

(3) The factors that Hall Company should consider before deciding whether or not
to submit a bid at the maximum allowable price include whether Hall has excess
capacity, whether there are available jobs on which earnings might be greater,
whether the maximum bid of $.015 contributes toward covering the fixed costs,
and whether this job could lead to more profitable business with Wyant in the
future.
(4) The competitive environment of the industry should have been considered by
Wyant Memorial Hospital to determine whether or not a lower price could be
obtained through competitive bidding. The hospital should also have considered
that cost-plus pricing is not usually viewed uniformly by prospective bidders, is
difficult to compute for products produced in “mass” quantity, and is better
suited for products that are unique and high priced.
Chapter 21 21-9

E21-9

Franchise fee collections per day:

Average gross revenues per franchise per day $ 500
Number of franchises.......................................................... × 420
Total gross revenue ............................................................. $210,000
Franchise fee........................................................................ × .25
Average daily franchise fee collections ............................ $ 52,500

First proposal (i.e., use local messenger service to collect and mail checks only):
Average daily franchise fee collections ............................ $ 52,500
Days saved ........................................................................... × 2
Total float saved................................................................... $105,000
Before-tax opportunity cost................................................ × 15%
Average annual savings...................................................... $ 15,750
Less cost of messenger service ........................................ 20,000
Annual reduction in income if proposal implemented .... $ (4,250)

Second proposal (i.e., use local messenger service with a lock-box arrangement):
Average daily franchise fee collections ............................ $ 52,500
Days saved ........................................................................... × 5
Total float saved................................................................... $262,500
Before-tax opportunity cost................................................ × 15%
Average annual savings...................................................... $ 39,375
Less costs:
Messenger service ....................................... $20,000
Compensating balance ($15,000 × 15%) 2,250 22,250
Annual increase in income if proposal implemented ...... $ 17,125
21-10 Chapter 21

E21-10

Silk-screen method:
Prepare screen (1 1/2 hours × 20,000 circuit
boards × $6.50) ............................................. $195,000
Screen patterns (1/3 hour × 20,000 circuit
boards × $6.50) ............................................. 43,333
Total cost................................................................ $238,333
AZ-17 process:
Labor (1/2 hour × 20,000 circuit boards × $6.50) $65,000
Monthly cost for materials and equipment
rental and operation ($4,000 × 12) .............. 48,000
Total cost................................................................ 113,000
Annual savings from changing from silk-screen method
to the new AZ-17 process..................................... $125,333
Chapter 21 21-11

E21-11 APPENDIX

Let MA = marking board assembled in automated assembly department

ML = marking board assembled in labor assembly department
TA = tack board assembled in automated assembly department
TL = tack board assembled in labor assembly department

MA ML TA TL
Sales price per unit ...................................... $60.00 $60.00 $45.00 $45.00
Less variable costs:
Direct materials:
Base ................................................ $ 6.00 $ 6.00 $ 6.00 $ 6.00
Covering.......................................... 14.50 14.50 7.75 7.75
Frame .............................................. 8.25 8.25 8.25 8.25
Direct labor:
Cutting Department ....................... 2.00 2.00 2.00 2.00
Assembly Department ................... .60 3.00 .60 3.00
Variable factory overhead:
Cutting Department ....................... 2.45 2.45 2.45 2.45
Assembly Department ................... 3.30 2.25 3.30 2.25
Variable marketing expenses............... 3.00 3.00 3.00 3.00
Total variable costs per unit ................ $40.10 $41.45 $33.35 $34.70
Contribution margin per unit....................... $19.90 $18.55 $11.65 $10.30

Objective function:

Maximize CM = $19.90 MA + $18.55 ML + $11.65 TA + $10.30 TL

Subject to:
.20 MA + .20 ML + .20 TA + .20 TL <_ 30,000 DLH in Cutting
.05 MA + .25 ML + .05 TA + .25 TL <_ 40,000 DLH in Assembly
.15 MA + .15 ML + .15 TA + .15 TL <_ 25,000 MH in Cutting
0 MA + .02 ML + 0 TA + .02 TL <_ 1,500 MH in Labor Assembly
.05 MA + 0 ML + .05 TA + 0 TL <_ 5,000 MH in Automated Assembly
1 MA + 1 ML + 0 TA + 0 TL >_ 30,000 units sales contract
0 MA + 0 ML + 1 TA + 1 TL >_ 30,000 units sales contract
21-12 Chapter 21

E21-12 APPENDIX

Let L = the number of legal pads

R = the number of regular pads

Objective function:

Maximize CM = $18L + $12R

Subject to:
20 L + 10 R <_ 900 minutes labor
(2 people × 7.5 hour × 60 minutes)
L + R <_ 60 boxes daily maximum demand
(300 boxes per week ÷ 5 work days)

90

80

70

60

L + R ≤ 60 boxes daily demand

50
45 B

40

C
30

20
20L + 10R ≤ 900 minutes of labor

10

A D

0 10 20 30 40 50 60 70 80 90 R

A = (L = 0, R = 0) = ($18)(0) + ($12)(0) = $0 CM
B = (L = 45, R = 0) = ($18)(45) + ($12)(0) = $810 CM
C = (L = 30, R = 30) = ($18)(30) + ($12)(30) = $900 CM Maximum CM
D = (L = 0, R = 60) = ($18)(0) + ($12)(60) = $720 CM

CGA-Canada (adapted). Reprint with permission.

Chapter 21 21-13

E21-13 APPENDIX

Graphic method:
Objective function: Maximize CM = 4 a + 3 b
Constraints: 2a + b <_ 1,000 Time
a + b <_ 800 Leather
a <_ 400 Buckles

When: a = 0 When: b = 0:
b = 1,000 Time a = 500
b = 800 Leather a = 800
No b Buckles a = 400

b
1200
1150
1100
1050
1000
950
Time Constraint
900
850
B
800
750
700 Buckle Constraint

650
600 C

550
500
450
400
350
300 Leather Constraint
250
200 D

150
100
50
E
a
A
50 150 250 350 450 550 650 750 850 950 1050 1150 1250
100 200 300 400 500 600 700 800 900 1000 1100 1200 1300

Trying values at each of the corner points:

A = (a = 0, b = 0); 4(0) + 3(0) = $0 CM
B = (a = 0, b = 800); 4(0) + 3(800) = $2,400 CM
C = (a = 200, b = 600); 4(200) + 3(600) = $2,600 CM
D = (a = 400, b = 200); 4(400) + 3(200) = $2,200 CM
E = (a = 400, b = 0); 4(400) + 3(0) = $1,600 CM
Optimum combination would be 200 a and 600 b
200 (4) + 600 (3) = $2,600 CM
21-14 Chapter 21

E21-14 APPENDIX

Graphic method:
Cost function is: Minimize C = $3x + $4y
Subject to constraints:
4x + 8y >_ 32
7x + 2y >_ 14
1.5x + 5y >_ 15
y
9

7 A

Product b Constraint
6

4
B (1, 3.5)
3.5
Product a Constraint
3

2
(5, 1.5) Product c Constraint
1.5
C
1

D
0 x
0 1 2 4 5 6 8 10 12

Possible solutions:

Points x y 3x 4y 3x + 4y
A 0 7 0 28 $28
Optimum solution: Use 1 ton of x
B 1 3.5 3 14 17
and 3.5 tons of y for
C 5 1.5 15 6 21 a minimum total
D 10 0 30 0 30 cost of $17
Chapter 21 21-15

E21-15 APPENDIX

Let x = pounds of hardwood per batch Subject to: x + y <_ 24,000

y = pounds of softwood per batch .8x + .5y >_ 12,000
.2x + .5y >_ 6,000
Minimize: C = .50X +.40Y
30,000

25,000
A
y, Pounds of Softwood per Batch

20,000

15,000 FEASIBLE
AREA

x + y ≤ 24,000
10,000

.2x + .5y ≥ 6,000 B

5,000 C

.8x + .5y ≥ 12,000

0
5,000 10,000 15,000 20,000 25,000 30,000

x, Pounds of Hardwood per Batch

Corner point B values: Corner point C values:

.2x + .5y = 6,000 .2x + .5y = 6,000
.8x + .5y = 12,000 x + y = 24,000
.6x = 6,000
x = 10,000
Substitute: Multiply by 2: .4x + y = 12,000
.2 (10,000) + .5y = 6,000 x+y= 24,000
.5y = 4,000 .6x = 12,000
y = 8,000 x= 20,000
Substitute:
.2 (20,000) + .5y = 6,000
.5y = 2,000
y= 4,000
Trying values at each of the corner points:
A = (x = 0, y = 24,000); $.50 (0) + $.40(24,000) = $9,600C
B = (x = 10,000, y = 8,000); $.50 (10,000) + $.40(8,000) = $8,200C
C = (x = 20,000, y = 4,000); $.50 (20,000) + $.40(4,000) = $11,600C
Optimal solution: 10,000 pounds of hardwood per batch and 8,000 pounds of soft-
wood per batch results in a cost equal to the $8,200 standard per batch
21-16 Chapter 21

PROBLEMS

P21-1

(1) The differential cost analysis for the Glasgow Industries’ order for 120,000 valves
follows:
Incremental revenue ($19 per unit × 120,000 units) .................. $2,280,000
Incremental costs:
Variable costs:
Direct materials ($5 per unit × 120,000
units) ...................................................... $ 600,000
Direct labor ($6 per unit × 120,000 units) 720,000
Variable overhead ($6 × 1/2 hour per
unit × 120,000 units) ............................. 360,000
Shipping expense ($1 per unit ×
120,000 units) ........................................ 120,000
Total variable costs .................................. $1,800,000
Fixed costs:
Supervisory and clerical costs
(120,000 ÷ 30,000 per month ×
$12,000 per month) ............................... 48,000 1,848,000
Increment to pretax profit as a result of
accepting the offer........................................................................ $432,000

(2) The minimum unit sales price that Sommers could accept without reducing net
income must cover all differential costs (i.e., the variable costs plus the out-of-
pocket fixed costs). Therefore, the minimum sales price per unit would be:
Variable cost per unit:
Direct materials ............................................ $ 5.00
Direct labor ................................................... 6.00
Variable overhead ($6 per hour × 1/2
hour per unit) ............................................ 3.00
Shipping expense......................................... 1.00
Additional fixed cost per unit:
Supervisory and clerical costs ($12,000
total cost ÷ 30,000 units) ......................... .40
Minimum unit sales price ..................................... $15.40
Chapter 21 21-17

P21-1 (Concluded)

(3) Sommers Company management should consider the following factors before
accepting the Glasgow Industries order.
a. The effect of the special order on Sommers’ sales to other customers at the
regular sales price.
b. The possibility of establishing contacts in the international marketplace as
a result of the sales to Glasgow Industries, which could lead to market
expansion.
c. The wear and tear on machinery that might increase maintenance and
repairs and result in a premature replacement of the machinery.
d. Possible retaliation by competitors who may learn of Sommers’ deep price-
cutting action, including risk of a price war that would disrupt regular selling
prices.

P21-2

(1) Impact on net income if APA accepts bid:

Submitted bid ........................................................ $165,000
Less sales commission ........................................ 16,500
Net sales ................................................................ $148,500
Variable costs:
Direct materials ............................................ $29,200
Direct labor ................................................... 56,000
Variable factory overhead (30% of
direct labor)* ................................................. 16,800 102,000
Contribution margin .............................................. $ 46,500
Income tax (40%) .......................................... 18,600
Increase in net income ......................................... $ 27,900

*The factory overhead rate is 50% of direct labor dollars. Based on the experi-
ence for the fiscal year ended September 30, the rate due to the variable factory
overhead cost is 30% ($2,250 ÷ $7,500).

(2) Framar would realize a positive contribution margin of $12,300 before income
tax, increasing net income by $7,380, if the $127,000 counteroffer is accepted:
Counteroffer ......................................................................... $127,000
Sales commission ............................................................... 12,700
Net sales ...................................................................... $114,300
Variable manufacturing costs (from requirement (1))...... 102,000
Contribution margin ............................................................ $ 12,300
Income tax (40%) ........................................................ 4,920
Increase in net income........................................................ $ 7,380
21-18 Chapter 21

P21-2 (Concluded)

(3) The lowest price that Framar could quote on this machinery without reducing its
net income is $113,333 ($102,000 ÷ .9). This bid would cover exactly the sum of
the variable manufacturing costs ($102,000) and the 10% sales commission,
thereby resulting in no increase in contribution margin and no income tax.
(4) If Framar Inc. accepted all of its work at prices similar to the $127,000 counterof-
fer, a loss situation could result. The analyses for requirements (1), (2), and (3)
were short-run decisions in situations in which Framar had excess capacity.
Consequently, the analyses concentrated on covering only the differential vari-
able cost. However, when all orders are considered, Framar must cover both its
variable and its fixed costs. A bid for all work similar to the one for $127,000
would not cover Framar’s fixed cost.

Calculations restating the most recent entire fiscal year on the $127,000
price/variable cost relationship are as follows 000s omitted):

Sales ($15,750 × 1.245)* ............................................................... $19,609

Less commission.......................................................................... 1,961
$17,648
Expenses (per income statement for year ended 9/30):
Variable cost .................................................... $15,750
Fixed cost......................................................... 2,250 18,000
$ (352)

*Annual variable costs:

Direct materials ..................................................... $ 6,000
Direct labor ............................................................ 7,500
Variable factory overhead..................................... 2,250
$15,750

Markup on variable costs = $127,000 = 1.245

$102,000
Chapter 21 21-19

P21-3

(1) An analysis comparing costs of each alternative:

(a) Schedule overtime hours:

Overtime Hours
Required
May ....................................... 1,000
June ...................................... 2,000
July ....................................... 2,000
August .................................. 2,500
September............................ 2,500
October ................................ 2,000
12,000
Inefficiency (5%).................. 600
Total overtime hours........... 12,600

Additional labor costs (12,600 × $6 × 1.5)......................... $113,400

Related fringe benefits ($113,400 × .10) ............................ 11,340
Differential cost if overtime is scheduled ......................... $124,740

(b) Hire temporary workers:

Extra hours required ........................................................... 12,000
Inefficiency factor (25%) ..................................................... 3,000
Total hours required ............................................................ 15,000
Hourly rate for temporary workers..................................... × $6
Differential cost if temporary workers hired ..................... $ 90,000

There are no fringe benefit costs with temporary workers.

21-20 Chapter 21

P21-3 (Continued)

(c) Expand labor force and schedule level production of 10,000 units per month:
If the labor force is expanded so that level production can be scheduled,
Valbec will produce 10,000 doll house units per month, requiring 5,000 direct
labor hours. This means that 12,000 additional regular direct labor hours will
be required during 20A with no scheduled overtime or need for temporary
workers, as shown below:

Requirements
Month Annual
Forecast production in units................................ 10,000 120,000
Direct labor hours required.................................. 5,000 60,000
Former direct labor constraint in hours ............. 4,000 48,000
Additional regular hours in 20A........................... 1,000 12,000
Direct labor costs:
Regular time (12,000 × $6).............................. $72,000
Related fringe benefits ($72,000 × .20).......... 14,400 $86,400
Additional inventory carrying costs (refer
to the schedule of inventory levels below):
Average monthly inventory with
overtime or temporary workers ............... 13,846
Average monthly inventory with level
production.................................................. 16,231
Difference ......................................................... 2,385
Estimated annual cost of carrying
inventory per unit ...................................... × $1 2,385
Differential costs if level production is
used ................................................................ $88,785
Chapter 21 21-21

P21-3 (Concluded)

Schedule of Inventory Levels

Use Overtime Level Production
Last Day or Temporary
of Month Workers* Beginning* Production Sales Ending*
December ...................................... 8,000 8,000
January ......................................... 8,000 8,000 10,000 8,000 10,000
February ....................................... 8,000 10,000 10,000 8,000 12,000
March ........................................... 8,000 12,000 10,000 8,000 14,000
April ........................................... 8,000 14,000 10,000 8,000 16,000
May ........................................... 10,000 16,000 10,000 8,000 18,000
June ........................................... 12,000 18,000 10,000 10,000 18,000
July ........................................... 12,000 18,000 10,000 12,000 16,000
August ........................................... 13,000 16,000 10,000 12,000 14,000
September ..................................... 13,000 14,000 10,000 13,000 11,000
October.......................................... 12,000 11,000 10,000 13,000 8,000
November ...................................... 8,000 8,000 10,000 12,000 6,000
December ...................................... 8,000 6,000 10,000 8,000 8,000
128,000 159,000

Average per month

excluding safety
stock (divide by 13) ................ 9,846 12,231
Safety stock .................................. 4,000 4,000
Average monthly
inventory.................................. 13,846 units 16,231 units

*Excludes safety stock of 4,000 doll house units.

Alternative (c) affords the lowest estimated differential cost.

(2) There are several noncost factors, or factors that are difficult to cost, that Valbec
should consider in conjunction with the cost analysis of the three alternative
courses of action. Relevant factors include:
(a) Consider the degree to which Valbec’s regular labor force is willing to work
overtime.
(b) The labor force may plan on overtime pay as part of their normal work situ-
ation. If wages should be reduced because overtime is not scheduled, due
to the use of temporary workers or an expanded labor force, then the morale
of the labor force could deteriorate, laborers might seek work elsewhere,
laborers might seek base pay increases, or the labor force might decrease
its efficiency.
(c) Overtime does provide a certain degree of flexibility, should sales volume
and patterns not occur according to the forecasted plan.
(d) If the labor force is to be expanded, Valbec must be sure there is an adequate
supply of skilled workers.
21-22 Chapter 21

P21-4

Group I production costs:

Materials ($3.27 ÷ 25) ............................................ $ .131
Labor (($9.48 × 2.5) ÷ 25) ...................................... .948
Variable factory overhead ($.948 × 150%)........... 1.422
Total variable unit cost ......................................... $ 2.501
Total variable cost ($2.501 × (3 + 2) × 2,000) ...... $ 25,010
Additional fixed factory overhead ....................... 7,040
$ 32,050
Group II production costs:
Materials ($3.60 ÷ 20) ............................................ $ .180
Labor (($12.16 × 2) ÷ 20) ....................................... 1.216
Variable factory overhead ($1.216 × 150%)......... 1.824
$ 3.220
Total variable cost ($3.220 × (2 + 2 + 4) × 2,000) $ 51,520
Additional fixed factory overhead ....................... 6,000
$ 57,520
Sales ($60 × 2,000) ............................................................. $120,000

Group I costs:
Outside suppliers:
Dissection knives ($3.20 × 3 × 2,000) ......... $19,200
Scalpels ($3.30 × 2 × 2,000)......................... 13,200

Group I production costs (computed above) .....

$32,400
$32,050 } $ 32,050

Group II costs:
Outside suppliers:
Scissors ($3.00 × 2 × 2,000) ........................ $12,000
Tweezers ($2.97 × 2 × 2,000) ....................... 11,880
Clamps ($3.28 × 4 × 2,000) .......................... 26,240

Group II production costs (computed above) ....

$50,120
$57,520 } 50,120

Glass slides ($.03 × 100 × 2,000) ...................................... 6,000

Cover slips ($.01 × 400 × 2,000)........................................ 8,000
Cases ($6 × 2,000).............................................................. 12,000
Subassembly costs ($3 × 2,000)....................................... 6,000
Total production costs ...................................................... $114,170
Operating profit contribution............................................ $ 5,830
Chapter 21 21-23

P21-4 (Concluded)

Production of Group I components is less costly than purchasing from out-

siders, and purchasing Group II components from outsiders is less costly than
producing them. However, the estimated operating profit contribution is only
marginally positive ($5,830 or 4.9% of the estimated sales figure) and any neces-
sary additional marketing cost related to the dissection instrument sets would
further reduce the expected profit contribution.

Present annual fixed factory overhead is excluded from the differential cost
analysis, because these costs will be incurred whether or not the sets are mar-
keted.

Based on the information assembled by the study team, the proposal has little
merit.
21-24 Chapter 21

P21-5

(1) The lowest price Chemco should bid for a one-time special order of 25,000
pounds (25 lots) would be $34,750, which is equal to the variable costs of the
order, determined as follows:

Direct materials:
On a one-time-only special order, chemicals used in manufacturing the firm’s
main product have a relevant cost of their expected future cost, represented
by the current market price per pound. Chemicals not used in current produc-
tion have a relevant cost of their value to the firm. CW-3 (400 pounds per lot
× 25 lots) = 10,000 pounds.
Substitute CN-5 on a one-for-one basis to its total of 5,500 pounds.
The relevant cost is the salvage value ................... $ 500
The remaining 4,500 pounds would be CW-3 at the
relevant cost of $.90 per pound, its expected
future cost.................................................................. 4,050
JX-6 (300 pounds per lot × 25 lots × $.60 per pound) ...... 4,500
MZ-8 (200 pounds per lot × 25 lots × $1.60 per pound).... 8,000
BE-7 (100 pounds per lot × 25 lots × ($.65 cost per
pound – $.10 handling per pound)) ............................... 1,375
Total direct materials cost ................................................... $18,425

Direct labor:
(60 DLH per lot × 25 lots) = 1,500 DLH
Because only 800 DLH can be scheduled during regular
time this month, overtime would have to be used for
the remaining 700 hours; therefore, overtime is a relevant
cost for this order.
1,500 DLH × $7.00 per DLH at regular time rate ................ $10,500
700 DLH × $3.50 overtime premium per DLH ................. 2,450
Total direct labor cost .......................................................... $12,950

Factory overhead:
This special order will not increase fixed factory overhead
cost, and it is not an order for a continuing project that
should contribute to the recovery of fixed factory overhead.
Therefore, the fixed factory overhead is not relevant, and
the relevant factory overhead charge is the variable factory
overhead rate.
1,500 DLH × $2.25 variable factory overhead rate............. $ 3,375
Total differential cost of manufacturing this special
order and the minimum bid price for the order ................. $34,750
Chapter 21 21-25

P21-5 (Concluded)

(2) Calculation of the price for recurring orders of 25,000 pounds (25 lots) follows:
Direct materials:
Because of the possibility of future orders, all raw materials
must be charged at their expected future cost, represented by
the current market price per pound.
CW-3 (400 pounds per lot × 25 lots × $.90 per pound) ..... $ 9,000
JX-6 (300 pounds per lot × 25 lots × $.60 per pound) ...... 4,500
MZ-8 (200 pounds per lot × 25 lots × $1.60 per pound).... 8,000
BE-7 (100 pounds per lot × 25 lots × $.65 per pound) ...... 1,625
Total direct materials cost ................................................... $23,125

Direct labor:
60% of the production of a batch (900 DLH) can be done
on regular time; the remaining 600 DLH directly cause
overtime to be incurred and are, thus, a relevant cost
of this new product.
1,500 DLH × $7.00 regular rate per DLH............................. $10,500
600 DLH × $3.50 overtime premium per DLH ................. 2,100
Total direct labor cost .......................................................... $12,600

Factory overhead:
All new products should contribute to the recovery of
fixed factory overhead as well as cover all variable costs.
Therefore, the overhead charge would be the full
overhead rate.
1,500 DLH × $6.00 per DLH.................................................. $ 9,000
Full manufacturing cost .......................................................... $44,725
Markup of 25% on cost ($44,725 × .25) .................................. 11,181
Full manufacturing cost plus 25% markup............................ $55,906
21-26 Chapter 21

P21-6

Present Additional
Capacity Capacity Total
Sales:
50,000 × $10 ............................................... $500,000
25,000 × $10 ............................................... $250,000 $750,000
Variable expenses:
Direct materials:
50,000 × $2 .......................................... $100,000
25,000 × ($2 × .94)............................... $ 47,000
50,000 × ($2 × .06)............................... (6,000) $141,000
Direct labor ($4 × 1.05) ................ $4.20
Factory overhead ......................... 1.30
$5.50
50,000 × $5.50 ..................................... 275,000
25,000 × $5.50 ..................................... 137,500 412,500
Marketing expense .................................... 12,000 6,000 18,000
Total variable expense ....................... $387,000 $184,500 $571,500
Contribution margin ......................................... $113,000 $ 65,500 $178,500

Fixed expenses:
Factory overhead....................................... $ 72,500 $ 15,000 $ 87,500
Marketing expense .................................... 11,000
Increase in advertising
($11,000 × .10 × .25)............................ 275 11,275
Additional plant depreciation:
$260,000 ÷ 25 yrs. = $10,400
$ 84,000 ÷ 20 yrs. = 4,200
$14,600
$14,600 × .95* =................................... 13,870 13,870
Total fixed expense.................................... $ 83,500 $ 29,145 $112,645
Operating income ............................................. $ 29,500 $ 36,355 $ 65,855

*5% allocated to inventories.

The expected operating income from additional capacity ($36,355) should be evaluated
as to whether or not it is a satisfactory return on the additional capital investment of
$344,000 ($260,000 + $84,000) (See Chapters 23 and 24).
Chapter 21 21-27

P21-7
(1)
MARX CORPORATION
Boston Plant
Computation of Number of Units of Xoff Required To Cover
Fixed Factory Overhead and Fixed Regional Promotional Costs
Total (000s omitted) Per Unit
Sales ................................................................ $2,200 $20
Variable factory costs:
Direct materials ..................................... $ 550 $5
Direct labor ............................................ 660 6
Variable factory overhead .................... 440 4
Total variable cost ................................. $1,650 $15
Contribution margin....................................... $ 550 $ 5

Units required to cover fixed factory overhead and fixed regular promotional
costs:
($700,000 + $100,000) = 160,000 units of Xoff
$5 contribution margin
(2)
MARX CORPORATION
Schedule of Budgeted Contribution Margin and Operating Income
If Boston Operations Are Expanded Under Plan A
(000s omitted)
Total Boston Chicago
Sales ................................................................... $7,400 $3,400 $4,000
Variable factory costs:
Direct materials......................................... $1,850 $ 850 $1,000
Direct labor................................................ 2,020 1,020 1,000
Variable factory overhead ........................ 1,380 680 700
Total variable cost .................................... $5,250 $2,550 $2,700
Contribution margin .......................................... $2,150 $ 850 $1,300
Fixed costs:
Fixed factory overhead ............................ $1,600 $ 700 $ 900
Regional promotional cost ...................... 320 220 100
Total fixed cost.......................................... $1,920 $ 920 $1,000
Plant operating income ..................................... $ 230 $ (70) $ 300
Allocated home office cost............................... 310 142* 168**
Operating income (loss) ................................... $ (80) $ (212) $ 132

* $3,400 Boston sales

$7,400 Total sales × $310 Home office cost = $142
**$4,000 Chicago sales
× $310 Home office cost = $168
$7,400 Total sales
21-28 Chapter 21

P21-7 (Continued)

MARX CORPORATION
Schedule of Budgeted Contribution Margin and Operating Income
If Boston Plant Is Closed and Chicago Operations Are Expanded
Under Plan B
Chicago Operations
(000s omitted)
Sales ....................................................................... $6,200
Variable factory costs:
Direct materials ............................................ $1,550
Direct labor ................................................... 1,550
Variable factory overhead............................ 1,085
Total variable factory cost ........................... $4,185
Contribution margin .............................................. $2,015
Fixed costs:
Fixed factory overhead ................................ $ 950
Regional promotional cost .......................... 200
Total fixed cost ............................................. $1,150
Plant operating income ........................................ $ 865
Allocated home office cost .................................. 310
Operating income.................................................. $ 555
Chapter 21 21-29

P21-7 (Concluded)

MARX CORPORATION
Schedule of Budgeted Contribution and Operating Income
If Boston Plant Is Closed and Royalty Agreement Is Contracted
Under Plan C
(000s omitted)
Revenues: Total Boston Chicago
Sales .......................................................... $4,000 $4,000
Royalties .................................................... 275 $275
Total revenues........................................... $4,275 $275 $4,000
Variable factory costs:
Direct materials......................................... $1,000 $1,000
Direct labor................................................ 1,000 1,000
Variable factory overhead ........................ 700 700
Total variable factory cost ....................... $2,700 $2,700
Contribution margin .......................................... $1,575 $275 $1,300
Fixed costs:
Fixed factory overhead ............................ $ 950 $ 50 $ 900
Regional promotional cost ...................... 200 100 100
Total fixed cost.......................................... $1,150 $150 $1,000
Plant operating income and royalties.............. $ 425 $125 $ 300
Allocated home office cost............................... 310 310
Operating income (loss) ................................... $ 115 $125 $ (10)
21-30 Chapter 21

P21-8

Source: Management Accounting Campus Report (Montvale, N.J.: Institute of Management Accountants
(formerly National Association of Accountants), Spring, 1987), pp. 4–5. Copyright Spring, 1987, by Institute
of Management Accountants (formerly National Association of Accountants). All rights reserved. Reprinted
by permission.

Lex Glass Company should implement the proposed plan to purchase silica in the dis-
count quantity. The annual savings from implementation of the plan would be $48,150,
determined as follows:

Annual cost with quantity discount plan:

Interest expense to finance carrying inventory:
Average level of inventory in tons:
Lex Glass’s requirements ............... 10,000
Requirements of other manufacturers
((300,000 ÷ 12 months ÷ 2) average +
(300,000 ÷ 12 months ÷ 2)
minimum).......................................... 25,000 35,000
Price per ton with discount ..................... × $1.80
Total average cost of inventory............... $63,000
Rate of interest to carry inventory .......... × 5% $ 3,150

Cost of purchasing inventory (420,000 tons × $1.80) .............. 756,000

Additional costs to carry additional inventory:
Labor .......................................................... $20,000
Administrative expenses ......................... 10,000
Lost revenue from rental of warehouse
required to store additional inventory 10,000 40,000
$799,150
Less revenue from the sale of silica to other
manufacturers (300,000 tons × $2 per ton) ......................... 600,000
Annual cost of quantity discount plan ...................................... $199,150

Annual cost without quantity discount plan:

Interest expense to finance inventory:
Average level of inventory in tons.............. 10,000
Price per ton without discount ................... × $2.00
Total average cost of inventory .................. $20,000
Rate of interest to carry inventory ............. × 5%
Interest expense ........................................... $ 1,000
Cost of purchasing silica (120,000 tons × $2) .... 240,000 241,000
Annual cost savings available by implementing
quantity discount plan ............................................................................. $(41,850)
P21-9

(1)
Chapter 21

Plain Colored Paper Glossy Paper

Paper
Late
Bulk Bulk First Class First Class First Class
Gross revenue potential ............. $1,200,000 $2,000,000 $2,200,000 $2,500,000 $2,200,000
Brochure and mailing costs:
Design..................................... $ 300 $ 1,000 $ 1,000 $ 3,000 $ 3,000
Typesetting............................. 100 800 800 2,000 2,000
Paper cost1 ............................. 10,000 16,000 16,000 36,000 36,000
Printing cost2 ......................... 6,000 20,000 20,000 80,000 80,000
Postage3 ............................... 80,000 80,000 520,000 520,000 520,000
Handling4 ............................... 20,000 20,000 20,000 40,000 40,000
Total cost ............................... $ 116,400 $ 137,800 $ 577,800 $ 681,000 $ 681,000
Net revenue potential.................. $1,083,600 $1,862,200 $1,622,200 $1,819,000 $1,519,000

1Paper cost: ............................... 3Postage:

Plain: $.005/unit × 2,000,000 units = $10,000 Bulk: $.04/unit × 2,000,000 units = $80,000
Colored: $.008/unit × 2,000,000 units = $16,000 First class: $.26/unit × 2,000,000 units = $520,000
Glossy: $.018/unit × 2,000,000 units = $36,000

2Printing cost:.............................. 4Handling:

Plain: $.003/unit × 2,000,000 units = $6,000 Plain and colored: $.01/unit × 2,000,000 units = $20,000
Colored: $.010/unit × 2,000,000 units = $20,000 Glossy: $.02/unit × 2,000,000 units = $40,000
Glossy: $.040/unit × 2,000,000 units = $80,000
21-31
21-32 Chapter 21

P21-9 (Concluded)

(2) Net revenue potential:

The colored paper brochure provides the most net revenue if it can be mailed
at bulk mail rates; however, there is a risk of earning only the third best rev-
enue if it must be mailed first class. The glossy paper, if it can be mailed on
time, produces the second largest amount of net revenue; however, the rank-
ing slips to the fourth best net revenue if it is mailed late. The plain paper bulk
mail brochure has a substantially lower net revenue than any of the other
alternatives.

Image as a well-run organization:

The image would be based upon comparison of two things related to the mail
campaign—the quality of the brochure (appearance) and the arrival of the
brochure immediately following the radio and television coverage. The glossy
brochure, if it arrives on time, would probably convey the best image; how-
ever, there is some risk that it would not arrive on a timely basis. The colored
paper brochure would be the next best in terms of quality, but the bulk mail
alternative raises some risk of a timely receipt of the brochures by the poten-
tial donors. The plain paper brochure would be the poorest quality, and
because it is to be sent bulk mail, it runs the additional risk of not being deliv-
ered on a timely basis.

Image as a fiscally responsible organization:

The image of fiscal responsibility will be based on a comparison of potential
donors’ perceptions regarding the cost of the brochure and cost of the mail-
ing. The glossy brochure mailed first class may be perceived as an extrava-
gance by the potential donors. At the other extreme, the potential donors may
conclude that the plain paper bulk mail alternative is an indication that the
organization is unwilling to devote adequate financial resources to the fund-
raising efforts.

The foundation staff must weigh the consequences of each of the alternatives
and the risks associated with them on the three criteria to select a specific alter-
native. The staff has good information on net revenue potential, but needs to
obtain information on the effects of the quality of the brochure, the timeliness of
the mailing, and the type of mailing on potential donors’ opinions as to what is a
well-run and fiscally responsible organization.
Chapter 21 21-33

P21-10

(1)
JUSTA CORPORATION
Quarterly Income Statement
Total Local Regional
Sales........................................................ $1,300,000 $1,000,000 $300,000
Variable expenses:
Manufacturing (Schedule A) ........ $ 820,000 $ 630,000 $190,000
Marketing (Schedule B) ................ 31,000 24,000 7,000
Total variable expense............ $ 851,000 $ 654,000 $197,000
Contribution margin............................... $ 449,000 $ 346,000 $103,000
Separable fixed marketing
expense.......................................... 74,000 36,000 38,000
Net market contribution ........................ $ 375,000 $ 310,000 $ 65,000

Common fixed expenses:

Manufacturing ($1,010,000 –
$820,000) .................................. $ 190,000
Administrative .................................. 52,000
Total common fixed expense $ 242,000
Operating income .................................. $ 133,000

Schedule A—Variable Manufacturing Expenses

(1) (2) (3) (4) (5) (6) (7)
Local Variable Regional Regional Variable Total Variable
Product % Local Sales Expenses (2) × (3) Sales Expenses (2) × (5) Expenses (4) + (6)
A 60 $400,000 $240,000 $100,000 $ 60,000 $300,000
B 70 300,000 210,000 100,000 70,000 280,000
C 60 300,000 180,000 100,000 60,000 240,000
Total.............................................. $630,000 $190,000 $820,000

Schedule B—Variable Marketing Expenses

(1) (2) (3) (4) (5) (6) (7)
Local Variable Regional Regional Variable Total Variable
Product % Local Sales Expenses (2) × (3) Sales Expenses (2) × (5) Expenses (4) + (6)
A 3 $400,000 $12,000 $100,000 $3,000 $15,000
B 2 300,000 6,000 100,000 2,000 8,000
C 2 300,000 6,000 100,000 2,000 8,000
Total.............................................. $24,000 $7,000 $31,000

Separable fixed marketing expense computation: Local Regional

Total marketing expense ...................................... $60,000 $45,000
Less variable (Schedule B) .................................. 24,000 7,000
Fixed marketing expense ..................................... $36,000 $38,000
21-34 Chapter 21

P21-10 (Concluded)
(2) No. The regional market should not be dropped. The regional market sales are
adequate to cover variable expense and separable fixed expense of the regional
market and contribute $65,000 toward the recovery of the $242,000 common
fixed expense and operating income.

If the regional market is dropped, the local market contribution margin must
absorb its own separable fixed marketing expense plus all common fixed
expense as shown below:
Contribution margin......................................................... $346,000
Separable fixed marketing expense ............................... 36,000
Net market contribution................................................... $310,000
Total common fixed expense .......................................... 242,000
Operating income ....................................................... $ 68,000

Thus the corporation operating income declines from $133,000 to $68,000. This
$65,000 reduction is the amount of the contribution loss from the regional market.
(3)
JUSTA CORPORATION
Quarterly Income Statement
Product Product Product
Total A B C
Sales .................................................. $1,300,000 $500,000 $400,000 $400,000
Variable expense:
Manufacturing
(Schedule A)* .......................... $820,000 $300,000 $280,000 $240,000
Marketing
(Schedule B)* .......................... 31,000 15,000 8,000 8,000
Total variable expense............ $ 851,000 $315,000 $288,000 $248,000
Contribution margin.............................. $ 449,000 $185,000 $112,000 $152,000
Fixed expenses:
Manufacturing ................................ $ 190,000
Marketing ........................................ 74,000
Administrative ................................ 52,000
Total fixed expense................. $ 316,000
Operating income.................................. $ 133,000

*Schedules A & B are in the requirement (1) solution.

(4) When the new product replaces Product C, the minimum contribution margin per
quarter must be at least $162,000 (the present contribution margin of Product C
+ $10,000 of new fixed expense) in order for Justa Corporation to be no worse off
financially than it is currently. This contribution margin will still provide operat-
ing income of $133,000.
Chapter 21 21-35

CASES

C21-1

(1) $21 per unit, a total of $210,000 for 10,000 units, is the lowest price the company
could accept without reducing budgeted income of the coming quarter. At any
lower price, the special order would add more to costs than it adds to revenues,
reducing the coming quarter’s budgeted operating income. The price is calcu-
lated to equal the relevant costs of filling the special order. First, calculate the
following per-unit variable costs of regular units:

Budgeted manufacturing costs for the quarter................ $5,400,000

Less: Budgeted fixed cost (3 mo. × $1,400,000)............... 4,200,000
Budgeted variable manufacturing costs ........................... $1,200,000
Budgeted volume of regular business .............................. ÷ 100,000 units
Budgeted variable manuf. cost per regular unit............... $ 12.00

Budgeted selling & admin. costs for the quarter ............. $3,200,000
Less: Budgeted fixed cost (3 mo. × $900,000).................. 2,700,000
Budgeted variable S & A costs for the quarter ................ $ 500,000
Budgeted volume of regular business .............................. ÷ 100.000 units
Budgeted variable S & A cost per regular unit................. $ 5.00
Regular sales commission (5% of $90 price) ................... 4.50
Budgeted S & A cost per unit, excl. commission............. $ .50

The case states how much to add to the regular direct material and direct labor
cost. Two other adjustments must be calculated: (1) The saw is needed for only
two months. At a rental of $5,500 per month, its cost totals $11,000 for the special
order, or $1.10 per unit. (2) Variable overhead per special unit is triple that of a reg-
ular unit, and the case states that this applies to total variable overhead and to the
variable overhead of the cut-off operation. The total variable overhead cost of a
regular unit is $2.50, and variable overhead of the regular cut-off operation is a
part of that total, so the entire $2.50 is tripled for the special order (and no sepa-
rate adjustment is needed specifically for the cut-off operation). The $2.50 is
included already in the budgeted costs of regular units, so the adjustment needed
to cost the special order is an additional $5.00 per unit [(3 × $2.50) – $2.50], or a
total adjustment of $50,000 for the special order.
Sufficient capacity must be available for the special order. (Otherwise, accept-
ing it would require canceling some regular order(s), and an opportunity cost
equal to the lost contribution margin on cancelled orders would be a relevant
cost of the special order.) Grinding-machine capacity is limited to 60,000 regular
units per month, so the quarter’s capacity is 180,000 regular units, and the bud-
geted volume of 100,000 regular units leaves available capacity equivalent to
80,000 regular units. Each special-order unit uses triple the grinding time of a
regular unit, so 10,000 special units require the equivalent of 30,000 regular
units’ grinding time, well within the 80,000 regular units of available capacity.
21-36 Chapter 21

C21-1 (Concluded)
Special Order
Relevant Cost Analysis
Total per unit
Units ................................................................ 10,000 1
Relevant costs of special order:
Regular manufacturing costs ....................... $120,000 $12.00
Regular selling & administrative
costs, excluding commission .............. 5,000 .50
Additional costs of special order:
Direct material ....................................... 20,000 2.00
Direct labor ............................................ — —
Variable overhead.................................. 50,000 5.00
Saw rental (2 mo. × $5,500) .................. 11,000 1.10
Metallurgist’s fee ................................... 4,000 .40
Relevant costs of special order .................... $210,000 $21.00

The relevant cost of $21 per special unit, although considerably higher than that
of a regular unit, is far below the regular selling price of $90. This is because the
company’s costs are predominately fixed costs, presumably due to high levels
of automation. The company will try to negotiate as high a price as possible, but
the $21 figure should be regarded as an absolute minimum.
(2) Nonquantitative factors to consider include the following:
(a) Effects on regular sales
Is the customer who placed the special order a new customer? If so, will they
become a regular customer provided the special order is successful?
Will that customer always demand large price discounts?
Will (or does) the customer use a large quantity of the regular product and
pay the full regular price for it?
Will regular customers learn of the special, low price? If so, will they demand
large price discounts on their future orders?
Will this special, low price start a price war that can erode regular prices?
(b) Effects on employees and community
Will the special materials and equipment affect levels of safety, environmen-
tal pollution, and noise in the company’s plant?
Will employees and managers gain valuable new skills and knowledge by
producing the special order? (The case states that this is the company’s first
opportunity to produce and sell this particular type of product.)
Will the special order’s effect on total production volume enable the com-
pany to avoid laying off valued employees in the coming quarter?
(c) Strategic effects (market share, growth, innovation, etc.)
Does the special order product represent a new or fast-growing market?
Are there learning-curve effects or other advantages to be gained from
adding the new type of product sooner rather than later?
Are prices and profit margins on this type of product expected to improve,
or is it a mature product likely to decline soon?
Chapter 21 21-37

C21-2

(1) Continuing to obtain covers from its own Denver Cover Plant would allow Big-
Auto 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 Big-
Auto more flexibility than purchasing the covering from outside suppliers. Big-
Auto could more easily alter the coverings’ design and change the quantities
produced, especially if long-term contracts are required with outside suppliers.
Big-Auto should also consider the economic impact that closing Denver Cover
will have on the community and how this might affect Big-Auto’s other opera-
tions in the region. In addition, relations with the workforce at other plants could
be affected by news of a closing and layoffs at Denver Cover.
(2) (a) The following recurring annual budgeted costs can be avoided by closing
the Denver Cover Plant:

Materials ................................................................ $12,000,000

Direct labor ............................................................ 13,000,000
Indirect costs:
Supervision................................................... $3,000,000
Indirect labor................................................. 4,000,000
Differential pension expense
($4,000,000 – $3,000,000) ....................... 1,000,000 8,000,000
$33,000,000

(b) The following recurring annual budgeted costs are not relevant to the deci-
sion to close the Denver Cover Plant:
Depreciation—equipment ............................ $ 5,000,000
Depreciation—building ................................ 3,000,000
Continuing pension expenses .................... 3,000,000
Plant manager and staff .............................. 2,000,000
Corporate allocation .................................... 6,000,000
$19,000,000

The depreciation amounts are not relevant to the decision because they repre-
sent portions of sunk costs that are being written off during 20A. Three-fourths
of the annual pension expense ($3,000,000) is not relevant because it would con-
tinue 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 Big-Auto and
administer the three remaining plants. The corporate allocation is not relevant
because this represents non-avoidable costs, incurred outside Denver Cover,
that are assigned to the plant.
21-38 Chapter 21

C21-2 (Concluded)

(c) The following nonrecurring costs would arise due to the closing of the
Denver Cover Plant:
Termination charges on cancelled material orders
($12,000,000 × 15%) ......................................... $1,800,000
Employment assistance .................................. 1,000,000
$2,800,000

These two costs are relevant to the decision because they are incurred only
if the Denver Cover Plant is closed. Consequently, they can be avoided if the
plant is not closed.

(d) Items not specifically mentioned in the case that should be considered by
Big-Auto before making a decision include:

(i) The disposal value or alternate uses of the plant.

(ii) Any income tax implications; including the income tax rates applicable
to gain or loss on the sales of plant and machinery, cost of losing
depreciation tax shields, any depreciation and investment tax credit
recapture, etc.
(iii) Outside supplier’s prices in future years.
(iv) Cost to manufacture coverings at the Denver Cover Plant in future
years.
Chapter 21 21-39

C21-3

(1) Factors Calco should consider, before entering the consumer products market,
follow:
(a) the product’s contribution margin and break-even point
(b) consumer demand for the product in the short run and long run
(c) the company’s ability to produce the quantity needed in the short and long
run
(d) the company’s lack of experience in the consumer market and the need for
different marketing techniques for products sold in the consumer markets
(e) quality of the competition
(f) the impact of the decision on employees, and the effect of the diversion of
Calco management effort on total business
(2) Alteration of financial forecasts for use in deciding between the alternatives:

Calco’s
Marketing
Department Jasco
Income before income tax ............................................. $ 225,000 $ 190,000
Add fixed manufacturing cost:
100,000-unit level .................................................... 750,000
120,000-unit level .................................................... 900,000
Add share of current Marketing Department’s
management costs.................................................. 100,000
Operating margin ........................................................... $1,075,000 $1,090,000

Instead of a difference of $35,000 income ($225,000 – $190,000) favoring Calco,

the new calculation shows a $15,000 operating margin ($1,075,000 – $1,090,000)
favoring Jasco. The financial difference is slight, adding significance to the reli-
ability of the financial estimates as well as to the relevance of nonquantitative
factors.
(3) One can only speculate about the reliability of the two proposals. The fact that
Jasco has experience in the consumer market is significant in predicting suc-
cess or failure of the project, but not necessarily for the estimates for the
expected benefits of the marketing program or the associated costs. It should be
remembered that the Jasco people recently lost their jobs and may be trying
especially hard to look good.
Similarly, Calco’s Marketing Department may be biased in its estimates in an
effort to avoid elimination of existing employee positions.
Manufacturing costs are the same because Calco will manufacture the prod-
uct. The sales price differs and an explanation of the 5% ($5 per $100 of sales)
difference in the sales commission rate is not given. Caico’s inclusion of
assigned Marketing Department management costs is perhaps an attempt to
hedge its estimates.
21-40 Chapter 21

C21-3 (Concluded)

(4) Significant nonquantitative factors that Calco’s management should consider

include:
(a) impact of the decision on Calco’s present work force; i.e., morale loss of
remaining employees if layoffs happen versus the ability of retained employ-
ees to work effectively In the new market,
(b) abilities and expectations of employees from Jasco, if Jasco is selected,
(c) the possible diversion of Calco top management effort from its regular line
of business, if it does not hire experienced talent.

No single item may in itself be important enough to warrant selection of one

alternative over another. The information presented in the case is limited and
does not give an indication that any one nonquantitative factor is more impor-
tant than any other. However, any one of the factors could be sufficiently signif-
icant. For instance, the impact of eliminating Calco’s Marketing Department
positions, if Jasco is acquired, is perhaps the biggest single nonquantitative fac-
tor for consideration. Since these new employees displace existing Calco
employees, the management process could be hampered by serious human rela-
tions problems.

C21-4

(1) (a) The product-line income statement for Precision Gauge Corporation is
presented on a full costing basis and, consequently, is not suitable for
analysis and decision making. The fact that the statement does not
distinguish between variable and fixed costs hinders any analysis of the
impact of volume changes on profits. In addition, the statement does not
distinguish between costs that are directly related (traceable) to a product
line from those that are shared among all products.
(b) An alternative income statement format that would be more suitable for analy-
sis and decision making would incorporate the contribution approach to cost-
ing. Expenses would be classified in terms of variability and controllability;
such as, variable manufacturing, variable selling and administrative, direct
fixed controllable by segment (discretionary), direct fixed controllable by
others (committed), and common fixed. The common fixed costs would not
be assigned to the product lines because such an allocation would be arbi-
trary. The contribution approach is more suitable for analysis and decision
making because there is a meaningful segregation of costs.
Chapter 21 21-41

C21-4 (Continued)

(2) (a) The suggested discontinuance of the T-gauges would be cost effective, but
the suggestions relating to D-gauges and P-gauges would not be cost
effective. These conclusions are based on the following quarterly differential
cost analysis.
D-gauge P-gauge T-gauge
Unit sales price .................................................. $90 $200 $180
Unit variable costs:
Direct materials.......................................... $17 $ 31 $ 50
Direct labor................................................. 20 40 60
Variable factory overhead ......................... 30 45 60
Selling expenses........................................ 4 10 10
Total variable costs ................................... $71 $126 $180
Unit contribution margin................................... $19 $ 74 $ 0
Increase (decrease) in units suggested:
D-gauge ($900,000 sales ÷
$90 price) × .50..................................... × (5,000)
P-gauge ($1,600,000 sales ÷
$200 price) × .15................................... × 1,200
T-gauge ($900,000 sales ÷ $180
price) × 1.0............................................ ×(5,000)
Increase (decrease) in total
contribution margin................................... $(95,000) $88,800 $0
Decrease (increase) in fixed costs:
D-gauge, $100,000 – $20,000 .................... 80,000
P-gauge....................................................... (100,000)
T-gauge ....................................................... 40,000
Increase (decrease) in segment
contribution ................................................ $(15,000) $(11,200) $40,000

(b) Yes.The president was correct in eliminating the T-gauges.The T-gauge sales
price covers only its variable cost and does not contribute anything to the
recovery of fixed factory overhead or promotion costs.Thus, the T-gauge has
a zero contribution margin.
21-42 Chapter 21

C21-4 (Concluded)

(c) Yes. The president was correct in promoting the P-gauge line rather than the
D-gauge line because the unit contribution margin and contribution margin
per labor dollar is greater for the P-gauge line than the D-gauge line, deter-
mined as follows:
D-gauge P-gauge
Unit contribution margin (see (a)) .................. $19.00 $74.00
Contribution margin per labor dollar
$19 contribution margin ÷ $20 labor .......... .95
$74 contribution margin ÷ $40 labor .......... 1.85

However, the president’s decisions regarding promotion expense do not

seem well conceived. The decreased promotion on the D-gauge line and the
increased promotion on the P-gauge line do not produce sufficient contribu-
tion margin to offset the promotion costs.

(d) No. The proposed course of action does not make effective use of
Precision’s capacity. The 15% increase in production volume on the P-gauge
line will not require all of the capacity that has been released by discontinu-
ing the T-gauge line and reducing the D-gauge line by 50%.

(3) Yes. The non-quantitative factors that Precision should consider before it
decides whether to drop the T-gauge line include:
(a) Customer relations—the sale of D-gauges and P-gauges may be related to
the sale of T-gauges (i.e., Precision may need a complete line of gauges
desired by many customers in order to maintain sales demand for D-gauges
and P-gauges).
(b) Labor relations—reducing employment may create labor (personnel) prob-
lems.
Chapter 21 21-43

C21-5 APPENDIX

(1) Let x = rolls of commercial carpet

y = rolls of residential carpet
Heavy duty fiber constraint: ........................... 80x + 40y = 42,000 lbs.
Regular fiber constraint: ................................. 20x + 40y = 24,000 lbs.
Solving by simultaneous equations:
80x + 40y = 42,000
20x + 40y = 24,000
60x = 18,000
x = 300 rolls of commercial carpet
80(300) + 40y = 42,000
24,000 + 40y = 42,000
40y = 18,000
y = 450 rolls of residential carpet
(2) Leastan cannot manufacture these quantities of commercial and residential car-
peting, because the direct labor constraint will be exceeded:
Labor constraint: 15x + 15y = 10,500
Using the requirement (1) solution:
15(300) + 15(450) = 11,250, which exceeds the direct labor hour constraint of
10,500 by 750 hours.
(3) Linear programming is a mathematical model for solving two or more unknowns
in two or more equations. Linear programming is used to determine a mix of
products that will maximize the contribution margin or minimize costs by identi-
fying the inputs, outputs, and their related assumptions and limitations (con-
straints) and combining them in the model. Linear programming can be used to
allocate limited facilities and resources among their many alternative uses in
such a way that optimum benefit is derived from their utilization.
21-44 Chapter 21

C21-5 APPENDIX (Concluded)

(4)
Commercial Residential
Sales price per unit ........................................... $1,000 $800
Less variable cost per unit:
Heavy duty fiber........................................ $ 240 $120
Regular fiber.............................................. 40 80
Direct labor................................................ 150 150
Variable factory overhead ........................ 90 90
$ 520 $440
Contribution margin per unit ............................ $ 480 $360

Let x = rolls of commercial carpet

y = rolls of residential carpet
c = pounds of scrap of heavy duty fiber
d = pounds of scrap of regular fiber

Objective function:
Maximize CM = 480x + 360y + .25c + .25d

Constraints:
80x + 40y + c = 42,000 pounds of heavy duty fiber
20x + 40y + d = 24,000 pounds of regular fiber
15x + 15y <_ 10,500 direct labor hours
Chapter 21 21-45

C21-6 APPENDIX

(1) The linear programming model starts with an objective or goal to be achieved sub-
ject to a set of limiting factors, called constraints. The linear programming model
allows the user to optimize (maximize or minimize) the objective function subject
to the constraints. The central assumption in all linear programming models is lin-
earity. The linearity assumption means that the objective function and the con-
straints in the model can be expressed in the form of linear equations. The
constraints can be in the form of strict equalities, upper bounds (less than or equal
to constraints), and lower bounds (greater than or equal to constraints).
(2) Linear programming methods are applied mainly to allocation problems, i.e.,
allocating scarce resources among alternative uses according to some objec-
tive. The scarce resources for a business firm may include personnel, material,
equipment, or capital. The objective function may take the form of profit maxi-
mization or some other measure of desired benefit. In this particular case, linear
programming is appropriate because the firm of Miller, Lombardi, and York has
an objective in the form of profit maximization subject to restricted resources,
i.e., staff available in the short run is restricted in each area.
(3) The following data would be needed to develop the linear programming model
for Miller, Lombardi, and York:
(a) Total management hours available in each category of service provided.
(b) Total hours available for each category of service provided by each type of
staff person, i.e., experienced and without experience.
(c) Number of microcomputers and hours available.
(d) Billing rates for management and staff.
(4) R. Oliva should consider the following alternative objectives before making the
staff allocations:
(a) Maximize the computer hours available.
(b) Minimize total variable costs consistent with maintaining a high level of pro-
fessional service.
(c) Nonquantitative objectives such as the preferences of individuals in man-
agement to be in specific areas of service.