CHAPTER 11

DECISION MAKING AND RELEVANT INFORMATION

11-16 Qualitative and quantitative factors. Which of the following is not a qualitative factor
that Atlas Manufacturing should consider when deciding whether to buy or make a part used in
manufacturing their product?
a. Quality of the outside producer’s product.
b. Potential loss of trade secrets.
c. Manufacturing deadlines and special orders.
d. Variable cost per unit of the product.

SOLUTION

Choice "d" is correct. Calculating the costs of production of the part versus buying the part from an
outside source is a quantitative factor used by a company to determine the lowest cost alternative.
Choice "a" is incorrect. Whether the outsourced part can be manufactured to the required level of quality
is a qualitative factor that Atlas would consider in their decision. Choice "b" is incorrect. Loss of
confidentiality and trade secrets is a qualitative factor to consider when buying outside of the
organization. Choice "c" is incorrect. An outside supplier may not be able to meet specific deadlines or
have the same priorities as the purchaser and is a qualitative factor that needs to be considered.

11-17 Special order, opportunity cost. Chade Corp. is considering a special order brought to it
by a new client. If Chade determines the variable cost to be $9 per unit, and the contribution margin
of the next best alternative of the facility to be $5 per unit, then if Chade has:
a. Full capacity, the company will be profitable at $4 per unit.
b. Excess capacity, the company will be profitable at $6 per unit.
c. Full capacity, the selling price must be greater than $5 per unit.
d. Excess capacity, the selling price must be greater than $9 per unit.

SOLUTION

Choice "d" is correct. At excess capacity, Chade will accept the special order as long as the sales price is
greater than the variable cost per unit. At $9 per unit for variable cost, Chade will accept the special
order at a sales price greater than $9 per unit. Choice "a" is incorrect. At full capacity, Chade will accept
the special order as long as the sales price is greater than both the variable cost per unit and the
opportunity cost (contribution margin) of the next best alternative per unit. The company will not be
profitable in this scenario unless the sales price is greater than $14 per unit ($9 variable cost + $5
contribution margin). Choice "b" is incorrect. At excess capacity, the company must receive a selling
price greater than $9 per unit in order to be profitable. Choice "c" is incorrect. At full capacity, the selling
price must be greater than $14 per unit in order for the special order to be profitable.

11-1
11-18 Special order, opportunity cost. In order to determine whether a special order should be
accepted at full capacity, the sales price of the special order must be compared to the per unit:
a. Contribution margin of the special order.
b. Variable cost and contribution margin of the special order.
c. Variable cost and contribution margin of the next best alternative.
d. Variable cost of current production and the contribution margin of the next best alternative.

SOLUTION

Choice "d" is correct. If the selling price is greater than the variable cost per unit of the special order (at
full capacity) plus the contribution margin per unit of the next best alternative (the opportunity cost),
then the company will accept the special order. Choice "a" is incorrect. Variable costs have to be taken
into account, in addition to the contribution margin of the next best alternative. Choice "b" is incorrect.
The contribution margin of the next best alternative (rather than the special order) must be taken into
account in order to determine whether to accept the special order. Choice "c" is incorrect. The variable
costs of the special order (not the next best alternative) must be accounted for in this determination.
11-19 Keep or drop a business segment. Lees Corp. is deciding whether to keep or drop a small
segment of its business. Key information regarding the segment includes:
Contribution margin: 35,000
Avoidable fixed costs: 30,000
Unavoidable fixed costs: 25,000
Given the information above, Lees should:
a. Drop the segment because the contribution margin is less than total fixed costs.
b. Drop the segment because avoidable fixed costs exceed unavoidable fixed costs.
c. Keep the segment because the contribution margin exceeds avoidable fixed costs.
d. Keep the segment because the contribution margin exceeds unavoidable fixed costs.

SOLUTION

Choice "c" is correct. Whether to keep or drop a segment will depend on whether the contribution
margin of the segment in question exceeds avoidable fixed costs (relevant costs that wouldn’t exist if the
segment did not exist). Unavoidable fixed costs will be incurred regardless of whether or not the
segment is kept, so they are not factored into the decision. Choice "a" is incorrect. Fixed costs need to be
broken out between avoidable and unavoidable in order to make the determination as to whether to keep
or drop a segment. Lees Corp. would only drop the segment if the contribution margin of the segment is
less than the avoidable fixed (relevant) cost. Choice "b" is incorrect. The contribution margin needs to
be compared to avoidable fixed costs in order to determine whether to keep or drop a segment. Choice
"d" is incorrect. Unavoidable fixed costs will be incurred regardless, so contribution margin of the
segment needs to be compared to the avoidable fixed costs as the key elements to determine whether to
keep or drop a segment.

11-20 Relevant costs. Ace Cleaning Service is considering expanding into one or more new
market areas. Which costs are relevant to Ace’s decision on whether to expand?

11-2
SOLUTION

Choice "a" is correct. Sunk costs are not relevant since they were incurred in the past and cannot be
recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable
fixed costs associated with the decision. Opportunity cost is the cost of foregoing the next best
alternative when making a decision. These costs are relevant since the company has alternative courses
of action. Choice "b" is incorrect. Sunk costs are not relevant since they were incurred in the past and
cannot be recovered as a result of the company’s current decision. Choice "c" is incorrect. Opportunity
cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant
since the company has alternative courses of action. Choice "d" is incorrect. Sunk costs are not relevant
since they were incurred in the past and cannot be recovered as a result of the company’s current
decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision.

11-21 Disposal of assets. Answer the following questions.

1. A company has an inventory of 1,250 assorted parts for a line of missiles that has been
discontinued. The inventory cost is $76,000. The parts can be either (a) remachined at total
additional costs of $26,500 and then sold for $33,500 or (b) sold as scrap for $2,500. Which
action is more profitable? Show your calculations.
2. A truck, costing $100,500 and uninsured, is wrecked its first day in use. It can be either (a)
disposed of for $18,000 cash and replaced with a similar truck costing $103,000 or (b) rebuilt
for $88,500 and thus be brand-new as far as operating characteristics and looks are concerned.
Which action is less costly? Show your calculations.

SOLUTION

(20 min.) Disposal of assets.

1. This is an unfortunate situation, yet the $76,000 costs are irrelevant regarding the decision
to remachine or scrap. The only relevant factors are the future revenues and future costs. By
ignoring the accumulated costs and deciding on the basis of expected future costs, operating
income will be maximized (or losses minimized). The difference in favor of remachining is $4,500:
(a) (b)
Remachine Scrap
Future revenues $33,500 $2,500
Deduct future costs 26,500 –
Operating income $ 7,000 $2,500

Difference in favor of remachining $4,500

11-3
2. This, too, is an unfortunate situation. But the $100,500 original cost is irrelevant to this
decision. The difference in relevant costs in favor of replacing is $3,500 as follows:

(a) (b)
Replace Rebuild
New truck $103,000 –
Deduct current disposal
price of existing truck 18,000 –
Rebuild existing truck – $88,500
$ 85,000 $88,500

Difference in favor of replacing $3,500

Note, here, that the current disposal price of $18,000 is relevant, but the original cost (or book
value, if the truck were not brand new) is irrelevant.

11-22 Relevant and irrelevant costs. Answer the following questions.

1. DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of $280 each.
Variable cost per unit is $190 and fixed cost per unit is $90. Peach Electronics offers to supply
5,200 units of CB76 for $260. If DeCesare buys from Peach it will be able to save $10 per unit
in fixed costs but continue to incur the remaining $80 per unit. Should DeCesare accept Peach’s
offer? Explain.
2. LN Manufacturing is deciding whether to keep or replace an old machine. It obtains the
following information:

Old Machine New Machine

Original cost $10,700 $9,000
Useful life 10 years 3 years
Current age 7 years 0 years
Remaining useful life 3 years 3 years
Accumulated depreciation $7,490 Not acquired yet
Book value $3,210 Not acquired yet
Current disposal value (in cash) $2,200 Not acquired yet
Terminal disposal value (3 years from now) $0 $0
Annual cash operating costs $17,500 $15,500

LN Manufacturing uses straight-line depreciation. Ignore the time value of money and income
taxes. Should LN Manufacturing replace the old machine? Explain.

SOLUTION

(20 min.) Relevant and irrelevant costs.

11-4
1.
Make Buy
Relevant costs
Variable costs $190
Avoidable fixed costs 10
Purchase price ____ $260
Unit relevant cost $200 $260

DeCesare Computers should reject Peach’s offer. The $80 of fixed costs is irrelevant because it
will be incurred regardless of this decision. When comparing relevant costs between the choices,
Peach’s offer price is higher than the cost to continue to produce.

2.
Keep Replace Difference
Cash operating costs (3 years) $52,500 $46,500 $6,000
Current disposal value of old machine (2,200) 2,200
Cost of new machine _ _____ 9,000 (9,000)
Total relevant costs $52,500 $53,300 $ (800)

LN Manufacturing should keep the old machine. The cost savings are less than the cost to purchase
the new machine.
11-23 Multiple choice. (CPA) Choose the best answer.
1. The Dalton Company manufactures slippers and sells them at $12 a pair. Variable
manufacturing cost is $5.00 a pair, and allocated fixed manufacturing cost is $1.25 a pair. It
has enough idle capacity available to accept a one-time-only special order of 5,000 pairs of
slippers at $6.25 a pair. Dalton will not incur any marketing costs as a result of the special
order. What would the effect on operating income be if the special order could be accepted
without affecting normal sales: (a) $0, (b) $6,250 increase, (c) $28,750 increase, or (d) $31,250
increase? Show your calculations.
2. The Sacramento Company manufactures Part No. 498 for use in its production line. The
manufacturing cost per unit for 30,000 units of Part No. 498 is as follows:

Direct materials $5
Direct manufacturing labor 22
Variable manufacturing overhead 8
Fixed manufacturing overhead allocated 15
Total manufacturing cost per unit 50

The Counter Company has offered to sell 30,000 units of Part No. 498 to Sacramento for $47 per
unit. Sacramento will make the decision to buy the part from Counter if there is an overall savings
of at least $30,000 for Sacramento. If Sacramento accepts Counter’s offer, $8 per unit of the fixed
overhead allocated would be eliminated. Furthermore, Sacramento has determined that the
released facilities could be used to save relevant costs in the manufacture of Part No. 575. For
Sacramento to achieve an overall savings of $30,000, the amount of relevant costs that would have
to be saved by using the released facilities in the manufacture of Part No. 575 would be which of
the following: (a) $90,000, (b) $150,000, (c) $180,000, or (d) $210,000? Show your calculations.

11-5
What other factors might Sacramento consider before outsourcing to Counter?

SOLUTION

(15 min.) Multiple choice.

1. (b) Special order price per unit $6.25

Variable manufacturing cost per unit 5.00
Contribution margin per unit $1.25

Effect on operating income = $1.25  5,000 units

= $6,250 increase

2. (b) Costs of purchases, 30,000 units  $47 $1,410,000

Total relevant costs of making:
Variable manufacturing costs, $5 + $22 + $8 $35
Fixed costs eliminated 8
Costs saved by not making $43
Multiply by 30,000 units, so total
costs saved are $43  30,000 1,290,000
Extra costs of purchasing outside 120,000
Minimum overall savings for Sacramento 30,000
Necessary relevant costs that would have
to be saved in manufacturing Part No. 575 $ 150,000

Before outsourcing to Counter, Sacramento must consider the consequence of increasing its
dependence on Counter. Sacramento would want to be sure about the quality of Counter’s product
and the reliability of its delivery schedules over a long-run period. Sacramento would also want
Counter to continuously reduce costs. To achieve all these goals, Sacramento may want to build
close partnerships and alliances with Counter.
11-24 Special order, activity-based costing. (CMA, adapted) The Gold Plus Company
manufactures medals for winners of athletic events and other contests. Its manufacturing plant has
the capacity to produce 11,000 medals each month. Current production and sales are 10,000 medals
per month. The company normally charges $150 per medal. Cost information for the current
activity level is as follows:
Variable costs that vary with number of units produced $ 350,000
Direct materials 375,000
Direct manufacturing labor 100,000
Variable costs (for setups, materials handling, quality control, and so on)
that vary with number of batches, 200 batches * $500 per batch
Fixed manufacturing costs 300,000
Fixed marketing costs 275,000
Total costs $1,400,000

11-6
Gold Plus has just received a special one-time-only order for 1,000 medals at $100 per medal.
Accepting the special order would not affect the company’s regular business. Gold Plus makes
medals for its existing customers in batch sizes of 50 medals (200 batches × 50 medals per batch
= 10,000 medals). The special order requires Gold Plus to make the medals in 25 batches of 40
medals.

Required:
1. Should Gold Plus accept this special order? Show your calculations.
2. Suppose plant capacity were only 10,500 medals instead of 11,000 medals each month. The
special order must either be taken in full or be rejected completely. Should Gold Plus accept
the special order? Show your calculations.
3. As in requirement 1, assume that monthly capacity is 11,000 medals. Gold Plus is concerned
that if it accepts the special order, its existing customers will immediately demand a price
discount of $10 in the month in which the special order is being filled. They would argue that
Gold Plus’s capacity costs are now being spread over more units and that existing customers
should get the benefit of these lower costs. Should Gold Plus accept the special order under
these conditions? Show your calculations.

SOLUTION

(30 min.) Special order, activity-based costing.

1. Direct materials cost per unit ($350,000  10,000 units) = $35 per unit
Direct manufacturing labor cost per unit ($375,000  10,000 units) = $37.50 per unit
Variable cost per batch = $500 per batch
Gold Plus’ operating income under the alternatives of accepting/rejecting the special order
are:

Without One- With One-

Time Only Time Only
Special Order Special Order Difference
10,000 Units 11,000 Units 1,000 Units
Revenues $1,500,000 $1,600,000 $100,000
Variable costs:
1
Direct materials 350,000 385,000 35,000
2
Direct manufacturing labor 375,000 412,500 37,500
3
Batch manufacturing costs 100,000 112,500 12,500
Fixed costs:
Fixed manufacturing costs 300,000 300,000 ––
Fixed marketing costs 275,000 275,000 ––
Total costs 1,400,000 1,485,000 85,000
Operating income $ 100,000 $ 115,000 $ 15,000

1
$350,000 + ($35  1,000 units)
2
$375,000 + ($37.50  1,000 units)
3
$100,000 + ($500  25 batches)

11-7
Alternatively, we could calculate the incremental revenue and the incremental costs of the
additional 1,000 units as follows:
Incremental revenue $100  1,000 $100,000
Incremental direct manufacturing costs $35  1,000 units 35,000
Incremental direct manufacturing costs $37.50  1,000 units 37,500
Incremental batch manufacturing costs $500  25 batches 12,500
Total incremental costs 85,000
Total incremental operating income from
accepting the special order $ 15,000

Gold Plus should accept the one-time-only special order if it has no long-term implications because
accepting the order increases Gold Plus’ operating income by $15,000.
If, however, accepting the special order would cause the regular customers to be
dissatisfied or to demand lower prices, then Gold Plus will have to trade off the $15,000 gain from
accepting the special order against the operating income it might lose from regular customers.

2. Gold Plus has a capacity of 10,500 medals. Therefore, if it accepts the special one-time
order of 1,000 medals, it can sell only 9,500 medals instead of the 10,000 medals that it currently
sells to existing customers. That is, by accepting the special order, Gold Plus must forgo sales of
500 medals to its regular customers. Alternatively, Gold Plus can reject the special order and
continue to sell 9,500 medals to its regular customers.
Gold Plus’ operating income from selling 9,500 medals to regular customers and 1,000
medals under one-time special order follow:

Revenues (9,500  $150) + (1,000  $100) $1,525,000

Direct materials (9,500  $35) + (1,000  $35) 367,500
Direct manufacturing labor (9,500  $37.50) + (1,000  $37.50) 393,750
1
Batch manufacturing costs (190  $500) + (25  $500) 107,500
Fixed manufacturing costs 300,000
Fixed marketing costs 275,000
Total costs 1,443,750
Operating income $ 81,250
1
Gold Plus makes regular medals in batch sizes of 50. To produce 9,500 medals requires 190 (9,500 ÷ 50) batches.

Accepting the special order will result in a decrease in operating income of $18,750
($100,000 – $81,250). The special order should, therefore, be rejected.
A more direct approach would be to focus on the incremental effects––the benefits of
accepting the special order of 1,000 units versus the costs of selling 500 fewer units to regular
customers. Increase in operating income from the 1,000-unit special order equals $15,000
(requirement 1). The loss in operating income from selling 500 fewer units to regular customers
equals:

Lost revenue, $150  500 $(75,000)

Savings in direct materials costs, $35  500 17,500

11-8
 Savings in direct manufacturing labor costs, $37.50  500 18,750
Savings in batch manufacturing costs, $500  10 5,000
Operating income lost $(33,750)

Accepting the special order will result in a decrease in operating income of $18,750 ($15,000 –
$33,750). The special order should, therefore, be rejected.
NOTE: Even if operating income had increased by accepting the special order, Gold Plus
should consider the effect on its regular customers of accepting the special order. For example,
would selling 1,000 fewer medals to its regular customers cause these customers to find new
suppliers that might adversely impact Gold Plus’s business in the long run.

3. Gold Plus should not accept the special order.

Increase in operating income by selling 1,000 units
under the special order (requirement 1) $ 15,000
Operating income lost from existing customers ($10  10,000) (100,000)
Net effect on operating income of accepting special order $ (85,000)
The special order should, therefore, be rejected.
11-25 Make versus buy, activity-based costing. The Svenson Corporation manufactures cellular
modems. It manufactures its own cellular modem circuit boards (CMCB), an important part of the
cellular modem. It reports the following cost information about the costs of making CMCBs in
2017 and the expected costs in 2018:

Svenson manufactured 8,000 CMCBs in 2017 in 40 batches of 200 each. In 2018, Svenson
anticipates needing 10,000 CMCBs. The CMCBs would be produced in 80 batches of 125 each.
The Minton Corporation has approached Svenson about supplying CMCBs to Svenson in 2018
at $300 per CMCB on whatever delivery schedule Svenson wants.

Required:
1. Calculate the total expected manufacturing cost per unit of making CMCBs in 2018.
2. Suppose the capacity currently used to make CMCBs will become idle if Svenson purchases
CMCBs from Minton. On the basis of financial considerations alone, should Svenson make
CMCBs or buy them from Minton? Show your calculations.

11-9
3. Now suppose that if Svenson purchases CMCBs from Minton, its best alternative use of the
capacity currently used for CMCBs is to make and sell special circuit boards (CB3s) to the
Essex Corporation. Svenson estimates the following incremental revenues and costs from
CB3s:

On the basis of financial considerations alone, should Svenson make CMCBs or buy them from
Minton? Show your calculations.

SOLUTION

(30 min.) Make versus buy, activity-based costing.

1. The expected manufacturing cost per unit of CMCBs in 2018 is as follows:

Total
Manufacturing Manufacturing
Costs of CMCB Cost per Unit
(1) (2) = (1) ÷ 10,000
Direct materials, $170  10,000 $1,700,000 $170
Direct manufacturing labor, $45  10,000 450,000 45
Variable batch manufacturing costs, $1,500  80 120,000 12
Fixed manufacturing costs
Avoidable fixed manufacturing costs 320,000 32
Unavoidable fixed manufacturing costs 800,000 80
Total manufacturing costs $3,390,000 $339

2. The following table identifies the incremental costs in 2015 if Svenson (a) made CMCBs
and (b) purchased CMCBs from Minton.

Total Per-Unit
Incremental Costs Incremental Costs
Incremental Items Make Buy Make Buy
Cost of purchasing CMCBs from Minton $3,000,000 $300
Direct materials $1,700,000 $170
Direct manufacturing labor 450,000 45
Variable batch manufacturing costs 120,000 12
Avoidable fixed manufacturing costs 320,000 32
Total incremental costs $2,590,000 $3,000,000 $259 $300

Difference in favor of making $410,000 $41

Note that the opportunity cost of using capacity to make CMCBs is zero because Svenson would
keep this capacity idle if it purchases CMCBs from Minton.

11-10
 Svenson should continue to manufacture the CMCBs internally because the incremental
costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note
that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to be
incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either
the make or the buy alternative and, hence, are irrelevant.

3. Svenson should continue to make CMCBs. The simplest way to analyze this problem is to
recognize that Svenson would prefer to keep any excess capacity idle rather than use it to make
CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are less than
expected incremental future costs, $2,150,000. If Svenson keeps its capacity idle, we know from
requirement 2 that it should make CMCBs rather than buy them.
An important point to note is that, because Svenson forgoes no contribution by not being
able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero. It
is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does not
manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle.
A longer and more detailed approach is to use the total alternatives or opportunity cost
analyses shown in Exhibit 11-7 of the chapter.

Choices for Svenson

Make CMCBs Buy CMCBs
and Do Not and Make
Relevant Items Make CB3s CB3s, if Profitable
TOTAL-ALTERNATIVES APPROACH TO MAKE-OR-BUY DECISIONS

Total incremental costs of

making/buying CMCBs (from
requirement 2) $2,590,000 $3,000,000

Because incremental future costs

exceed incremental future revenues
from CB3s, Svenson will make zero
CB3s even if it buys CMCBs from
Minton 0 0

Total relevant costs $2,590,000 $3,000,000

Svenson will minimize manufacturing costs and maximize operating income by making CMCBs.

OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS

Total incremental costs of

making/buying CMCBs (from
requirement 2) $2,590,000 $3,000,000
Opportunity cost: profit contribution
forgone because capacity will not
be used to make CB3s 0* 0

11-11
 Total relevant costs $2,590,000 $3,000,000
*
Opportunity cost is zero because Svenson does not give up anything by not making CB3s.
Svenson is best off leaving the capacity idle (rather than manufacturing and selling CB3s).

11-26 Inventory decision, opportunity costs. Best Trim, a manufacturer of lawn mowers,
predicts that it will purchase 204,000 spark plugs next year. Best Trim estimates that 17,000 spark
plugs will be required each month. A supplier quotes a price of $9 per spark plug. The supplier
also offers a special discount option: If all 204,000 spark plugs are purchased at the start of the
year, a discount of 2% off the $9 price will be given. Best Trim can invest its cash at 10% per year.
It costs Best Trim $260 to place each purchase order.
Required:
1. What is the opportunity cost of interest forgone from purchasing all 204,000 units at the start
of the year instead of in 12 monthly purchases of 17,000 units per order?
2. Would this opportunity cost be recorded in the accounting system? Why?
3. Should Best Trim purchase 204,000 units at the start of the year or 17,000 units each month?
Show your calculations.
4. What other factors should Best Trim consider when making its decision?

SOLUTION

(10 min.) Inventory decision, opportunity costs.

1. Unit cost, orders of 17,000 $9.00

Unit cost, order of 204,000 (0.98  $9.00) $8.82

Alternatives under consideration:

(a) Buy 204,000 units at start of year.
(b) Buy 17,000 units at start of each month.

Average investment in inventory:

(a) (204,000  $8.82) ÷ 2 $899,640
(b) (17,000  $9.00) ÷ 2 76,500
Difference in average investment $823,140

Opportunity cost of interest forgone from 204,000-unit purchase at start of year

= $823,140  0.10 = $82,314

2. No. The $82,314 is an opportunity cost rather than an incremental or outlay cost. No actual
transaction records the $82,314 as an entry in the accounting system.

3. The following table presents the two alternatives:

11-12
 Alternative A: Alternative B:
Purchase Purchase
204,000 17,000
spark plugs at spark plugs
beginning of at beginning
year of each month Difference
(1) (2) (3) = (1) – (2)
Annual purchase-order costs
(1  $260; 12  $260) $ 260 $ 3,120 $ (2,860)
Annual purchase (incremental) costs
(204,000  $8.82; 204,000  $9) 1,799,280 1,836,000 (36,720)
Annual interest income that could be earned
if investment in inventory were invested
(opportunity cost)
(10%  $899,640; 10%  $76,500) 89,964 7,650 82,314
Relevant costs $1,889,504 $1,846,770 $42,734

Column (3) indicates that purchasing 17,000 spark plugs at the beginning of each month is
preferred relative to purchasing 204,000 spark plugs at the beginning of the year because the
opportunity cost of holding larger inventory exceeds the lower purchasing and ordering costs.

4. If other incremental benefits of holding lower inventory such as lower insurance, materials
handling, storage, obsolescence, and breakage costs were considered, the costs under Alternative
A would have been higher, and Alternative B would be preferred even more.

11-27 Relevant costs, contribution margin, product emphasis. The Beach Comber is a take-
out food store at a popular beach resort. Sara Miller, owner of the Beach Comber, is deciding how
much refrigerator space to devote to four different drinks. Pertinent data on these four drinks are
as follows:

Miller has a maximum front shelf space of 12 feet to devote to the four drinks. She wants a
minimum of 1 foot and a maximum of 6 feet of front shelf space for each drink.

Required:
1. Calculate the contribution margin per case of each type of drink.
2. A coworker of Miller’s recommends that she maximize the shelf space devoted to those drinks
with the highest contribution margin per case. Do you agree with this recommendation?
Explain briefly.
3. What shelf-space allocation for the four drinks would you recommend for the Beach Comber?

11-13
 Show your calculations.

SOLUTION

(20–25 min.) Relevant costs, contribution margin, product emphasis.

1. Natural
Orange
Cola Lemonade Punch Juice
Selling price $19.10 $20.25 $27.10 $39.50
Deduct variable cost per case 14.40 15.90 21.50 29.80
Contribution margin per case $ 4.70 $ 4.35 $ 5.60 $ 9.70

2. The argument fails to recognize that shelf space is the constraining factor. There are only
12 feet of front shelf space to be devoted to drinks. Sexton should aim to get the highest daily
contribution margin per foot of front shelf space:

Natural
Orange
Cola Lemonade Punch Juice
Contribution margin per case $ 4.70 $ 4.35 $ 5.60 $ 9.70
Sales (number of cases) per foot
of shelf space per day  10  24  25  22
Daily contribution per foot
of front shelf space $47.00 $104.40 $140.00 $213.40

3. The allocation that maximizes the daily contribution from soft drink sales is:

Daily Contribution
Feet of per Foot of Total Contribution
Shelf Space Front Shelf Space Margin per Day
Natural Orange Juice 6 $213.40 $1,280.40
Punch 4 140.00 560.00
Lemonade 1 104.40 104.40
Cola 1 47.00 47.00
$1,991.80

The maximum of six feet of front shelf space will be devoted to Natural Orange Juice because it
has the highest contribution margin per unit of the constraining factor. Four feet of front shelf
space will be devoted to Punch, which has the second highest contribution margin per unit of the
constraining factor. No more shelf space can be devoted to Punch because each of the remaining
two products, Lemonade and Cola (that have the second lowest and lowest contribution margins
per unit of the constraining factor), must each be given at least one foot of front shelf space.

11-28 Selection of most profitable product. Isochlorine is produced in a chemical process that
is very threatening to the environment. As a result of this, the government has limited the yearly

11-14
production. Company Soleil uses isochlorine to produce four cosmetic products A, B, C, and D.
Soleil has a inventory of 2,000 kg of isochlorine at a value of $20,000:
As a result of production restrictions imposed on their supplier, Soleil will not be able to
purchase additional isochlorine during the coming period.
Although Soleil, by means of its commercial campaign, suggests that its main goal is to
let people experience the sanitary effects of its cosmetic products, the management is only
interested in profit maximization.
The management of Soleil must decide how to use the scarce material. The following
information is available concerning the next period:

Product Sales Selling price Labor hours Material per

per unit per unit unit (Grams)
A 3,000 $ 70 1.0 500
B 8,000 $ 60 1.2 300
C 4,000 $100 2.0 600
D 5,000 $ 80 1.0 800

The labor tariff per hour is $30. Labor costs are linear variable. Sales provision is 10% of the
selling price. Which product(s) must Soleil produce during the next period? What is the
contribution margin for the next period? Show your calculations.

SOLUTION

(10 min.) Selection of most profitable product.

Product A B C D
Material 5 3 6 8
Labor 30 36 60 30
Costs 35 39 66 38
Selling 70 60 100 80
price
Sales 7 6 10 8
provision
Net selling 63 54 90 72
price
CMPP 28 15 24 34
CM per kg. 56 50 40 42.5
Material
Priority 1 2 4 3

Product A Product B Product A +B

Sales 3000 8000
CM 28 15
Total CM 84000 120000
Used material 1500 2400

11-15
 Ending material 500 –1900
CM Max 84000 120000 204000
Sales (restricted) 3000 1666
CM restricted 84000 24,990 108,990

11-29 Theory of constraints, throughput margin, relevant costs. The Pierce Corporation
manufactures filing cabinets in two operations: machining and finishing. It provides the following
information:

Machining Finishing
Annual capacity 110,000 units 90,000 units
Annual production 90,000 units 90,000 units
Fixed operating costs (excluding direct materials) $540,000 $270,000
Fixed operating costs per unit produced $6 per unit $3 per unit
($540,000 ,90,000; $270,000 ,90,000)

Each cabinet sells for $70 and has direct material costs of $30 incurred at the start of the machining
operation. Pierce has no other variable costs. Pierce can sell whatever output it produces. The
following requirements refer only to the preceding data. There is no connection between the
requirements.

Required:
1. Pierce is considering using some modern jigs and tools in the finishing operation that would
increaseannual finishing output by 1,150 units. The annual cost of these jigs and tools is
$35,000. Should Pierce acquire these tools? Show your calculations.
2. The production manager of the Machining Department has submitted a proposal to do faster
setups that would increase the annual capacity of the Machining Department by 9,000 units
and would cost $4,000 per year. Should Pierce implement the change? Show your calculations.
3. An outside contractor offers to do the finishing operation for 9,500 units at $9 per unit, triple
the $3 perunit that it costs Pierce to do the finishing in-house. Should Pierce accept the
subcontractor’s offer? Show your calculations.
4. The Hammond Corporation offers to machine 5,000 units at $3 per unit, half the $6 per unit
that it costsPierce to do the machining in-house. Should Pierce accept Hammond’s offer? Show
your calculations.
5. Pierce produces 1,700 defective units at the machining operation. What is the cost to Pierce of
the defective items produced? Explain your answer briefly.
6. Pierce produces 1,700 defective units at the finishing operation. What is the cost to Pierce of
the defective items produced? Explain your answer briefly.

SOLUTION

(25 min.) Theory of constraints, throughput contribution, relevant costs.

1. Finishing is a bottleneck operation. Therefore, producing 1,150 more units will generate
additional contribution (throughput) margin and operating income.
Increase in contribution (throughput) margin ($70 – $30)  1,150 $46,000

11-16
 Incremental costs of the jigs and tools 35,000
Increase in operating income investing in jigs and tools $11,000
Pierce should invest in the modern jigs and tools because the benefit of higher contribution
(throughput) margin of $46,000 exceeds the cost of $35,000.
2. The Machining Department has excess capacity and is not a bottleneck operation.
Increasing its capacity further will not increase contribution (throughput) margin. There is,
therefore, no benefit from spending $4,000 to increase the Machining Department's capacity by
9,000 units. Pierce should not implement the change to do setups faster.
3. Finishing is a bottleneck operation. Therefore, getting an outside contractor to produce
9,500 units will increase contribution (throughput) margin.
Increase in contribution (throughput) margin ($70 – $30)  9,500 $380,000
Incremental contracting costs $9  9,500 85,500
Increase in operating income by contracting 9,500 units of finishing $294,500
Pierce should contract with an outside contractor to do 9,500 units of finishing at $9 per unit
because the benefit of higher throughput margin of $380,000 exceeds the cost of $85,500. The fact
that the cost of $9 per unit is three times Pierce's finishing cost of $3 per unit is irrelevant.
4. Operating costs in the Machining Department of $540,000, or $6 per unit, are fixed costs.
Pierce will not save any of these costs by subcontracting machining of 5,000 units to Hammond
Corporation. Total costs will be greater by $15,000 ($3 per unit  5,000 units) under the
subcontracting alternative. Machining more filing cabinets will not increase contribution
(throughput) margin, which is constrained by the finishing capacity. Pierce should not accept
Hammond’s offer. The fact that Hammond’s costs of machining per unit are half of what it costs
Pierce in-house is irrelevant.
5. The cost of 1,700 defective units in the Machining Operation is $30 per unit  1,700 units
= $51,000. Because the Machining Operation has a capacity of 110,000 units, it can still produce
and transfer 90,000 good units to the Finishing Operation. There is, therefore, no opportunity cost
of producing defective units in the Machining Operation.
6. The cost of 1,700 defective units in the Finishing Operation is:
Cost of direct materials used in the defective units $30 per unit  1,700 units $ 51,000
Opportunity cost, lost contribution (throughput) margin $40 per unit  1,700 units 68,000
Total cost of defective unit in the Finishing Operation $119,000
Alternatively, the cost of 1,700 defective units in the Finishing Operation equals the revenues lost
by selling 1,700 fewer units = $70 per unit  1,700 units = $119,000. The cost of the defective unit
at a bottleneck operation is much higher than at a non-bottleneck operation because of the
opportunity cost of lost contribution margin at the bottleneck operation.

11-30 Closing and opening stores. Sanchez Corporation runs two convenience stores, one in
Connecticut and one in Rhode Island. Operating income for each store in 2017 is as follows:

11-17
The equipment has a zero disposal value. In a senior management meeting, Maria Lopez, the
management accountant at Sanchez Corporation, makes the following comment, “Sanchez can
increase its profitability by closing down the Rhode Island store or by adding another store like
it.”

Required:
1. By closing down the Rhode Island store, Sanchez can reduce overall corporate overhead costs
by $44,000. Calculate Sanchez’s operating income if it closes the Rhode Island store. Is Maria
Lopez’s statement about the effect of closing the Rhode Island store correct? Explain.
2. Calculate Sanchez’s operating income if it keeps the Rhode Island store open and opens
another store with revenues and costs identical to the Rhode Island store (including a cost of
$22,000 to acquire equipment with a one-year useful life and zero disposal value). Opening
this store will increase corporate overhead costs by $4,000. Is Maria Lopez’s statement about
the effect of adding another store like the Rhode Island store correct? Explain.

SOLUTION

(2530 min.) Closing and opening stores.

1. Solution Exhibit 11-30, Column 1, presents the relevant loss in revenues and the relevant
savings in costs from closing the Rhode Island store. Lopez is correct that Sanchez Corporation’s
operating income would increase by $7,000 if it closes down the Rhode Island store. Closing down
the Rhode Island store results in a loss of revenues of $860,000 but cost savings of $867,000 (from
cost of goods sold, rent, labor, utilities, and corporate costs). Note that by closing down the Rhode
Island store, Sanchez Corporation will save none of the equipment-related costs because this is a
past cost. Also note that the relevant corporate overhead costs are the actual corporate overhead
costs $44,000 that Sanchez expects to save by closing the Rhode Island store. The corporate
overhead of $40,000 allocated to the Rhode Island store is irrelevant to the analysis.
2. Solution Exhibit 11-30, Column 2, presents the relevant revenues and relevant costs of
opening another store like the Rhode Island store. Lopez is correct that opening such a store would
increase Sanchez Corporation’s operating income by $11,000. Incremental revenues of $860,000
exceed the incremental costs of $849,000 (from higher cost of goods sold, rent, labor, utilities, and
some additional corporate costs). Note that the cost of equipment written off as depreciation is
relevant because it is an expected future cost that Sanchez will incur only if it opens the new store.
Also note that the relevant corporate overhead costs are the $4,000 of actual corporate overhead

11-18
costs that Sanchez expects to incur as a result of opening the new store. Sanchez may, in fact,
allocate more than $4,000 of corporate overhead to the new store, but this allocation is irrelevant
to the analysis.
The key reason that Sanchez’s operating income increases either if it closes down the Rhode
Island store or if it opens another store like it is the behavior of corporate overhead costs. By
closing down the Rhode Island store, Sanchez can significantly reduce corporate overhead costs
presumably by reducing the corporate staff that oversees the Rhode Island operation. On the other
hand, adding another store like Rhode Island does not increase actual corporate costs by much,
presumably because the existing corporate staff will be able to oversee the new store as well.
SOLUTION EXHIBIT 11-30
Relevant-Revenue and Relevant-Cost Analysis of Closing Rhode Island Store and Opening
Another Store Like It.
Incremental
(Loss in Revenues) Revenues and
and Savings in (Incremental Costs)
Costs from Closing of Opening New Store
Rhode Island Store Like Rhode Island Store
(1) (2)
Revenues $(860,000) $ 860,000
Cost of goods sold 660,000 (660,000)
Lease rent 75,000 (75,000)
Labor costs 42,000 (42,000)
Depreciation of equipment 0 (22,000)
Utilities (electricity, heating) 46,000 (46,000)
Corporate overhead costs 44,000 (4,000)
Total costs 867,000 (849,000)
Effect on operating income (loss) $ 7,000 $ 11,000

11-31 Choosing customers. Rodeo Printers operates a printing press with a monthly capacity of
4,000 machine-hours. Rodeo has two main customers: Trent Corporation and Julie Corporation.
Data on each customer for January are:
Trent Corporation Julie Corporation Total
Revenues $210,000 $140,000 $350,000
Variable costs 84,000 85,000 169,000
Contribution margin 126,000 55,000 181,000
Fixed costs (allocated) 102,000 68,000 170,000
Operating income $ 24,000 $ (13,000) $ 11,000
Machine-hours required 3,000 hours 1,000 hours 4,000 hours

Julie Corporation indicates that it wants Rodeo to do an additional $140,000 worth of printing
jobs during February. These jobs are identical to the existing business Rodeo did for Julie in
January in terms of variable costs and machine-hours required. Rodeo anticipates that the
business from Trent Corporation in February will be the same as that in January. Rodeo can
choose to accept as much of the Trent and Julie business for February as its capacity allows.
Assume that total machine-hours and fixed costs for February will be the same as in January.

11-19
Required:
What action should Rodeo take to maximize its operating income? Show your calculations. What
other factors should Rodeo consider before making a decision?

SOLUTION

(20 min.) Choosing customers.

If Rodeo accepts the additional business from Julie, it would take an additional 1,000 machine-
hours. If Rodeo accepts all of Julie’s and Trent’s business for February, it would require 5,000
machine-hours (3,000 hours for Trent and 2,000 hours for Julie). Rodeo has only 4,000 hours of
machine capacity. It must, therefore, choose how much of the Trent or Julie business to accept.
To maximize operating income, Rodeo should maximize contribution margin per unit of
the constrained resource. (Fixed costs will remain unchanged at $170,000 regardless of the
business Rodeo chooses to accept in February and are, therefore, irrelevant.) The contribution
margin per unit of the constrained resource for each customer in January is:

Trent Julie
Corporation Corporation
$126,000 $55,000
Contribution margin per machine-hour = $42 = $55
3,000 1,000

Because the $140,000 of additional Julie business in February is identical to jobs done in
January, it will also have a contribution margin of $55 per machine-hour, which is greater than the
contribution margin of $42 per machine-hour from Trent. To maximize operating income, Rodeo
should first allocate all the capacity needed to take the Julie Corporation business (2,000 machine-
hours) and then allocate the remaining 2,000 (4,000 – 2,000) machine-hours to Trent.

Trent Julie
Corporation Corporation Total
Contribution margin per machine-hour $42 $55
Machine-hours to be worked  2,000  2,000
Contribution margin $84,000 $110,000 $194,000
Fixed costs 170,000
Operating income $ 24,000

An alternative approach is to use the opportunity cost approach. The opportunity cost of
giving up 1,000 machine-hours for the Trent Corporation jobs is the contribution margin forgone
of $42 per machine-hour  1,000 machine-hours equal to $42,000. The contribution margin
gained from using the 1,000 machine-hours for the Julie Corporation business is the contribution
margin per machine-hour of $55  1,000 machine-hours equal to $55,000.

The net benefit is:

Contribution margin from Julie Corporation business $55,000

11-20
 Less: Opportunity cost (of giving up Trent Corporation business) (42,000)
Net benefit $13,000
Although taking the Julie Corporation business over the Trent Corporation business will maximize
Rodeo’s profits in the short run, Rodeo’s managers must also consider the long-run effects of this
decision. Will Julie Corporation continue to demand the same level of business going forward?
Will turning down the Trent business affect customer satisfaction? If Rodeo turns down the Trent
business, will Trent continue to place orders with Rodeo or seek alternative suppliers? Rodeo’s
managers need to consider these long-run effects and then decide whether it should accept Julie’s
business at the cost of Trent’s. In other words, choosing customers is a strategic decision. If it sees
long-run benefit in working with Trent, Rodeo’s managers must also look for ways to increase the
profitability of the business it does with Trent by increasing prices or reducing costs.

11-32 Relevance of equipment costs. Papa’s Pizza is considering replacement of its pizza oven
with a new, more energy-efficient model. Information related to the old and new pizza ovens
follows:
Old oven—original cost $60,000
Old oven—book value $50,000
Old oven—current market value $42,000
Old oven—annual operating cost $14,000
New oven—purchase price $75,000
New oven—installation cost $ 2,000
New oven—annual operating cost $ 6,000

The old oven had been purchased a year ago. Papa’s Pizza estimates that either oven has a
remaining useful life of five years. At the end of five years, either oven would have a zero salvage
value. Ignore the effect of income taxes and the time value of money.

Required:
1. Which of the costs and benefits above are relevant to the decision to replace the oven?
2. What information is irrelevant? Why is it irrelevant?
3. Should Papa’s Pizza purchase the new oven? Provide support for your answer.
4. Is there any conflict between the decision model and the incentives of the manager who has
purchased the “old” oven and is considering replacing it a year later?
5. At what purchase price would Papa’s Pizza be indifferent between purchasing the new oven
and continuing to use the old oven?

SOLUTION

(20 min.) Relevance of equipment costs.

1. The current market value and annual operating costs of the old oven, and the purchase
price, installation cost, and annual operating costs of the new oven are relevant when deciding
whether to replace the oven because these are future costs that would differ between the
alternatives of keeping or replacing the old oven.

11-21
2. The original cost and book value of the old oven are irrelevant because they are variations
of the same past (sunk) cost. All past costs are irrelevant because past costs will be the same
whether Papa’s Pizza keeps or replaces the oven. No decision can change what has already been
incurred in the past.

3. Papa’s Pizza should purchase the new oven, based on the following calculations:

Keep the old oven Replace the old oven

Current market value of old oven $ 42,000
Purchase price of the new oven (75,000)
Installation cost of the new oven (2,000)
Operating costs for 5 years Operating costs for 5 years
($14,000 × 5) $(70,000) ($6,000 × 5) (30,000)
Cost of keeping the old oven $(70,000) Net cost of the new oven $(65,000)

The cost of replacing the old oven is $65,000, while the cost of continuing to operate the old
oven is $70,000.

4. The manager may be reluctant to replace because it might reflect badly on him for having
purchased the old oven in the first place if the new oven was available a year earlier.

5. At a purchase price of $80,000, Papa’s Pizza would be indifferent between purchasing the
new oven and continuing to use the old oven ($75,000 current purchase price + $5,000 savings
above). Note that a cost of $80,000, the cost of replacing the old oven would be $70,000, equal to
the cost of keeping the old oven.
11-33 Equipment upgrade versus replacement. (A. Spero, adapted) The TechGuide Company
produces and sells 7,500 modular computer desks per year at a selling price of $750 each. Its
current production equipment, purchased for $1,800,000 and with a five-year useful life, is only
two years old. It has a terminal disposal value of $0 and is depreciated on a straight-line basis. The
equipment has a current disposal price of $450,000. However, the emergence of a new molding
technology has led TechGuide to consider either upgrading or replacing the production equipment.
The following table presents data for the two alternatives:

All equipment costs will continue to be depreciated on a straight-line basis. For simplicity, ignore
income taxes and the time value of money.

Required:
1. Should TechGuide upgrade its production line or replace it? Show your calculations.

11-22
2. Now suppose the one-time equipment cost to replace the production equipment is somewhat
negotiable. All other data are as given previously. What is the maximum one-time equipment
cost that TechGuide would be willing to pay to replace rather than upgrade the old equipment?
3. Assume that the capital expenditures to replace and upgrade the production equipment are
as given in the original exercise, but that the production and sales quantity is not known.
For what production and sales quantity would TechGuide (i) upgrade the equipment or (ii)
replace the equipment?
4. Assume that all data are as given in the original exercise. Dan Doria is TechGuide’s manager,
and his bonus is based on operating income. Because he is likely to relocate after about a year,
his current bonus is his primary concern. Which alternative would Doria choose? Explain.

SOLUTION

(30 min.) Equipment upgrade versus replacement.

1. Based on the analysis in the table below, TechGuide will be better off by $337,500 over
three years if it replaces the current equipment.
Over 3 years Difference in
Comparing Relevant Costs of Upgrade and Upgrade Replace favor of Replace
Replace Alternatives (1) (2) (3) = (1) – (2)
Cash operating costs
$150; $75 per desk  7,500 desks per yr.  3
yrs. $3,375,000 $1,687,500 $1,687,5000
Current disposal price (450,000) 450,000
One time capital costs, written off periodically
as
depreciation 3,000,000 4,800,000 (1,800,000)
Total relevant costs $6,375,000 $6,037,500 $ 337,500

3
Note that the book value of the current machine, $1,800,000  = $1,080,000 would either be
5
written off as depreciation over three years under the upgrade option or all at once in the current
year under the replace option. Its net effect would be the same in both alternatives: to increase
costs by $1,080,000 over three years; hence, it is irrelevant in this analysis.

2. Suppose the capital expenditure to replace the equipment is $X. From requirement 1,
column (2), substituting for the one-time capital cost of replacement, the relevant cost of replacing
is $1,687,500 – $450,000 + $X. From column (1), the relevant cost of upgrading is $6,375,000.
We want to find X such that

$1,687,500 – $450,000 + $X < $6,375,000 (i.e., TechGuide will favor replacing)

Solving the above inequality gives us X < $6,375,000 – $1,237,500 = $5,137,500.

TechGuide would prefer to replace, rather than upgrade, if the replacement cost of the new
equipment does not exceed $5,137,500. Note that this result can also be obtained by taking the

11-23
original replacement cost of $4,800,000 and adding to it the $337,500 difference in favor of
replacement calculated in requirement 1.

3. Suppose the units produced and sold over 3 years equal y. Using data from requirement 1,
column (1), the relevant cost of upgrade would be $150y + $3,000,000, and from column (2), the
relevant cost of replacing the equipment would be $75y – $450,000 + $4,800,000. TechGuide
would want to upgrade when

$150y + $3,000,000 < $75y – $450,000 + $4,800,000

$75y < $1,350,000
y < $1,350,000  $75 = 18,000 units

That is, upgrade when y < 18,000 units (or 6,000 per year for 3 years) and replace when y > 18,000
units over 3 years.
When production and sales volume is low (less than 6,000 per year), the higher operating
costs under the upgrade option are more than offset by the savings in capital costs from upgrading.
When production and sales volume is high, the higher capital costs of replacement are more than
offset by the savings in operating costs in the replace option.

4. Operating income for the first year under the upgrade and replace alternatives are shown
below:
Year 1
Upgrade Replace
(1) (2)
Revenues (7,500  $750) $5,625,000 $5,625,000
Cash operating costs
$150; $75 per desk  7,500 desks per year 1,125,000 562,500
Depreciation ($1,080,000 + $3,000,000)  3; $4,800,000  3
a
1,360,000 1,600,000
Loss on disposal of old equipment (0; $1,080,000 –
$450,000) 0 630,000
Total costs 2,485,000 2,792,500
Operating Income $3,140,000 $2,832,500
a
The book value of the current production equipment is $1,800,000  5  3 = $1,080,000; it
has a remaining useful life of 3 years.

First-year operating income is higher by $307,500 ($3,140,000 – $2,832,500) under the upgrade
alternative, and Dan Doria, with his one-year horizon and operating income-based bonus, will
choose the upgrade alternative, even though, as seen in requirement 1, the replace alternative is
better in the long run for TechGuide. This exercise illustrates the possible conflict between the
decision model and the performance evaluation model.

11-34 Special order, short-run pricing. GamesAhoy Corporation produces cricket bats for kids
that it sellsfor $36 each. At capacity, the company can produce 50,000 bats a year. The costs of
producing and selling 50,000 bats are as follows:

11-24
 Cost per Bat Total Costs
Direct materials $13 $ 650,000
Direct manufacturing labor 5 250,000
Variable manufacturing overhead 2 100,000
Fixed manufacturing overhead 6 300,000
Variable selling expenses 3 150,000
Fixed selling expenses 2 100,000
Total costs $31 $1,550,000
Required:

1. Suppose GamesAhoy is currently producing and selling 40,000 bats. At this level of
production and sales, its fixed costs are the same as given in the preceding table.
FieldTactics Corporation wants to place a one-time special order for 10,000 bats at $23
each. Slugger will incur no variable selling costs for this special order. Should GamesAhoy
accept this one-time special order? Show your calculations.
2. Now suppose GamesAhoy is currently producing and selling 50,000 bats. If GamesAhoy
accepts FieldTactics’ offer it will have to sell 10,000 fewer bats to its regular customers.
(a) On financial considerations alone, should GamesAhoy accept this one-time special
order? Show your calculations. (b) On financial considerations alone, at what price would
GamesAhoy be indifferent between accepting the special order and continuing to sell to its
regular customers at $36 per bat. (c) What other factors should GamesAhoy consider in
deciding whether to accept the one-time special order?

(20 min.) Special order, short-run pricing

1.
Revenues from special order ($23  10,000 bats) $230,000
Variable manufacturing costs ($201  10,000 bats) (200,000)
Increase in operating income if Bench order accepted $ 30,000
1
Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable manufacturing
overhead cost per unit = $13 + $5 + $2 = $20

GamesAhoy should accept FieldTactics’ special order because it increases operating income by
$30,000. Because no variable selling costs will be incurred on this order, this cost is irrelevant.
Similarly, fixed costs are irrelevant because they will be incurred regardless of the decision.
$230,000
2a. Revenues from special order ($23  10,000 bats)
Variable manufacturing costs ($20  10,000 bats) (200,000)
Contribution margin foregone ([$36─$23 ]  10,000 bats)
1
(130,000)
Decrease in operating income if Bench order accepted $(100,000)
1
Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable manufacturing
overhead cost per unit + Variable selling expense per unit = $13 + $5 + $2 + $3 = $23

11-25
Based strictly on financial considerations, GamesAhoy should reject FieldTactics’ special order
because it results in a $100,000 reduction in operating income.

2b. GamesAhoy will be indifferent between the special order and continuing to sell to regular
customers if the special order price is $33. At this price, GamesAhoy recoups the variable
manufacturing costs of $200,000 and the contribution margin given up from regular customers of
$130,000 ([$200,000 + $130,000] ÷ 10,000 units = $33). That is, at the special order price of $33,
Slugger recoups the variable cost per unit of $20 and the contribution margin per unit given up
from regular customers of $13 per unit.
An alternative approach is to recognize that GamesAhoy needs to earn $100,000 more than
the revenues of $230,000 in requirement 2a, so that the decrease in operating income of $100,000
becomes $0. GamesAhoy will be indifferent between the special order and continuing to sell to
regular customers if revenues from the special order = $230,000 + $100,000 = $330,000 or $33
per bat ($330,000  10,000 bats)
Looked at a different way, GamesAhoy needs to earn the full price of $36 less the $3 saved
on variable selling costs.

2c. GamesAhoy may be willing to accept a loss on this special order if the possibility of future
long-term sales seem likely at a higher price. Moreover, GamesAhoy should also consider the
negative long-term effect on customer relationships of not selling to existing customers.
GamesAhoy cannot afford to sell bats to customers at the special order price for the long term
because the $23 price is less than the full manufacturing cost of the product of $31. This means
that in the long term, the contribution margin earned will not cover the fixed costs and result in a
loss. GamesAhoy will then be better off shutting down.

11-35 Short-run pricing, capacity constraints. Fashion Fabrics makes pants from a special
material. The fabric is special because of the way it fits many body types. The pants sell for $142.
A well-known retail establishment has asked Fashion Fabrics to produce 3,000 shorts from the
same fabric. The factory has unused capacity, so Barbara Brooks, the owner of Fashion Fabrics,
calculates the cost of making a pair of shorts from the fabric. Costs for the pants and shorts are as
follows:

Required:
1. Suppose Fashion Fabrics can acquire all the fabric that it needs. What is the minimum price
the company should charge for the shorts?
2. Now suppose that the fabric is in short supply. Every yard of fabric Fashion Fabrics uses to
make shorts will reduce the pants that it can make and sell. What is the minimum price the

11-26
 company should charge for the shorts?

SOLUTION

(15-20 min.) Short-run pricing, capacity constraints.

1. Per pair of shorts:

Fabric (3 yards  $12 per yard) $36

Variable direct manufacturing labor 10
Variable manufacturing overhead 4
Fixed manufacturing cost allocated 9
Total manufacturing cost $59

If Fashion Fabrics can get all the fabric it needs and has sufficient production capacity, then the
minimum price it should charge per pair of shorts is the variable cost per pair of shorts = $36 +
$10 + $4 = $50 per pair of shorts.

2. If the fabric is in short supply, then the fabric used for 2 shorts displaces 1 pant (6 yards of
fabric per pant versus 3 yards of fabric per short).

We calculate the contribution margin per pair of pants = Selling price – Variable costs
= $142 − $100a = $42
a
Direct materials, $72 + Variable direct manufacturing labor, $20 + Variable manufacturing
overhead, $8

Pants require 6 yards of fabric so the contribution margin per unit of the constrained resource is
$42 ÷ 6 yards = $7 per yard
The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per pair
of shorts plus the contribution margin from 3 yards of fabric, or,

$50 + (3  $7 per yard) = $71 per pair of shorts

That is, if fabric is in short supply, Fashion Fabrics should not agree to produce any shorts unless
the buyer is willing to pay at least $71 per pair of shorts.

Another way to calculate the opportunity cost of producing a pair of shorts is to recognize that
every time Fashion Fabrics uses fabric to produce a pair of shorts, it gives up the opportunity to
produce 0.5 pants. So,
Opportunity cost of a pair of shorts = 0.5 × Contribution margin from producing a pair of pants =
0.5 × $42 = $21.

The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per pair
of shorts plus the opportunity cost of not producing 0.5 pants = $50 + $21 = $71.

11-27
11-36 International outsourcing. Cuddly Critters, Inc., manufactures plush toys in a facility in
Queensland, Brisbane. Recently, the company designed a group of collectible resin figurines to go
with the plush toy line. Management is trying to decide whether to manufacture the figurines
themselves in existing space in the Queensland facility or to accept an offer from a manufacturing
company in Indonesia. Data concerning the decision are:

Expected annual sales of figurines (in units) 400,000

Average selling price of a figurine $5
Price quoted by Indonesian company, in Indonesian Rupiah (IDR), 27,300 IDR
for each figurine
Current exchange rate 9,100 IDR = $1
Variable manufacturing costs $2.85 per unit
Incremental annual fixed manufacturing costs associated with the new $200,000
product line
Variable selling and distribution costsa $0.50 per unit
Annual fixed selling and distribution costsa $285,000
a
Selling and distribution costs are the same regardless of whether the figurines are manufactured in Cleveland
or imported.

1. Should Cuddly Critters manufacture the 400,000 figurines in the Queensland facility or
purchase them from the Indonesian supplier? Explain.
2. Cuddly Critters believes that the dollar may weaken in the coming months against the
Indonesian rupiah and does not want to face any currency risk. Assume that Cuddly Critters
can enter into a forward contract today to purchase 27,300 IDRs for $3.40. Should Cuddly
Critters manufacture the 400,000 figurines in the Queensland facility or purchase them from
the Indonesian supplier? Explain.
3. What are some of the qualitative factors that Cuddly Critters should consider when deciding
whether to outsource the figurine manufacturing to Indonesia?

SOLUTION

(20 min.) International outsourcing.

27,300 IDR
1. Cost to purchase each figurine from Indonesian supplier =  $3 .
9,100 IDR/$
Cost of purchasing 400,000 figurines from Indonesian supplier = $3 400,000 figurines =
$1,200,000.

Costs of
manufacturing Variable Quantity of Incremental fixed
figurines in = manufacturing  figurines + manufacturing
Cleveland cost per unit produced costs
facility

= ($2.85  400,000 units) + $200,000

11-28
 = $1,340,000

Variable and fixed selling and distribution costs are irrelevant because they do not differ between
the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing the
figurines in Queensland.
Cuddly Critters should purchase the figurines from the Indonesian supplier because the
cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in
Cleveland.

2. If Cuddly Critters enters into a forward contract to purchase 27,300 IDRs for $3.40, each
figurine acquired from the Indonesian supplier will cost $3.40.

Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40  400,000
figurines = $1,360,000.
Cost of manufacturing 400,000 figurines in Queensland (see requirement 1) = $1,340,000.

As in requirement 1, selling and distribution costs are irrelevant.

Cuddly Critters should manufacture the figurines in Queensland because the relevant cost of
$1,340,000 to manufacture the figurines in Queensland is less than the cost of $1,360,000 to enter
into the forward contract and purchase the figurines from the Indonesian supplier.

3. In deciding whether to purchase figurines from the Indonesian supplier, Cuddly Critters
should consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of
the Indonesian Rupiah relative to the dollar, and (d) the negative public and media reaction to not
providing jobs in Queensland and instead supporting job creation in Indonesia.

11-37 Relevant costs, opportunity costs. Gavin Martin, the general manager of Oregano
Software, must decide when to release the new version of Oregano’s spreadsheet package,
Easyspread 2.0. Development of Easyspread 2.0 is complete; however, the diskettes, compact
discs, and user manuals have not yet been produced. The product can be shipped starting July 1,
2017.
The major problem is that Oregano has overstocked the previous version of its spreadsheet
package, Easyspread 1.0. Martin knows that once Easyspread 2.0 is introduced, Oregano will
not be able to sell any more units of Easyspread 1.0. Rather than just throwing away the
inventory of Easyspread 1.0, Martin is wondering if it might be better to continue to sell
Easyspread 1.0 for the next three months and introduce Easyspread 2.0 on October 1, 2017,
when the inventory of Easyspread 1.0 will be sold out.
The following information is available:

11-29
Development cost per unit for each product equals the total costs of developing the software
product divided by the anticipated unit sales over the life of the product. Marketing and
administrative costs are fixed costs in 2017, incurred to support all marketing and
administrative activities of Oregano Software. Marketing and administrative costs are
allocated to products on the basis of the budgeted revenues of each product. The preceding
unit costs assume Easyspread 2.0 will be introduced on October 1, 2017.

Required:
1. On the basis of financial considerations alone, should Martin introduce Easyspread 2.0 on July
1, 2017, or wait until October 1, 2017? Show your calculations, clearly identifying relevant
and irrelevant revenues and costs.
2. What other factors might Gavin Martin consider in making a decision?

SOLUTION

(30 min.) Relevant costs, opportunity costs.

1. Easyspread 2.0 has a higher relevant operating income than Easyspread 1.0. Based on this
analysis, Easyspread 2.0 should be introduced immediately:

Easyspread 1.0 Easyspread 2.0

Relevant revenues $165 $215
Relevant costs:
Manuals, diskettes, compact discs $ 0 $38
Total relevant costs 0 38
Relevant operating income $165 $177

Reasons for other cost items being irrelevant are

Easyspread 1.0
 Manuals, diskettes—already incurred
 Development costs—already incurred
 Marketing and administrative—fixed costs of period

Easyspread 2.0
 Development costs—already incurred
 Marketing and administration—fixed costs of period

Note that total marketing and administration costs will not change whether Easyspread 2.0 is
introduced on July 1, 2017, or on October 1, 2017.

2. Other factors to be considered:

a. Customer satisfaction. If 2.0 is significantly better than 1.0 for its customers, a
customer-driven organization would immediately introduce it unless other factors
offset this bias toward “do what is best for the customer.”

11-30
 b. Quality level of Easyspread 2.0. It is critical for new software products to be fully
debugged. Easyspread 2.0 must be error-free. Consider an immediate release only if
2.0 passes all quality tests and can be supported fully by the salesforce.
c. Importance of being perceived to be a market leader. Being first in the market with a
new product can give Oregano Software a “first-mover advantage,” e.g., capturing an
initial large share of the market that, in itself, causes future potential customers to lean
toward purchasing Easyspread 2.0. Moreover, by introducing 2.0 earlier, Oregano can
get quick feedback from users about ways to further refine the software while its
competitors are still working on their own first versions. Moreover, by locking in early
customers, Oregano may increase the likelihood of these customers also buying future
upgrades of Easyspread 2.0.
d. Morale of developers. These are key people at Oregano Software. Delaying
introduction of a new product can hurt their morale, especially if a competitor then
preempts Oregano from being viewed as a market leader.
11-38 Opportunity costs and relevant costs. Jason Wu operates Exclusive Limousines, a fleet
of 10 limousines used for weddings, proms, and business events in Washington, D.C. Wu charges
customers a flat fee of $250 per car taken on contract plus an hourly fee of $80. His income
statement for May follows:

All expenses are fixed, with the exception of driver wages and benefits and fuel costs, which are both
variable per hour. During May, the company’s limousines were fully booked. In June, Wu expects that
Exclusive Limousines will be operating near capacity. Shelly Worthington, a prominent Washington
socialite, has asked Wu to bid on a large charity event she is hosting in late June. The limousine
company she had hired has canceled at the last minute, and she needs the service of five limousines for
four hours each. She will only hire Exclusive Limousines if they take the entire job. Wu checks his
schedule and finds that he only has three limousines available that day.

Required:
1. If Wu accepts the contract with Worthington, he would either have to (a) cancel two prom
contracts each for one car for six hours or (b) cancel one business event for three cars
contracted for two hours each. What are the relevant opportunity costs of accepting the
Worthington contract in each case? Which contract should he cancel?
2. Wu would like to win the bid on the Worthington job because of the potential for lucrative
future business. Assume that Wu cancels the contract in requirement 1 with the lowest

11-31
 opportunity cost, and assume that the three currently available cars would go unrented if the
company does not win the bid. What is the lowest amount he should bid on the Worthington
job?
3. Another limousine company has offered to rent Exclusive Limousines two additional cars for
$300 each per day. Wu would still need to pay for fuel and driver wages on these cars for the
Worthington job. Should Wu rent the two cars to avoid canceling either of the other two
contracts?

SOLUTION

(30 min.) Opportunity costs and relevant costs

1. If Wu cancels the two prom contracts, the opportunity cost of accepting the Worthington job
would be $886.40, as follows:

Lost revenue (2 × $250) + (12 hrs. × $80) $1,460.00

Less variable costs
Driver wages and benefits* ($35 × 12 hrs.) 420.00
Fuel costs** ($12.80 × 12 hrs.) 153.60
Opportunity cost $ 886.40
*Driver wages and benefits are $35/hour ($43,750 ÷ 1,250 hours)
** Fuel costs are $12.80/hour ($16,000 ÷ 1,250 hours)

If Wu cancels the business event contract, the opportunity cost would be $943.20, as
follows:

Lost revenue (3 × $250) + (6 hrs. × $80) $1,230.00

Less variable costs
Driver wages and benefits* ($35 × 6 hrs.) 210.00
Fuel costs** ($12.80 × 6 hrs.) 76.80
Opportunity cost $ 943.20

*Driver wages and benefits are $35/hour ($43,750 ÷ 1,250 hours)

** Fuel costs are $12.80/hour ($16,000 ÷ 1,250 hours)

Wu should cancel the prom contracts because the opportunity cost would be lower by $56.80
($943.20 – $886.40).

2. If Wu cancels the two prom contracts, opportunity cost equals $886.40. In addition, variable
costs of the 20-hour Worthington job would be (20 hrs. × $35) + (20 hrs. × $12.80) = $956.
Therefore, the minimum amount Wu would bid is $1,842.40 ($886.40 + $956).

3. Yes, it would be in Wu’s best interest to lease the additional cars for a total of $600 because it
is less than the opportunity cost of $886.40.

11-32
11-39 Opportunity costs. (H. Schaefer, adapted) The Wild Orchid Corporation is working at full
production capacity producing 13,000 units of a unique product, Everlast. Manufacturing cost per
unit for Everlast is:

Manufacturing overhead cost per unit is based on variable cost per unit of $8 and fixed costs of
$78,000 (at full capacity of 13,000 units). Marketing cost per unit, all variable, is $4, and the selling
price is $52.
A customer, the Apex Company, has asked Wild Orchid to produce 3,500 units of Stronglast,
a modification of Everlast. Stronglast would require the same manufacturing processes as Everlast.
Apex has offered to pay Wild Orchid $40 for a unit of Stronglast and share half of the marketing
cost per unit.

Required:
1. What is the opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast?
(Assume that no overtime is worked.)
2. The Chesapeake Corporation has offered to produce 3,500 units of Everlast for Wild Orchid
so that Wild Orchid may accept the Apex offer. That is, if Wild Orchid accepts the Chesapeake
offer, Wild Orchid would manufacture 9,500 units of Everlast and 3,500 units of Stronglast
and purchase 3,500 units of Everlast from Chesapeake. Chesapeake would charge Wild Orchid
$36 per unit to manufacture Everlast. On the basis of financial considerations alone, should
Wild Orchid accept the Chesapeake offer? Show your calculations.
3. Suppose Wild Orchid had been working at less than full capacity, producing 9,500 units of
Everlast, at the time the Apex offer was made. Calculate the minimum price Wild Orchid
should accept for Stronglast under these conditions. (Ignore the previous $40 selling price.)

SOLUTION

(20 min.) Opportunity costs.

1. The opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast is the
contribution margin lost on the 3,500 units of Everlast that would have to be forgone, as computed
below:
Selling price $ 52
Variable costs per unit:
Direct materials $10
Direct manufacturing labor 2
Variable manufacturing overhead 8
Variable marketing costs 4 24
Contribution margin per unit $ 28
Contribution margin for 3,500 units ($28  3,500 units) $98,000

11-33
 The opportunity cost is $98,000. Opportunity cost is the maximum contribution to
operating income that is forgone (rejected) by not using a limited resource in its next-best
alternative use.

2. Contribution margin from manufacturing 3,500 units of Stronglast and purchasing 3,500
units of Everlast from Chesapeake is $105,000, as follows:
Manufacture Purchase
Stronglast Everlast Total
Selling price $ 40 $ 52
Variable costs per unit:
Purchase costs – 36
Direct materials 10
Direct manufacturing labor 2
Variable manufacturing costs 8
Variable marketing overhead 2 4
Variable costs per unit 22 40
Contribution margin per unit $ 18 $ 12
Contribution margin from selling 3,500 units
of Stronglast and 3,500 units of Everlast
($18  3,500 units; $12  3,500 units) $63,000 $42,000 $105,000

As calculated in requirement 1, Wild Orchid’s contribution margin from continuing to

manufacture 3,500 units of Everlast is $98,000. Accepting the Apex Company and Chesapeake
offer will benefit Wild Orchid by $7,000 ($105,000 – $98,000). Hence, Wild Orchid should accept
the Apex Company and Chesapeake Corporation’s offers.

3. The minimum price would be any price greater than $22, the sum of the incremental costs
of manufacturing and marketing Stronglast as computed in requirement 2. This follows because,
if Wild Orchid has surplus capacity, the opportunity cost = $0. For the short-run decision of
whether to accept Apex’s offer, fixed costs of Wild Orchid are irrelevant. Only the incremental
costs need to be covered for it to be worthwhile for Wild Orchid to accept the Apex offer.

11-40 Make or buy, unknown level of volume. (A. Atkinson, adapted) Denver Engineering
manufactures small engines that it sells to manufacturers who install them in products such as lawn
mowers. The company currently manufactures all the parts used in these engines but is considering
a proposal from an external supplier who wishes to supply the starter assemblies used in these
engines.
The starter assemblies are currently manufactured in Division 3 of Denver Engineering. The
costs relating to the starter assemblies for the past 12 months were as follows:

11-34
Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for each
starter assembly is $10 ($1,500,000  150,000).
Further analysis of manufacturing overhead revealed the following information. Of the total
manufacturing overhead, only 25% is considered variable. Of the fixed portion, $300,000 is an
allocation of general overhead that will remain unchanged for the company as a whole if
production of the starter assemblies is discontinued. A further $200,000 of the fixed overhead is
avoidable if production of the starter assemblies is discontinued. The balance of the current fixed
overhead, $100,000, is the division manager’s salary. If Denver Engineering discontinues
production of the starter assemblies, the manager of Division 3 will be transferred to Division 2 at
the same salary. This move will allow the company to save the $80,000 salary that would otherwise
be paid to attract an outsider to this position.

Required:
1. Tutwiler Electronics, a reliable supplier, has offered to supply starter-assembly units at $8 per
unit. Because this price is less than the current average cost of $10 per unit, the vice president
of manufacturing is eager to accept this offer. On the basis of financial considerations alone,
should Denver Engineering accept the outside offer? Show your calculations. (Hint:
Production output in the coming year may be different from production output in the past year.)
2. How, if at all, would your response to requirement 1 change if the company could use the
vacated plant space for storage and, in so doing, avoid $100,000 of outside storage charges
currently incurred? Why is this information relevant or irrelevant?

SOLUTION

(30–40 min.) Make or buy, unknown level of volume.

1. The variable costs required to manufacture 150,000 starter assemblies are

Direct materials $400,000

Direct manufacturing labor 300,000
Variable manufacturing overhead 200,000
Total variable costs $900,000

The variable costs per unit are $900,000 ÷ 150,000 = $6.00 per unit.

Let X = number of starter assemblies required in the next 12 months.

The data can be presented in both “all data” and “relevant data” formats:

All Data Relevant Data

11-35
 Alternative Alternative Alternative Alternative
1: 2: 1: 2: Buy
Make Buy Make
Variable manufacturing costs $ 6X – $ 6X –
Fixed general manufacturing overhead 300,000 $300,000 – –
Fixed overhead, avoidable 200,000 – 200,000 –
Division 2 manager’s salary 80,000 100,000 80,000 $100,000
Division 3 manager’s salary 100,000 – 100,000 –
Purchase cost, if bought from
Tutwiler Electronics – 8X – 8X
Total costs $680,000 $400,000 $380,000 $100,000
+ $ 6X + $ 8X + $ 6X + $ 8X

The number of units at which the costs of make and buy are equivalent is

All data analysis: $680,000 + $6X = $400,000 + $8X

2X = 280,000
X = 140,000
or
Relevant data analysis: $380,000 + $6X = $100,000 + $8X
2X = 280,000
X = 140,000

Assuming cost minimization is the objective, then

• If production is expected to be less than 140,000 units, it is preferable to buy units from
Tutwiler.
• If production is expected to exceed 140,000 units, it is preferable to manufacture
internally (make) the units.
• If production is expected to be 140,000 units, Denver should be indifferent between
buying units from Tutwiler and manufacturing (making) the units internally.

2. The information on the storage cost, which is avoidable if self-manufacture is discontinued,

is relevant; these storage charges represent current outlays that are avoidable if self-manufacture
is discontinued. Assume these $100,000 charges are represented as an opportunity cost of the make
alternative. The costs of internal manufacture that incorporate this $100,000 opportunity cost are

All data analysis: $780,000 + $6X

Relevant data analysis: $480,000 + $6X

Alternatively stated, we would add the following line to the table shown in requirement 1
causing the total costs line to change as follows:

All Data Relevant Data

Alternative 1: Alternative 2: Alternative 1: Alternative 2:
Make Buy Make Buy

11-36
 Outside storage $100,000 $0 $100,000 $0
charges
Total costs $780,0001 + 6X $400,000 + 8X $480,0002 + 6X $100,000 + 8X

1 2
$780,000 = $680,000 + $100,000 $480,000 = $380,000 + $100,000

The number of units at which the costs of make and buy are equivalent is

All data analysis: $780,000 + $6X = $400,000 + $8X

2X = 380,000
X = 190,000

Relevant data analysis: $480,000 + $6X = $100,000 + $8X

2X = 380,000
X = 190,000

If production is expected to be less than 190,000, it is preferable to buy units from Tutwiler. If
production is expected to exceed 190,000, it is preferable to manufacture the units internally.

11-37