DISCUSSION QUESTIONS



Chapter 25

Differential analysis and

product pricing

EYE OPENERS

1. a. Differential revenue is the amount of increase or decrease in revenue expected from a particular course of action compared with an alternative.

b. Differential cost is the amount of increase or decrease in cost expected from a particular course of action compared with an alternative.

c. Differential income is the difference between differential revenue and differential cost.

2. This decision is an example of a make-vs.-buy decision. Exabyte is focusing on its comparative advantages, which include marketing and distribution, while building partnerships with others to actually manufacture key elements of the product.

3. The differential income and costs of the lease option should be compared against selling the building. The differential revenue would be the lease revenue compared to the proceeds from sale. The differential expenses would be the costs associated with leasing the building, including maintenance, property tax, and insurance compared to the expense of selling, such as sales commissions. The opportunity cost of money should also be considered in the analysis.

4. Assuming there is demand for the premium-grade product, this would assume the differ- ential price (premium less commodity) exceeded the differential cost to process the product to premium grade.

5. A business should only accept business at a special price if the lower price will not contaminate the regular pricing for other customers or induce other customers to buy at the special price. In addition, the business must be careful not to violate the Robinson-Patman Act, which prohibits uncompetitive price differences across different markets for the same product. Lastly, the company may only offer the special price once for an incremental order. Thus, the business must consider the longer-term ramifications of offering discount business to a customer that may wish to order in the future.

6. It would be reasonable to purchase from the supplier if the fixed cost per unit was less than 50 cents. That is, if the fixed cost were less than 50 cents per unit, then the variable cost per unit would exceed the supplier’s price, making the supplier price more attractive.

7. Some of the financial considerations include the profitability of the store, including all the revenues, variable and fixed costs associated with the store, since they would all be differential to the decision. In addition, any costs of closing the store and preparing the store for disposal would need to be consid- ered (legal costs, demolition costs, employee severance costs). Lastly, the opportunity cost of the value of the equipment and land (either in cash or rental income) should be considered. For example, if the opportunity value of the assets were $500 per month, then the store would need to have a profitability exceeding this amount to remain an attractive alternative.

8. In the long run, the normal selling price must be set high enough to cover all costs (both fixed and variable) and provide a reasonable amount for profit.

9. The use of ideal standards might not allow for such factors as normal spoilage or normal periods of idle time, with the result that these costs might not be covered by the product price. In such cases, the product price could be too low to earn a desired profit.

10. In setting prices, managers should also consider such factors as the prices of competing products and the general economic conditions of the marketplace.

11. Activity-based costing can be used to determine the product cost in a complex manufacturing setting.

12. The target cost concept begins with a price that can be sustained in the marketplace, then subtracts a target profit, thus determining the target cost. The cost is made to conform to the price required in the market. In contrast, under cost plus, a markup is added to the cost. The resulting price is assumed to be acceptable in the market.

13. The target cost concept is most appropriate in highly competitive product markets, where margins are under pressure and prices are falling.

14. A production bottleneck is a point in the production process where demand exceeds the ability to produce (i.e., the segment is operating at full capacity). As a result, the complete production system output is limited by the output of the bottleneck.

15. The proper measure of product value in a bottlenecked process is the contribution margin per bottleneck hour.

PRACTICE EXERCISES

PE 25–1A

Differential revenue from alternatives:

Revenue from lease $ 42,000

Revenue from sale 40,000

Differential revenue from lease $ 2,000

Differential cost of alternatives:

Repair, insurance, and property tax expenses

from lease $ 7,000

Commission expense on sale (6% × $40,000) 2,400

Differential cost of lease 4,600

Net differential loss from the lease alternative $(2,600)

PE 25–1B

Differential revenue from alternatives:

Revenue from lease $268,000

Revenue from sale 250,000

Differential revenue from lease $ 18,000

Differential cost of alternatives:

Repair, insurance, and property tax expenses

from lease $ 24,000

Commission expense on sale (5% × $250,000) 12,500

Differential cost of lease 11,500

Net differential income from the lease alternative $ 6,500

PE 25–2A

a. Differential revenue from annual sales of Product L:

Revenue from sales $ 56,000

Differential cost of annual sales of Product L:

Variable cost of goods sold $ 29,000

Variable selling expenses 12,000 41,000

Annual differential income from sales of Product L $ 15,000

b. Product L should be continued.

PE 25–2B

a. Differential revenue from annual sales of Product V:

Revenue from sales $204,000

Differential cost of annual sales of Product V:

Variable cost of goods sold $ 134,000

Variable selling expenses 74,000 208,000

Annual differential loss from sales of Product V $ (4,000)

b. Product V should be discontinued.

PE 25–3A

Differential cost to purchase:

Purchase price of small bottles (per 1,000) $32

Freight for bottles 7 $39

Differential cost to manufacture:

Variable manufacturing costs ($52 – $15 fixed costs) 37

Cost savings from manufacturing small bottles $ 2

PE 25–3B

Differential cost to purchase:

Purchase price of bread $109

Delivery cost for bread 8 $117

Differential cost to manufacture:

Variable baking costs ($160 – $38 fixed costs) 122

Cost savings from purchasing bread $ (5)

PE 25–4A

Annual direct labor cost reduction $ 2,800

Number of years applicable × 5

Total differential decrease in cost $ 14,000

Proceeds from sale of old equipment 50,000 $ 64,000

Cost of new equipment 62,000

Net differential decrease in cost from replacing

equipment, five-year total $ 2,000

Annual net differential decrease in cost—new machine $ 400

PE 25–4B

Annual direct labor cost reduction $ 12,000

Number of years applicable × 6

Total differential decrease in cost $ 72,000

Proceeds from sale of old equipment 243,000 $ 315,000

Cost of new equipment 320,000

Net differential increase in cost from replacing

equipment, six-year total $ (5,000)

Annual net differential increase in cost—new machine $ (833) (rounded)

PE 25–5A

Differential revenue from further processing per gallon:

Revenue per gallon from sale of Product E $105

Revenue per gallon from sale of Product D 85

Differential revenue $20

Differential cost per gallon:

Additional cost for producing Product E ($19 – $3) 16

Differential income from further processing into Product E $ 4

PE 25–5B

Differential revenue from further processing per pound:

Revenue per pound from sale of Product U $4.45

Revenue per pound from sale of Product T 4.10

Differential revenue $ 0.35

Differential cost per pound:

Additional cost for producing Product U ($0.50 – $0.12) 0.38

Differential loss from further processing into Product U $(0.03)

PE 25–6A

Differential revenue from export:

Revenue per unit from export sale $ 5.60

Differential cost from export:

Variable manufacturing costs $4.50

Export tariff (25% × $5.60) 1.40 5.90

Differential loss from accepting export sale $(0.30)

PE 25–6B

Differential revenue from export:

Revenue per unit from export sale $46.00

Differential cost from export:

Variable manufacturing costs $ 32.00

Export tariff (15% × $46) 6.90 38.90

Differential income from accepting export sale $ 7.10

PE 25–7A

Markup percentage on total cost: [pic] = 20%

PE 25–7B

Markup percentage on total cost: [pic] = 12.5%

PE 25–8A

Markup percentage on product cost: [pic] = 80%

*$150 – $50

PE 25–8B

Markup percentage on product cost: [pic] = 150%

*$80 – $44

PE 25–9A

Markup percentage on variable cost: [pic] = 44%

*$150 – $125

PE 25–9B

Markup percentage on variable cost: [pic] = 200%

*$80 – $30

PE 25–10A

Product K Product L

Unit contribution margin $ 240 $ 200

Furnace hours per unit ÷ 8 ÷ 5

Unit contribution margin per production bottleneck hour $ 30 $ 40

Product L is the most profitable in using bottleneck resources.

PE 25–10B

Product A Product B

Unit contribution margin $45 $60

Testing hours per unit ÷ 3 ÷ 5

Unit contribution margin per production bottleneck hour $15 $12

Product A is the most profitable in using bottleneck resources.

EXERCISES

Ex. 25–1

a.

Proposal to Lease or Sell Machinery

January 3, 2010

Differential revenue from alternatives:

Revenue from lease $ 312,000

Proceeds from sale 292,000

Differential revenue from lease $ 20,000

Differential cost of alternatives:

Repairs, insurance, and property tax expenses

from lease $ 36,000

Commission on sale 14,600*

Differential cost of lease 21,400

Net differential loss from lease alternative $ (1,400)

*5% × $292,000

b. Sell the machinery. The net gain from selling is $1,400.

Ex. 25–2

a.

Proposal to Discontinue Royal Cola

March 3, 2010

Differential revenue from annual sales of Royal Cola:

Revenue from sales $254,000

Differential cost of annual sales of Royal Cola:

Variable cost of goods sold $102,480*

Variable operating expenses 124,800** 227,280

Annual differential income from sales of Royal Cola $ 26,720

*(1 – 16%) × $122,000

**(1 – 20%) × $156,000

b. Royal Cola should be retained. As indicated by the differential analysis in part (a), the income would decrease by $26,720 (excess of differential revenue over differential cost) if the product is discontinued.

Ex. 25–3

a.

SUFFOLK CHINA WARE COMPANY

Differential Product Analysis Report

For the Month Ended December 31, 2010

Bowls Plates Cups

Differential revenue from annual sales:

Revenue from sales $54,000 $68,500 $24,500

Differential costs of annual sales:

Variable cost of goods sold $ 19,040 $ 26,945 $10,115

Variable selling and administrative

expenses 16,980 15,180 12,240

$ 36,020 $ 42,125 $22,355

Annual differential income from sales $ 17,980 $ 26,375 $ 2,145

b. The Cups line should be retained. As indicated by the differential analysis in part (a), the income would decrease by $2,145 (excess of differential revenue over differential cost) if the Cups line is discontinued.

Ex. 25–4

Note to Instructors: Many students may be unfamiliar with the financial services industry. This exercise provides an opportunity to introduce students to some basic terms and concepts used within the industry.

a. The “Individual Investor” segment serves the retail customer, you and me. These are the brokerage, Internet, and mutual fund services used by individual investors. The “Institutional Investor” segment includes the same services provided for financial institutions, such as banks, mutual fund managers, insurance companies, and pension plan administrators. Although not required by the question, the “Corporate and Retirement Services” segment provides wealth management services for affluent individuals and families.

b. Variable costs in the “Individual Investor” segment include:

1. Commissions to brokers

2. Fees paid to exchanges for executing trades

3. Transaction fees incurred by Schwab mutual funds to purchase and sell shares

4. Advertising

Fixed costs in the “Individual Investor” segment include:

1. Depreciation on brokerage offices

2. Depreciation on brokerage office equipment, such as computers and computer networks

3. Property taxes on brokerage offices

c.

Corporate

and

Individual Institutional Retirement

Investor Investor Services

Income from operations $1,237 $482 $ 139

Plus depreciation 98 25 15

Estimated contribution margin $1,335 $507 $154

d. If one assumes that the fixed costs that serve institutional investors (computers, servers, and facilities) would not be sold but would be used by the other two sectors, then the contribution margin of $507 million would be an estimate of the reduced profitability. If the fixed assets were sold, then the operating income decline would approach $482 million. Since the institutional and retail investors use nearly the same assets, the $507 million answer is probably the better estimate.

Ex. 25–5

The flaw in the decision was the failure to focus on the differential revenues and costs, which indicate that operating income would be reduced by $40,000 if Children’s Shoes is discontinued. This differential income from sales of Children’s Shoes can be determined as follows:

Differential revenue from annual sales of Children’s

Shoes:

Revenue from sales $170,000

Differential cost of annual sales of Children’s Shoes:

Variable cost of goods sold $100,000

Variable selling and administrative expenses 30,000 130,000

Annual differential income from sales of Children’s

Shoes $ 40,000

Ex. 25–6

a.

Proposal to Manufacture Carrying Case

October 11, 2010

Purchase price of carrying case $68.00

Differential cost to manufacture carrying case:

Direct materials $25.00

Direct labor 32.00

Variable factory overhead (15% × $32) 4.80 61.80

Cost savings from manufacturing carrying case $ 6.20

b. It would be advisable to manufacture the carrying cases because the cost savings would be $6.20 per unit. Fixed factory overhead is irrelevant, since it will continue whether the carrying cases are purchased or manufactured.

Ex. 25–7

a.

Proposal to Purchase Outside Page Layout Services

December 15, 2009

Differential revenue:

Salvage of computer equipment $ 7,000

Differential expenses:

Purchase price of layout work:

Number of pages 20,000

Price per page × $15.00

Total $300,000

Differential cost to perform internally:

Salaries $220,000

Benefits 35,000

Supplies 30,000

Office expenses 25,000 310,000

Cost savings from purchasing layout services $ 10,000

Total benefit from using an outside service $ 17,000

b. The benefit from using an outside service is shown to be $17,000 greater than performing the layout work internally. The fixed costs (depreciation expenses) in the budget are irrelevant to the decision. Thus, the work should be purchased from the outside on a strictly financial basis. In addition, the decision to purchase from the outside would be further favored if the need for administrative expansion space were great. If more administrative space were needed immediately, then any avoided lease costs would become a differential benefit to the decision to outsource.

c. Before electing to terminate the five employees, the guild should consider the long-run impact of the decision. Specifically, future page layout rates may grow faster than the cost of internal salaries, thus favoring the use of employees over the long term. This would especially be the case if the outside company provided a low bid in order to win the initial business. In addition, the guild may wish to consider noneconomic factors such as the ability to more directly control the quality and timing of the layout work by internal employees.

Ex. 25–8

a. Annual variable costs—present equipment $165,000

Annual variable costs—new equipment 112,750

Annual differential decrease in cost $ 52,250

Number of years applicable × 8

Total differential decrease in cost $418,000

Proceeds from sale of present equipment 72,000 $490,000

Cost of new equipment 450,000

Net differential income, eight-year total $ 40,000

Annual differential income from new equipment

($40,000/8) $ 5,000

b. The sunk cost is the $250,000 book value ($600,000 cost less $350,000 accumulated depreciation) of the present equipment. The original cost and

accumulated depreciation were incurred in the past and are irrelevant to the decision to replace the machine.

Ex. 25–9

a.

Proposal to Replace Machine

February 20, 2010

Annual costs and expenses—present machine $203,000

Annual costs and expenses—new machine 188,000

Annual differential decrease in costs and expenses $ 15,000*

Number of years applicable × 5

Total differential decrease in costs and expenses $ 75,000

Cost of new equipment 111,000

Net differential increase in costs and expenses, five-year total $ 36,000

Annual differential increase in costs and expenses—

new machine ($36,000/5 years) $ 7,200

*The annual differential decrease in costs and expenses could be computed alternatively as follows:

Decrease in direct labor costs $ 40,000

Less: Increase in power and maintenance $22,000

Increase in taxes, insurance, etc. 3,000 25,000

Annual differential decrease in costs and expenses $ 15,000

b. The proposal should not be accepted.

c. In addition to the factors given, consideration should be given to such factors as: Do both present and proposed operations provide the same capacity? What are the opportunity costs associated with alternative uses of the $111,000 outlay required to purchase the automatic machine? Is the product improved by using automatic machinery? Does the federal income tax have an effect on the decision?

Ex. 25–10

a. Differential revenue: $840 – $635 = $205

b. Differential cost: $565 – $490 = $75

c. Differential income: $205 – $75 = $130

Ex. 25–11

a.

Proposal to Process Columbian Coffee Further

Differential revenue from further processing per batch:

Revenue from sale of Decaf Columbian [(8,000

pounds – 400* pounds evaporation) × $12.50] $95,000

Revenue from sale of Columbian coffee

(8,000 pounds × $10.80) 86,400

Differential revenue $ 8,600

Differential cost per batch:

Additional cost of producing Decaf Columbian 10,500

Differential loss from further processing:

Decaf Columbian per batch $ (1,900)

*5% × 8,000

b. The differential revenue from processing further to Decaf Columbian is less than the differential cost of processing further. Thus, Seattle Roast Coffee Company should sell Columbian coffee and not process further to Decaf Columbian.

c. The price of Decaf Columbian would need to increase to $12.75 per pound in order for the differential analysis to yield neither an advantage or a disadvantage (indifference). This is determined as follows:

[pic] = [pic] = $0.25 per lb.

The price of Decaf Columbian would need to be $0.25 higher, or $12.75, to yield no net differential income or loss. This is verified by the following differential analysis:

Differential revenue from further processing per batch:

Revenue from sale of Decaf Columbian [(8,000

pounds – 400 pounds evaporation) × $12.75] $96,900

Revenue from sale of Columbian coffee

(8,000 pounds × $10.80) 86,400

Differential revenue $10,500

Differential cost per batch:

Additional cost of producing Decaf Columbian 10,500

Differential income from further processing:

Decaf Columbian per batch $ 0

Ex. 25–12

a.

Proposal to Sell to Fields Company

March 18, 2010

Differential revenue from accepting the offer:

Revenue from sale of 18,000 additional units at $29 $522,000

Differential cost of accepting the offer:

Variable costs from sale of 18,000 additional units at $22 396,000

Differential income from accepting the offer $ 126,000

b. The additional units can be sold for $29 each, and since unused capacity is available, the only costs that would be added if this additional production were accepted are the variable costs of $22 per unit. The differential revenue is therefore $29 per unit, and the differential cost is $22 per unit. Thus, the net gain is $7 per unit × 18,000 units, or $126,000.

c. $22.01. Any selling price above $22 (variable costs per unit) will produce a positive contribution margin.

Ex. 25–13

Total costs $478,000

Less fixed costs 58,000

Total variable costs $420,000

Variable cost per unit:

$420,000/30,000 batteries = $14.00

The lowest bid should be sufficient to cover the variable cost of $14 per unit.

Ex. 25–14

a.

Proposal to Sell to Euro Motors

May 4, 2010

Per Unit Total

Differential revenue from accepting special offer $75.00 $1,875,000*

Differential costs from accepting special offer:

Direct materials $32.00

Direct labor 8.00

Variable factory overhead 15.00

Variable selling and administrative 7.00

Less avoided sales commission (4.50)**

Additional shipping costs 6.00

Variable special offer product cost $63.50 $1,587,500

Incremental certification costs 125,000

Total differential costs $1,712,500

Differential income from accepting special order $ 162,500

*$75 × 25,000 units

**5% × $90. The avoided sales commission should not be computed on the basis of the $75 price to Euro Motors, but on the existing domestic sales price of $90.

b. [pic] = $68.50

or

$75 – [pic] = $68.50

Ex. 25–15

a. $100,000 ($400,000 × 25%)

b. Total costs:

Variable ($240 × 5,000 units) $1,200,000

Fixed ($215,000 + $75,000) 290,000

Total $1,490,000

Cost amount per unit: $1,490,000/5,000 units = $298

c. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 6.71% (rounded)

d. Cost amount per unit $298

Markup ($298 × 6.71%) 20

Selling price $318

Ex. 25–16

a. Total manufacturing costs:

Variable ($210 × 5,000 units) $1,050,000

Fixed factory overhead 215,000

Total $1,265,000

Cost amount per unit: $1,265,000/5,000 units = $253

b. [pic] = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 25.69% (rounded)

c. Cost amount per unit $253

Markup ($253 × 25.69%) 65

Selling price $318

Ex. 25–17

a. Total variable costs: $240 × 5,000 units $1,200,000

Cost amount per unit: $1,200,000/5,000 units = $240

b. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 32.5%

c. Cost amount per unit $240

Markup ($240 × 32.5%) 78

Selling price $318

Ex. 25–18

a. The price will be set at the estimated market price required to remain competitive, or $22,000. Under the target cost concept, the market dictates the price, not the markup on cost.

b. The required profit margin of 20% of the estimated $22,000 price implies a $17,600 target product cost as follows:

Target Product Cost = $22,000 – ($22,000 × 20%)

Target Product Cost = $22,000 – $4,400

Target Product Cost = $17,600

Since the estimated manufacturing cost of $18,100 exceeds the target cost of $17,600, Toyota will try to remove $500 from its total costs in order to maintain competitive pricing within its profit objectives.

Note to Instructors: Target costing provides pressure to keep costs competitive. The method assumes that the company may not be able to successfully add a markup to its costs because the resulting price may be too high in the marketplace. For example, merely adding the 25% markup on the $18,100 product cost would result in an uncompetitive price of $22,625. The target cost concept moves backward by taking the price as given and then determining the cost that is required for a given profit objective.

Ex. 25–19

a. Historical markup percentage: [pic] = 25%

[pic] = 20% markup on selling price

$380 revised selling price × 20% markup = $76 amount of markup

$380 selling price – $76 markup = $304 target cost

b. Required cost reduction: $320 – $304 = $16

c.

|1. Direct labor reduction: [pic] × $25 = | | $ 3.75 |

|2. Additional inspection: [pic] × $25 = |$(2.50) | |

| Direct material reduction: | 8.00 |5.50 |

|3. Injection molding productivity improvement: | | |

| Direct labor improvement (25%* × 30% × $60) | $ 4.50 | |

| Factory overhead improvement (25%* × 42% × $30) | 3.15 | 7.65 |

|Total savings | |$16.90 |

*Improving the cycle time from four minutes to three minutes is a 25% reduction.

The total savings exceeds the required target cost reduction by $0.90. Thus, these improvements are sufficient to meet the target cost.

Ex. 25–20

Determine the contribution margin per furnace hour as follows:

Type 5 Type 10 Type 20

Revenue $36,000 $40,000 $ 22,000

Variable cost 22,500 20,000 15,000

Contribution margin $ 13,500 $ 20,000 $ 7,000

Divide by number of units ÷ 5,000 units ÷ 5,000 units ÷ 5,000 units

Unit contribution margin $ 2.70 $ 4.00 $ 1.40

*Contribution margin per furnace hour $ 0.54 $ 0.40 $ 0.28

*Calculated as follows:

Type 5: [pic] = $0.54 per furnace hour

Type 10: [pic] = $0.40 per furnace hour

Type 20: [pic] = $0.28 per furnace hour

Emphasize Type 5. In a production-constrained environment, Type 5 generates the most unit contribution margin per hour of furnace resource and, thus, is the most profitable. While Type 10 has the largest profit per unit ($2.80) and unit contribution margin ($4.00), these would not be the correct metrics for determining the product to emphasize in the marketing campaign.

Ex. 25–21

a.

Large Medium Small Total

Units produced 3,000 3,000 3,000

Revenues $360,000 $300,000 $270,000 $930,000

Less variable costs 288,000 255,000 225,000 768,000

Contribution margin $ 72,000 $ 45,000 $ 45,000 $162,000

Less fixed costs 74,000

Income from operations $ 88,000

b. The Small glass product is the most profitable in a bottleneck operation, demonstrated as follows:

Large Medium Small

Unit contribution margin $ 24 $ 15 $ 15

Autoclave hours per unit ÷ 4 ÷ 2 ÷ 1

Unit contribution margin per production

bottleneck hour $ 6.00 $ 7.50 $15.00

Ex. 25–22

Small is the highest profit item, since it produces more contribution margin per autoclave hour. The prices of Large and Medium would need to be increased in order to match Small’s profitability. The two calculations are as follows:

Revised price of Large:

[pic] = [pic]

$15.00 = [pic]

$60.00 = Revised Price of Large – $96

$156.00 = Revised Price of Large

Revised price of Medium:

[pic] = [pic]

$15.00 = [pic]

$30.00 = Revised Price of Medium – $85

$115.00 = Revised Price of Medium

Thus, prices of $156 for Large and $115 for Medium both produce a unit contribution margin per hour of bottleneck operation of $15.00. The price of Small would remain unchanged. At these prices, the company should be indifferent about the product mix.

Appendix Ex. 25–23

Activity Activity

Activity-Base Usage × Rate = Cost

Stationary Bicycle

Fabrication 1,950 machine hours × $24 per mh $ 46,800

Assembly 436 direct labor hours × $12 per dlh 5,232

Setup 48 setups × $40 per setup 1,920

Inspecting 725 inspections × $22 per inspection 15,950

Production scheduling 68 production orders × $14 per prod. order 952

Purchasing 166 purchase orders × $6 per purch. order 996

Total $ 71,850

Number of units ÷ 1,000

Activity costs per unit $ 71.85

Rowing Machine

Fabrication 975 machine hours × $24 per mh $ 23,400

Assembly 162 direct labor hours × $12 per dlh 1,944

Setup 15 setups × $40 per setup 600

Inspecting 375 inspections × $22 per inspection 8,250

Production scheduling 20 production orders × $14 per prod. order 280

Purchasing 126 purchase orders × $6 per purch. order 756

Total $ 35,230

Number of units ÷ 1,000

Activity costs per unit $ 35.23

Appendix Ex. 25–24

a.

Production Quality Materials

Activity Rates Setup Procurement Control Management

Overhead cost $ 54,000 $ 122,000 $ 170,000 $ 125,000

Activity base ÷ 500 ÷ 1,000 ÷ 2,000 ÷ 500

Activity rate $ 108/setup $ 122/PO $ 85/inspection $250/component

b.

Custom Standard

Number of setups 375 125

Rate per setup × $108 × $108

$ 40,500 $ 13,500

Number of purchase orders 900 100

Rate per purchase order × $122 × $122

109,800 12,200

Number of inspections 1,800 200

Rate per inspection × $85 × $85

153,000 17,000

Number of components 300 200

Rate per component × $250 × $250

75,000 50,000

Total product cost $378,300 $ 92,700

Unit volume ÷ 3,000 ÷ 3,000

Unit cost $ 126.10 $ 30.90

c. The factory overhead allocated to each product on the basis of direct labor hours would be 50%, since each product has the same 3,000 direct labor hours. The factory overhead per direct labor hour for each product is computed as follows:

[pic]= $78.50 per hour

Since each product requires one direct labor hour, the cost per unit is also $78.50 for each product.

d. The factory overhead allocated to the custom power unit is much higher under the activity-based approach, compared to the direct labor method. The reason is that the setup, procurement, and quality control activities are not directly related to the number of direct labor hours but are instead related to the number of setups, purchase orders, and inspections. In addition, the custom product has a more complex design (more components) than does the standard product. As a result, the custom product will consume more materials management activities than will the standard product.

PROBLEMS

Prob. 25–1A

1.

Proposal to Operate Warehouse

March 1, 2010

Differential revenue from alternatives:

Revenue from operating warehouse $4,270,0001

Revenue from investment in bonds 735,0002

Differential revenue from operating warehouse $3,535,000

Differential cost of alternatives:

Costs to operate warehouse $2,730,0003

Cost of equipment less residual value 674,000

Differential cost of operating warehouse 3,404,000

Differential income from operating warehouse $ 131,000

1 (7 yrs. × $330,000) + (7 yrs. × $280,000)

2 7% × $750,000 × 14 yrs.

3 $195,000 × 14 yrs.

2. The proposal should be accepted.

3. Total estimated revenue from operating

warehouse $4,270,000

Total estimated expenses to operate warehouse:

Costs to operate warehouse, excluding

depreciation $2,730,000

Cost of equipment less residual value 674,000 3,404,000

Total estimated income from operating

warehouse $ 866,000*

*The $866,000 income from operations could also be determined by adding the $131,000 income from operating the warehouse as derived in part (1) to the $735,000 of investment income forgone by electing to operate the warehouse.

Prob. 25–2A

1.

Proposal to Replace Machine

May 22, 2010

Annual manufacturing costs associated with present machine $ 14,500

Annual manufacturing costs associated with proposed

new machine 5,200

Annual reduction in manufacturing costs $ 9,300

Number of years applicable × 6

Cost reduction attributable to difference in manufacturing costs $ 55,800

Proceeds from sale of present machine 18,000

$ 73,800

Cost of new machine 58,500

Differential income anticipated from replacement, six-year total $ 15,300

2. Other factors to be considered include the following:

a. Are there any improvements in the quality of work turned out by the new machine?

b. What effect does the federal income tax have on the decision?

c. What opportunities are available for the use of the $40,500 of funds ($58,500 less $18,000 sales price of old machine) that are required to purchase the new machine?

After considering such factors as those listed above, the net cost reduction anticipated over the six-year period may not be sufficient to justify the replacement. For example, if there is an opportunity to invest the $40,500 ($58,500 – $18,000) of additional funds required for the replacement in a project that earns a return of 6%, the amount of the return over the six-year period would be $14,580 ($40,500 × 6% × 6). However, this is less than the differential income determined in part (1), suggesting the proposal to replace is preferred.

Prob. 25–3A

1.

Proposals for Sales Promotion Campaign

May 13, 2010

Tennis Shoe Walking Shoe

Differential revenue from proposals $550,0001 $600,0002

Differential cost of proposals:

Direct materials $100,000 $132,000

Direct labor 40,000 54,000

Variable factory overhead 25,000 36,000

Variable selling expenses 35,000 30,000

Sales promotion expenses 125,000 125,000

Differential cost of proposals $325,000 $377,000

Differential income from proposed sales

promotion campaign $225,000 $223,000

1 5,000 shoes × $110

2 6,000 shoes × $100

2. The sales manager’s tentative decision should be opposed. The sales manager erroneously considered the full unit costs instead of the differential (additional) revenue and differential (additional) costs. An analysis similar to that presented in part (1) would lead to the selection of tennis shoes for the promotional campaign, since this alternative will contribute $2,000 ($225,000 – $223,000) more to operating income than would be contributed by promoting walking shoes.

Prob. 25–4A

1.

Proposal to Process Aluminum Ingot Further

December 20, 2010

Differential revenue from further processing per batch:

Revenue from sale of rolled aluminum

[(66 tons/1.2 tons) × $1,600] $88,000

Revenue from sale of aluminum ingot

(66 tons × $950) 62,700

Differential revenue $25,300

Differential cost per batch:

Additional cost of processing rolled aluminum

(66 tons × $425) 28,050

Differential loss from further processing aluminum

ingot, per batch $ (2,750)

2. Allegheny Valley Aluminum Co. should decide not to further process aluminum ingot to produce rolled aluminum, since profits would be decreased by $2,750 per batch.

Prob. 25–5A

1. $60,000 ($500,000 × 12%)

2. a. Total costs:

Variable ($44.00 × 12,000 units) $528,000

Fixed ($120,000 + $60,000) 180,000

Total $708,000

Cost amount per unit: $708,000/12,000 units $ 59.00

b. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 8.48% (rounded)

c. Cost amount per unit $59.00

Markup ($59.00 × 8.48%) 5.00

Selling price $64.00

3. a. Total manufacturing costs:

Variable ($40 × 12,000 units) $480,000

Fixed factory overhead 120,000

Total $600,000

Cost amount per unit: $600,000/12,000 units $ 50.00

b. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 28%

c. Cost amount per unit $50.00

Markup ($50.00 × 28%) 14.00

Selling price $64.00

Prob. 25–5A Concluded

4. a. Variable cost amount per unit: $44.00

Total variable costs: $44 × 12,000 units = $528,000

b. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 45.45% (rounded)

c. Cost amount per unit $44.00

Markup ($44.00 × 45.45%) 20.00

Selling price $64.00

5. The cost-plus approach price of $64.00 should be viewed as a general guideline for establishing long-run normal prices. Other considerations, such as the price of competing products and general economic conditions of the marketplace, could lead management to establish a short-run price more or less than $64.00.

6. a.

Proposal to Sell to Forever Glow Inc.

September 5, 2010

Differential revenue from accepting offer:

Revenue from sale of 2,000 additional units at $45.00 $90,000

Differential cost of accepting offer:

Variable costs of 2,000 additional units at $40.00* 80,000

Differential income from accepting offer $10,000

*$44 – $4 (Excluding variable selling and administrative expenses)

b. The proposal should be accepted.

Prob. 25–6A

1.

Ethylene Butane Ester

Selling price $165 $128 $115

Variable conversion cost per unit* $ 21 $ 21 $ 14

Direct materials cost per unit 110 75 85

$131 $ 96 $ 99

Contribution margin per unit $ 34 $ 32 $ 16

*$7 × 3 process hours = $21

$7 × 2 process hours = $14

2. The contribution margin per unit may give false signals when an organization has production bottlenecks. Instead, Delaware Bay Chemical Company should use the contribution margin per bottleneck hour to determine relative product profitability as follows:

Ethylene Butane Ester

Contribution margin per unit $ 34 $ 32 $ 16

Reactor (bottleneck) hours per unit ÷ 1.0 ÷0.8 ÷0.5

Contribution margin per reactor hour $ 34 $ 40 $ 32

Unlike the analysis in part (1), this analysis shows butane to be the most profitable product, rather than ethylene. The reason is that butane delivers more contribution margin per bottleneck hour than does ethylene or ester ($40 vs. $34 and $32).

Prob. 25–6A Concluded

3. One way to revise the pricing would be to increase the price to the point where all three products produce profitability equal to the highest profit product. This would be determined as follows:

Revised Price of Ethylene:

[pic]= [pic]

$40 = (Revised Price of Ethylene – $131)/1.0 hr.

$40 = (Revised Price of Ethylene – $131)

$171 = Revised Price of Ethylene

Ethylene would require a revised price of $171 in order to deliver the same unit contribution margin per bottleneck hour as does butane.

Revised Price of Ester:

[pic]= [pic]

$40 = (Revised Price of Ester – $99)/0.5 hr.

$20 = (Revised Price of Ester – $99)

$119 = Revised Price of Ester

Ester would require a revised price of $119 in order to deliver the same unit contribution margin per bottleneck hour as does butane.

Prob. 25–1B

1.

Proposal to Operate Retail Store

November 1, 2010

Differential revenue from alternatives:

Revenue from operating store $1,200,0001

Revenue from investment bonds 112,0002

Differential revenue from operating store $1,088,000

Differential cost of alternatives:

Costs to operate store $ 992,0003

Cost of store equipment less residual value 125,000

Differential cost of operating store 1,117,000

Differential loss from operating store $ (29,000)

1 (8 yrs. × $78,000) + (8 yrs. × $72,000)

2 5% × $140,000 × 16

3 $62,000 × 16

2. The proposal should be rejected.

3. Total estimated revenue from operating store $1,200,000

Total estimated expenses to operate store:

Costs to operate store, excluding depreciation $992,000

Cost of store equipment less residual value 125,000 1,117,000

Total estimated income from operating store $ 83,000*

*The $83,000 income could also be determined by subtracting the $29,000 loss from operating the store as derived in part (1) from the $112,000 of investment income forgone by electing to operate the store.

Prob. 25–2B

1.

Proposal to Replace Machine

August 13, 2010

Annual manufacturing costs associated with present machine $ 42,500

Annual manufacturing costs associated with proposed

new machine 18,900

Annual reduction in manufacturing costs $ 23,600

Number of years applicable × 6

Cost reduction attributable to difference in manufacturing costs $141,600

Proceeds from sale of present machine 32,400

$174,000

Cost of new machine 144,000

Differential income anticipated from replacement, six-year total $ 30,000

2. Other factors to be considered include:

a. Are there any improvements in the quality of work turned out by the new machine?

b. What effect does the federal income tax have on the decision?

c. What opportunities are available for the use of the $111,600 of funds ($144,000 less $32,400 sales price of old machine) that are required to purchase the new machine?

After considering such factors as those listed above, the net cost reduction anticipated over the six-year period may not be sufficient to justify the replacement. For example, if there is an opportunity to invest the $111,600 ($144,000 – $32,400) of additional funds required for the replacement in a project that earns a return of 5%, the amount of the return over the six-year period would be $33,480 ($111,600 × 5% × 6), which is more advantageous than the replacement, other factors being equal.

Prob. 25–3B

1.

Proposals for Sales Promotion Campaign

June 15, 2010

Moisturizer Perfume

Differential revenue from proposals $572,0001 $612,0002

Differential cost of proposals:

Direct materials $ 99,000 $ 99,000

Direct labor 22,000 27,000

Variable factory overhead 33,000 36,000

Variable selling expenses 121,000 135,000

Sales promotion expenses 120,000 120,000

Differential cost of proposals $395,000 $417,000

Differential income from proposed sales

promotion campaign $177,000 $195,000

111,000 units × $52

29,000 units × $68

2. The sales manager’s tentative decision should be opposed. The sales manager erroneously considered the full unit costs instead of the differential (additional) revenue and differential (additional) costs. An analysis similar to that presented in part (1) would lead to the selection of perfume for the promotional campaign, since this alternative will contribute $18,000 ($195,000 – $177,000) more to operating income than would be contributed by promoting moisturizer.

Prob. 25–4B

1.

Proposal to Process Raw Sugar Further

January 30, 2010

Differential revenue from further processing per batch:

Revenue from sale of refined sugar

[(27,000 lbs./1.2 lbs.) × $1.90] $42,750

Revenue from sale of raw sugar

(27,000 lbs. × $1.10) 29,700

Differential revenue $ 13,050

Differential cost per batch:

Additional cost of processing refined sugar

(27,000 lbs. × $0.35) 9,450

Differential income from further processing raw

sugar per batch $ 3,600

2. Caribbean Sugar Company should decide to further process raw sugar to produce refined sugar, since profits would be increased by $3,600 per batch.

Prob. 25–5B

1. $300,000 ($1,500,000 × 20%)

2. a. Total costs:

Variable ($245 × 12,000 units) $2,940,000

Fixed ($960,000 + $480,000) 1,440,000

Total $4,380,000

Cost amount per unit: $4,380,000/12,000 units $ 365

b. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 6.85% (rounded)

c. Cost amount per unit $365

Markup ($365 × 6.85%) 25

Selling price $390

3. a. Total manufacturing costs:

Variable ($220 × 12,000 units) $2,640,000

Fixed factory overhead 960,000

Total $3,600,000

Cost amount per unit: $3,600,000/12,000 units $ 300

b. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 30%

c. Cost amount per unit $300

Markup ($300 × 30%) 90

Selling price $390

Prob. 25–5B Concluded

4. a. Variable cost amount per unit: $245

Total variable costs: $245 × 12,000 units = $2,940,000

b. Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = [pic]

Markup Percentage = 59.18%

c. Cost amount per unit $245

Markup ($245 × 59.18%) 145

Selling price $390

5. The cost-plus approach price of $390 should be viewed as a general guideline for establishing long-run normal prices. Other considerations, such as the price of competing products and general economic conditions of the marketplace, could lead management to establish a short-run price more or less than $390.

6. a.

Proposal to Sell to Vision Systems Inc.

August 3, 2010

Differential revenue from accepting offer:

Revenue from sale of 1,500 additional units at $235 $352,500

Differential cost of accepting offer:

Variable costs of 1,500 additional units at $220* 330,000

Differential income from accepting offer $ 22,500

*$245 – $25 (Excluding variable selling and administrative expenses)

b. The proposal should be accepted.

Prob. 25–6B

1.

High Good Regular

Grade Grade Grade

Selling price $270 $250 $210

Variable conversion cost per unit* $120 $120 $ 96

Direct materials cost per unit 120 100 78

$240 $220 $174

Contribution margin per unit $ 30 $ 30 $ 36

*$8 × 15 process hours = $120

$8 × 12 process hours = $96

2. The contribution margin per unit may give false signals when an organization has production bottlenecks. Instead, Gemini should use the contribution margin per bottleneck hour to determine relative product profitability, as follows:

High Good Regular

Grade Grade Grade

Contribution margin per unit $ 30 $ 30 $ 36

Furnace (bottleneck) hours per unit ÷ 5 ÷ 4 ÷ 3

Contribution margin per furnace hour $ 6.00 $ 7.50 $ 12.00

The Regular Grade steel has the largest contribution margin per unit ($36) and the largest contribution margin per furnace hour ($12). Both Good Grade and High Grade have the same contribution margin per unit of $30. However, using production bottleneck analysis indicates that the Good Grade is actually more profitable at $7.50 contribution margin per furnace hour than High Grade’s $6.00 contribution margin per furnace hour. Thus, the company would want to sell product in the following preference order:

1. Regular Grade

2. Good Grade

3. High Grade

Prob. 25–6B Concluded

3. One way to revise the pricing would be to increase the price to the point where all three products produce profitability equal to the highest profit product. This would be determined as follows:

Revised Price of High Grade Steel:

[pic] = [pic]

$12 = (Revised Price of High Grade – $240)/5 hrs.

$60 = (Revised Price of High Grade – $240)

$300 = Revised Price of High Grade

High Grade steel would require a revised price of $300 in order to deliver the same unit contribution margin per bottleneck hour as does Regular Grade steel.

Revised Price of Good Grade Steel:

[pic] = [pic]

$12 = (Revised Price of Good Grade – $220)/4 hrs.

$48 = (Revised Price of Good Grade – $220)

$268 = Revised Price of Good Grade

Good Grade steel would require a revised price of $268 in order to deliver the same unit contribution margin per bottleneck hour as does Regular Grade steel.

SPECIAL ACTIVITIES

Activity 25–1

No, it would be unethical for Lucinda to attend the meeting. Such a meeting would be considered price fixing and would be a violation of federal law. Thus, Lucinda’s attendance would be a criminal act. Her actions would also discredit her reputation and that of the profession.

Activity 25–2

The contribution margin is $6 ($24 – $18) per dozen on the special order. Thus, Fairways and Greens’ manager can contribute to fixed costs by accepting the order. However, there are some additional considerations the manager must consider before accepting this order.

1. Have we ever done business overseas? Exports require additional administrative activities. Have these additional administrative costs been considered in the differential analysis?

2. Will the customer sell the golf balls overseas, or will they relabel the golf balls and have them imported back into the United States? Such a situation would cause Fairways and Greens to be competing against itself.

3. Is it likely that other customers will learn of the “special deal” the overseas company received and demand equal treatment? That is, is there a risk that we’ll spoil the pricing structure in the domestic market?

4. Will the overseas customer want to do business in the future, or is this just a single sale? If the overseas customer is expected to purchase more golf balls in the future, then it is likely that the customer will come to expect the $24 price in the future.

5. Is there a possibility of another customer being willing to purchase the golf balls at the $34 price? If so, Fairways and Greens may not want to commit capacity to the overseas customer. Once the capacity is committed, it will be difficult to sell to anyone else.

6. Will we help the overseas customer establish a presence in the overseas golf ball market where we may wish to compete in the future?

Activity 25–3

First, Marriott has excess capacity for this day. Thus, it should not be concerned about using its capacity to accept business from the customer. The customer is incremental revenue that will not crowd out other business. Given this, however, the price must at least cover variable cost, or else Marriott would lose money. The variable cost per room night is shown below.

Housekeeping labor cost $34

Cost of room supplies (soap, paper, etc.) 6

Laundry labor and material cost 10

Utility cost (mostly air conditioning) 4

Total variable cost per day per room $54

These costs are mostly avoidable, or variable to room nights. This answer assumes that the maid and laundry staff hours are highly flexible and can be staffed to demand. Likewise, the air conditioning and lights can be turned off if the room is not rented for the night, saving most of the utility cost. The desk staff and hotel depreciation are either sunk (depreciation) or mostly fixed to the number of room nights. Therefore, they are not variable to accepting this business. The total variable costs are $54 per night, so the $70 customer bid should be accepted.

Note to Instructors: There could be some discussion about the degree that some of these costs are fully variable. For example, it’s likely that some utility cost must be incurred for the room, whether it is occupied or not. Likewise, the housekeeping and laundry staff hours may not be as flexible to demand as assumed here. There should be very little question about the room supplies (full variable) or the hotel depreciation (sunk). Regardless of the assumptions, the decision would remain the same.

Activity 25–4

a. Cam believes that the fixed costs should be treated as a sunk cost and ignored in the pricing decision. In essence, Cam is suggesting that the new computer model be treated as an incremental decision. However, the new model is not a special incremental decision. It is a core product that must contribute to covering fixed costs. If the product price does not cover fixed costs and provide a profit, then Digi-Comp Computer Company will not be competitive in the long term. In the long term, the price must cover all costs, plus a profit markup. Thus, Cam’s solution to the pricing decision is not a good one.

b. Target costing provides a different perspective to the pricing issue. Under target costing, Digi-Comp Computer Company should begin with the price the market is willing to pay, which is $1,250. This price should then be reduced by the required profit markup. This would yield a target cost of $1,000 ($1,250/1.25), which is $200 lower than the present product cost. The new target cost should be established as a cost reduction target. The company should vigorously improve the product design and processes in order to achieve a $1,000 product cost. In this way, the company can compete profitably.

Target costing takes the market price as given and adjusts the cost in order to yield the required profitability. This approach is best used in highly competitive product markets where declining prices require cost reduction in order to compete.

Activity 25–5

a. This activity is designed to have students access a number of products and services on the Internet to see their commercial potential. Each of the listed sites will provide product descriptions and pricing.

The list of costs in the products will not be determined at the Internet site but must be assumed. Some examples include:

Delta Air Lines—Airline tickets Fixed or Variable?

Fuel V

Crew salaries F

Plane depreciation F

Landing fees V

Travel agent commissions V

Lease costs (gates) F

Ground salaries F

Equipment depreciation F

Assume that the activity base is the number of passenger miles for determining fixed and variable costs. Employee salaries for an airline are relatively fixed, and only become variable when there are significant changes to the flight schedule.

—Books Fixed or Variable?

Cost of books (purchased for resale) V

Web page design and programming F

Computer depreciation F

Order handling and packing wages V

Freight V

Assume that the activity base is the number of books sold for determining fixed and variable costs.

Dell Inc.—Personal computers Fixed or Variable?

Cost of computers (dl, dm, and foh) V (mostly)

Web page design and programming F

Advertising F

Order handling and packing wages V

Freight V

Bundled software V (depends on

contract terms with

software vendor)

Assume that the activity base is the number of PCs sold for determining fixed and variable costs. One could argue that advertising might be variable.

Activity 25–5 Concluded

b. The product with the largest markup on variable cost is the airline ticket. The portion of variable cost to total cost for an airline flight will be much smaller (more fixed cost) than the other two products. Thus, the markup on variable cost will be a greater percent. As a result, the airline product has a larger contribution margin, but it also has a larger fixed cost to cover. This creates larger operating leverage (and risk) than the other two products.

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