Managerial Accounting 08

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ost major airlin e s ,in c lu d in gDe lt a , o u t s o u rc ewo rk . I n 20 02, Delta announcedplan s t o s a v e o v e r $ 1 5 millio n a y e a r b y and its work to call centersin the Philippines outsourcing reservation plansto cut maintenance costs347"ayear lndia.ln 2005,Deltarevealed b y outsourcing much of its a irp la n e ma in t e n a n c et o Mia mi- a n d firms. But why would Delta outsourceso much of its Canadian-based are work? Primarily cut costs.Most of the majorairlines experiencing to s fin ancial due to ri s in gf u e l c o s t sa n d t ig h t c o mp e t it io n , o difficulties they need to find ways to cut costs.One way is through outsourcing. call center work to can save 20o/o more by outsourcing or Companies countries. English-speaking workersin developing to on companies concentrate their core Outsourcing alsoenables in When competencies-theoperatingactivities whichthey are experts.
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companies focus on just their core competencies, they often outsource the activitiesthat do not give them a competitive advantage.For example,heavy maintenance aircraft,which can take two to three of weeks per plane, requires specializedexpertise. This expertise is providedby members the outsideairlinemaintenance of industry, which performsover half of all airlinemaintenance. Delta'sstrategyis to focus on its core competency-flying passengers-and outsource other operatingactivities, such as reservations and airplanemaintenance, to companies who excel at those activities.ffi
Learning Objectives
fl Oescribe and identifyinformation relevant short-term to business decisions
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V"t" special orderdecisions
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Vrt" pricing decisions
a department, territory or decisions ffil V.t" dropping product,
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V"t" product decisions mix

(make-or-buy) V"t" outsourcing decisions Vf.t" sellasis or process furtherdecisions
[n th. last chapter, we saw how managers use cost behavior to determine the company's breakevenpoint and to estimate the sales volume needed to achieve target profits. In this chapter,we'll seehow managersuse their knowledge of cost behavior to make six specialbusiness decisions, such as whether to outsourceoperating activities.The decisionswe'll discussin this chapter pertain to short periods of time, so managersdo not needto worry about the time value of money.In other words, they do not need to compute the present value of the revenuesand expensesrelating to the decision.In Chapter 9, we will discusslonger-termdecisions(suchas buying equipment and undertaking plant expansions)in which the time value of money becomesimportant. Before we look at the six businessdecisionsin detail, Iet's consider a manager's decision-makingprocessand the information managersneedto evaluatetheir options.
How ManagersMake Decisions

Exhibit 8-1 illustrates how managers decide among alternative courses of action. Management accountants help gather and analyze releuant information to compare alternatives. Management accountants also help with the follow-up: comparing the actual results of a decision to those originally anticipated. This feedback helps management as it faces similar types of decisionsin the future. It also helps management adjust current operations if actual results of its decision are markedly different from those anticioated.
Business Decisions Short-Term
415
MakeDecisions HowManagers
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'When managersmake decisions, they focus on costs and revenuesthat are relevant to the decisions.Exhibit B-2 shows that relevant information: 1,. Is expectedfuture data. 2. Differs among alternatives. Describe and identify i nformati on relevant to short-term busi ness decisions
Relevant Information
S ales o re c a s t F
Ac c ept pec i a l r d e r s o Salesev en u$ 1 0 0 r e M R e j e c tp e c i a l r d e r s o Sales revenue M $75
Recall our discussionof relevant costs in Chapter 2. In deciding whether to purchase a Toyota Corolla or Nissan Sentra, the cost of the car, the salestax, and the insurancepremium are relevant because thesecosts: . Are incurred in the future (after you decide to buy the car). . Differ between abernatiues (each car has a different invoice price, salestax, and insurancepremium).
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These costs are releuant because they affect your decision of which car to purchase. Irreleuant costs are costs that do not affect your decision. For example, becausethe Corolla and Sentra both have similar fuel efficiency and maintenance ratings, we do not expect the car operating costs to differ between alternatives. Because these costs do not differ, they do not affect your decision. In other words, they are irreleuant to the decision. Similarly, the cost of a campus parking sticker is also irrelevant because the sticker costs the same whether vou buv the Sentra or the Corolla. Sunk costs are also irrelevant to your decision. Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. Perhaps you want to trade in your current truck when you buy your new car. The amount you paid for the truck-which you bought for $15,000 ayear ago-is a sunk cost. In fact,it doesn't matter whether you paid $15,000 or $50,000-it's still a sunk cost. No decision made now can alter the past. You akeady bought the truck, so the price you paid for it is a sunk cost. AII you can do now is keep the truck, trade it in, or sell it for the best price you can get, even if that price is substantially less than what you originally paid for the truck. \7hat rs relevant is what you can get for your truck in the future. Supposethe Nissan dealership offers you $8,000 for your truck. The Toyota dealership offers you $10,000. Becausethe amounts differ and the transaction will take place in the future, the trade-in value is relevant to your decision. The sameprinciple applies to all situations-only releuant data affect decisions. Let's consider another application of this general principle. Suppose Pendleton tffoolen Mills is deciding whether to use pure wool or a wool blend in a new line of sweaters.Assume that Pendleton'Woolen Mills oredicts the following costs under the two alternatives:
The cost of direct materials is relevant becausethis cost differs between alternatives (the wool costs $4 more than the wool blend). The labor cost is irrelevant becausethat cost is the same for both kinds of wool.
Youareconsidering your Pentium computer replacing lV with the latest model.ls the $1,200 you spent (in 2005) the Pentium on relevant your decision to about buying the newmodel? Artfiu'+.*r'; $'l,2OO The cost of your Pentiumis irrelevant. $1,200 a sunkcost The is that you incurredin the past, so it is the same whether or not you buy the new comouter.
BusinessDecisions Short-Term
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Relevant Nonfinancial Information

Nonfinancial, or qualitative factors, also play a role in managers' decisions. For example, closing manufacturing plants and laying off employeescan seriously hurt employee morale. Outsourcing can reduce control over delivery time and product quality. Offering discounted prices to select customers can upset regular customers and tempt them to take their businesselsewhere.Managers must think through the likely quantitative and qualitative effects of their decisions. Managers who ignore qualitative factors can make serious mistakes. For example, the City of Nottingham, England, spent $t.6 million on 215 solarpowered parking meters after seeing how well the parking meters worked in countries along the Mediterranean Sea. However, the city did not consider that British skies are typically overcast. The result? The meters didn't always work because of the lack of sunlight. The city /osf money because people ended up parking for free! Relevant qualitative information has the same characteristics as relevant financial information: The qualitative factor occurs in the future, and it differs between alternatives. The amount of futwre sunshine required differed between alternatives: The mechanical meters didn't require any sunshine, but the solar-powered meters needed a great deal of sunshine. Likewise, in deciding between the Corolla and Sentra, you will likely consider qualitative factors that differ between the cars (legroom, trunk capacity, dashboard design, and so forth) before making your final decision. Since you must live with these factors in the future, they become relevant to your decision.
Keysto Nlaking$hort-Terrn SpecialDecisions

Our approach makingshort-term is information to special decisions calledthereleuant approachor the incremental approach.Instead looking at the company's of analysis entire income statementunder each decisionalternative,we'll just look at how Usingthis approach, operating incomewould change differ undereachalternative. or that won't differ we'II leaveout irrelevantinformation-the costsand revenues between alternatives. 'We'll consider kinds of decisions this chapter: in six 1. Special sales orders 2. Pricing 3. Droppingproducts,departments, territories and 4. Productmix (makeor buy) 5. Outsourcing 6. Sellingasis or processing further As you study thesedecisions, keep in mind the two keys in analyzingshort-term special business decisions shownin Exhibit 8-3: 1. Focus on relevant revenues, costs,and profits. Irrelevant information only cloudsthe picture and creates information overload.That's why we'll usethe incremental analysis approach. 2. Use a contribution margin approachthat separates variablecostsfrom fixed theymustbe anacosts. Because fixed costs costsbehave differently, and variable (absorption lyzedseparately. incomestatements, which blend Traditional costing) marginincome fixed and variablecosts, managers. Contribution can mislead statements, which isolatecostsby behavior(variableor fixed), help managers gatherthe cost-behavior Keepin mind that unit manufacinformationthey need. managers. you use turing costsare mixed costs, If too, so they can alsomislead the fixed unit manufacturing in makesureyou separate cost's costs your analysis, and variable comoonents first.
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\7e'll use these two keys in each decision.
Two Keysto MakingShort-Term Decisions Special
SalesOrder and Regular Special PricingDecisions

'We'll by decisions looking at specialsales on start our discussion the six business did In the past,managers not consider and order decisions regularpricing decisions. product life cyclesare shrinking in pricing to be a short-termdecision.However, often sell productsfor only a few months before most industries.Companies have industries them with an updatedmodel.The clothingand technology replacing frequently. Pricing styles change Evenauto and housing alwayshad short life cycles. than it was in the past. decision a hasbecome shorter-term regularpricing order in detail;then we will discuss sales a Let'sexamine special decisions.
SpecialSalesOrder Decisions
Makespecial o r derdec is ions
requests one time order at a reducedsales a order occurswhen a customer A special pri-e. Often, thesespecialorders are for large quantities.Before agreeingto the shownin Exhibit 8-4. the must consider questions deal,management special
OrderConsiderations Special
. Do we have excesscapacity available to fill this order? .'Will the reduced salesprice be high enough to cover the incremental costs of filling the order (the variable costs and any additional fixed costs)? . Will the special order affect regular salesin the long run? : ,,' ,,, t:
419
First, managers must consider available capacity. If the company is already making as many units as possible and selling them all at its regular sales price, it 'Why sell for less wouldn't make senseto fill a special order at a reduced salesprice. than the current sales price? Therefore, available excess capacity is a necessityfor accepting a special order. This is true for service firms (law firms, caterers, and so forth) as well as manufacturers. Second, managers need to consider whether the special reduced salesprice is high enough to cover the incremental costs of filling the order. The special price must exceed the variable costs of filling the order, or the company will lose money on the deal. In other words, the special order must provide a positive contribution margin. Next, the company must consider fixed costs. If the company has excess capacity, fixed costs probably won't be affected by producing more units (or delivering more service). However, in some cases, management may need to hire a consultant or incur some other fixed cost to fill the special order. If so, management will need to consider whether the special sales price is high enough to generate a positive contribution margin and cover the additional fixed costs. Finally, managersneed to consider whether the special order will affect regular 'Will salesin the long run. regular customersfind out about the special order and demand a lower price or take their business Vill the specialorder customer elsewhere? 'Sfill the specialorder come back again and again, askingfor the samereduced price? price start a price war with competitors?Managers must gamble that the answersto thesequestionsare no or consider how customerswill respond.Managers may decide that any profit from the specialsalesorder is not worth theserisks. Let's consider a special sales order example. Suppose ACDelco sells oil filters for $3.20 each. Assume that a mail-order company has offered ACDelco + $35,000 for 20,000 oil filters, or $1.75 per filter ($3S,OOO 20,000 = $1.75). This sale will: o Use manufacturing capacity that would otherwise be idle. o Not change fixed costs. o Not require any variable nonmanufactwring expenses (because no extra marketing costs are incurred with this special order). r Not af.fectregular sales. have addressed every consideration except one: Is the special sales price high enough to cover the variable manufacturing costs associatedwith the order? Let's take a look at the wrong way and then the right way to figure out the answer to that question. Suppose ACDelco made and sold 250,000 oil filters before considering the special order. Using the traditional (absorption costing) income statement on the left-hand side of Exhibit 8-5, the manufacturing cost per unit is $2 ($500,000 + 250,000). A manager who does not examine these numbers carefully may believe that ACDelco should not accept the special order at a sale price of $1.75 because each oil filter costs $2.00 to manufacture. But appearances can be deceiving! Remember that the unit manufacturing cost of a product ($2) is a mixed cost containing both fixed and variable cost components. To correctly answer our question, we need to find only the variable portion of the manufacturing unit cost. 'We
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(Absorption Traditional Formatand Contribution Costing) Margin FormatIncomeStatements

- --,
Traditional
Sales revenue Less cost of goods sold Gross profit Less marketing and administrative expenses
Format
Contribution M $800,000 Salesrevenue (500,000) Less variable expenses: Manufacturing 300,000 (200,000) Marketing and administrative
Contribution margin Less fixed expenses: Manufacturing Marketing and
$800,000 $(300,000) (7s,000) (37s,000 ) 425,000
Operating income
$1o0,oo0
Operating income
$(200,000) administrative (125,000) (325,000) $100,000
The right-handsideof Exhibit 8-5 showsthe contributionmarginincomestarement that separates variableexpenses from fixed expenses. coniributionmargin The incomestatement showsthat the uariablemanufacturing costper unit is only $1.20 + ($300,000 250,000). The special sales priceof $1.75is higherthan the variable manufacturing cost of $1.20.Therefore, special the order will providea positive contribution marginof $0.55per unit ($1.2S $1.20).Since special the orderis for 20,000 units, ACDelco'stotal contributionmargin should increase $tt,000 by (20,000 unitsx $0.55per unit) if it accepts order. this Remember that in this example,ACDelco'svariablemarketing expenses are irrelevant because the company will not incur the usual variable marketing expenses this specialorder.However,this won't always be the case.Many on times,companies will also incur variableoperatingexpenses (suchas freight-out) on special orders. Using an incrementalanalysisapproach,ACDelco comparesthe additional revenues from the specialorder with the incrementalexpenses seeif the special to order will contributeto profits. Exhibit 8-6 showsthat the specialsalesorder will increase revenue $gs,o00 (20,000x $1.75),but it will alsoincrease by variable manufacturingcost by $24,000 (20,000 x $1.20). As a result,ACDelco's contributionmargin will increase $11,000,as previously by anticipated.
Incremental Analysis Special of SalesOrder

Expected increasein revenues-sale of 20,000 oil filters x $1.75 each Expected increasein expenses-variable manufacturing costs: 20,000 oil filters X $1.20 each
The other costs shown in Exhibit 8-5 are irrelevant. Variable marketing and administrative expenseswill be the same whether or not ACDelco accepts the special order because ACDelco made no marketing efforts to get this sale. Fixed manufacturing expenses won't change becauseACDelco has enough idle capacity to produce 20,000 extra oil filters without requiring additional facilities. Fixed marketing and administrative expenses won't be affected by this special order either.
BusinessDecisions Short-Term
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Because there are no additional fixed costs,the total increasein contribution margin flows directly to operating income. As a result, the special salesorder will increase operating income by $11,000. Notice that the analysis follows the two keys to making short-term special businessdecisions discussedearlier: (1) focus on relevant data (revenuesand costs that will change if ACDelco accepts the special order) and (2) use a contribution margin approach that separatesvariable costs from fixed costs. To summarize, for special salesorders, the decision rule is:
side of ExhibitB-5 on The absorption costingincomestatement the left-hand What is the filtersis $500,000. 250,000 shows that the total costof manufacturing only if the saleprice orders special flawin reasoning ACDelco shouldaccept that exceeds each? $2 Ammvrru*m flaw in this analysis from treatinga mixedcostas thoughit arises The werevariable. one Manufacturing extraoil filterwill costonly$1.20-the variable ACDelcowill incur because manufacturing are cost. Fixedexpenses irrelevant or whether not the company expenses overhead of $200,000 fixedmanufacturing tota/ will not increase moreoil filters 20,000 accepts special the order.Producing per unit,not at fixedexpenses, manufacturing costsincrease the rateof $1.20 so
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Regular Pricing Decisions

to ACDelcodecided sella limited quantityof oil filters In the special order decision, for $1.75 eacheventhough the normal price was $3.20 per unit. But how did ACDelco decideto set its regularprice at $3.20 per filter? Exhibit 8-7 showsthat when settingregular pricesfor their managers start with three basicquestions Droducts services. or
Makepri ci ng deci si ons
Pricing Regular Considerations

. What is our target profit? . How much rMill customers pay? r Are we a price-taker or a price-setterfor this product?
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The answers to these questions are often complex and ever-changing. Stockholders expect the company to achieve certain profits. Economic conditions, historical company earnings, industry risk, competition, and new business developments all affect the level of profit that stockholders expect. Stockholders usually tie their profit expectations to the amount of assets invested in the company. For example, stockholders may expect a 1,0%"annual return on their investment. A company's stock price tends to decline if the company does not meet target profits, so managers must keep costs low while generating enough revenue to meet target profits. This leads to the second question: How much will customers pay? Managers cannot set prices above what customers are willing to pay, or sales will decline. The amount customers will pay depends on the competition, the product's uniqueness, the effectivenessof marketing campaigns, general economic conditions, and so forth. To addressthe third pricing question, imagine a continuum with price-takers at one end and price-settersat the other end. A company's products and servicesfall somewhere along this continuum, shown in Exhibit 8-8. Companies are price-takers when they have little or no control over the prices of their products or services.This occurs when their products and servicesare not unique or when competition is heavy. Examples include food commodities (milk and corn), natural resources (oil and lumber), and generic consumer products and services (paper towels, dry cleaning,and banking).
Price-Takers VersusPrice-Setters
Price-takers Price-setters
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Companies are price-setterswhen they have more control over pricing-in other words, they can "set" the price to some extent. Companies are price-setters when their products are unique, which results in less competition. Unique products such as original art and jewelrS specially manufactured machinery, patented perfume scents,and custom-made furniture can command higher prices. Obviously, managers would rather be price-setters than price-takers. To gain more control over pricing, companies try to differentiate their products. They want to make their products unique in terms of features, service, or quality-or at least make you think their product is unique or somehow better even if it isn't. How do they do this? Primarily through advertising. Consider Nike's tennis shoes,Starbucks' coffee, Hallmark's wrapping paper, Nexus' shampoo, Tylenol's acetaminophen, General Mills' cereal, Capital One's credit cards, Shell'sgas,Abercrombie and Fitch's jeans-the list goes on and on. Are theseproducts really better or significantly different from their lower-priced competitors? Possibly.If these companies can make you think so, they've gained more control over their pricing becauseyou are willing to pay more for their products or services.The downside? These companies must charge higher prices or sell more just to cover their advertising costs.
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A company's approach to pricing depends on whether its product or service is on the price-taking or price-setting side of the spectrum. Price-takers emphasize a target-pricing approach. Price-settersemphasizea cost-plus pricing approach. Keep in mind that many products fall somewhere along the continuum. Therefore, managers tend to use both approaches to some extent. 'We'll now discuss each approach in turn.
Target Pricing
\flhen a company is a price-taker, it emphasizesa target pricing approach to pricing. Target pricing starts with the market price of the product (the price customers are willing to pay) and subtracts the company's desiredprofit to determine the product's target full cost-the full cost to develop, design, produce, market, deliver, and service the product. In other words, the full cost includes every cost incurred throughout the value chain. Revenue market price at Less: Desiredprofit
Iarggtls!-sqq-In this relationship, the market price is "taken." If the product's current cost is higher than the target cost, the company must find ways to reduce costs; otherwise it will not meet its profit goals. Managers often use ABC costing along with value engineering (as discussedin Chapter 5) to find ways to cut costs. Let's look at an example of target pricing. Let's assumethat oil filters are a commodity and that the current market price i s $3. 00 per f ilt er (n o t th e $ 3 .2 0 s a l e s p ri c e assumed i n the earl i er A C D el co example). Becausethe oil filters are a commodity, ACDelco will emphasize a target-pricing approach. Let's assumethat ACDelco's stockholdersexpect a 1,0Yo the annual return on the company'sassets. the company has $1,000,000 of assets, If profit is $100,000 ($1,000,000x 10%). Exhibit 8-9 calculates target full the desired cost at the current salesvolume (250,000 units). Once we know the target full cost, we can analyzethe fixed and variable cost components separately.
TargetFullCost Calculating
Total
Revenue at market price Less: Desired profit
250,000 unitsX $3.00price= 10% x $1,000,000 assets of
$750,000
I
full cost
000
Can ACDelco make and sell 250,000 oil filters at a fsII cost of $650,000?We know from ACDelco's contribution margin income statement (Exhibit 8-5) that the co m pany ' s v ar iab l e c o s ts a re $ 1 .5 0 p e r u n i t ($375,000 + 250,000 uni ts). Thi s variable cost per unit includes both manufacturing costs ($t.ZO per unit) and marketing and administrative costs ($0.30 per unit). We also know that the company incurs $325,000 in fixed costs in its current relevant range. Again, some fixed cost stems from manufacturing and some from marketing and administrative activities. In setting regwlar sales prices, companies must couer all of their costswhether inuentoriable or period, fixed or uariable.
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Making and selling 250,000 filters currently costs the company $700,000 [(250,000 units x $1.50 variable cost per unit) + $325,000 of fixed costs],which is more than the target full cost ($650,000). So, what are ACDelco's options? 1. Accept a lower profit (an operating income of $50,000, which is a 5"/o return, not the 10"/" target return) 2. Cut fixed costs 3. Cut variable costs 4. Use other strategies. For example, ACDelco could attempt to increase salesvolume. Recall that the company has excesscapacity, so making and selling more units would affect only variable costs. The company could also consider changing or adding to its product mix. Finally, it could attempt to differentiate its oil filters (or strengthen its name brand) to gain more control over salesprices. Let's look at some of these options. ACDelco may first try to cut fixed costs. As shown in Exhibit 8-10, the company would have to reduce fixed costs to $275,000 to meet its target profit level.
Calculating TargetFixedCost
Total 375
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The companywould start by considering whetherany discretionary fixed costs could be eliminated without harmingthe company. Since committedfixed costsare nearlyimpossible change the short run, ACDelcowill probablynot be ableto to in reduce this type of fixed cost. If the company its can'treduce fixedcosts $50,000($325,000 by currentfixed costs- $275,000target fixed costs),it would haveto lower its variablecost ro $1.30per unit, asshownin Exhibit 8-11.
Calculating TargetUnitVariable Cost

Total
Target full cost Less: Current fixed costs Target total variable costs Divided by number of units
i:-
25 $325,000
+2
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1.30
Perhapsthe company could renegotiateraw materials costs with its suppliers or find a less costly way of packaging or shipping the air filters.
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However, if ACDelco can't reduce variable costs to $1.30 per unit, could it meet its target profit through a combination of lowering both fixed costs and variable costs?
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lf Suppose ACDelco its fixedcosts onlyby $25,000. it wants but canreduce current the variable cost of to meet its targetprofit,by how muchwill it haveto reduce units. eachunit? Assume that sales volumeremains 250,000 at 1" Companies 'ilir";'', costs Because typically to cut both fixed and variable try ACDelco cancut itsfixedcostsonlyby $25,000, meet itstargetprofit,it would to haveto cut itsvariable costsaswell: Targetfull cost...... ($325,000 $25,000).............. Less: Reduced fixedcosts Targettotal variablecosts Dividedby numberof units....... Target variable costper unit............. $ 650,000 (300,000) $ 350,000 + 250,000 $ 1.40
In additionto cutting its fixed costsby $25,000, companymust reduceits the variable per to costsby $0.'10 unit ($1.50 $1.40) meet its target profit at the existing volume sales. of
Another strategy would be to increasesales.ACDelco's managers can use CVP analysis,as you learned in Chapter 7, to figure out how many oil filters the company would have to sell to achieve its target profit. How could the company increase demand for the oil filters? Perhaps it could reach new markets or advertise. How much would advertising cost-and how many extra oil filters would the company have to sell to cover the cost of advertising? These are only some of the questions managersmust ask. As you can see,managers don't have an easytask when the current cost exceedsthe target full cost. Sometimes,companies just can't compete given the current market price. If that's the case, they may have no other choice than to exit the market for that product.
Cost-PlusPricing
S7hen a company is a price-setter, it emphasizes a cost-plus approach to pricing. This pricing approach is essentiallythe opposite of the target-pricing approach. Cost-plus pricing starts with the product's full costs (as a given) and adds its desired profit to determine a cost-plus price. Full cost profit Plus:Desired price Cost-plus
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When the product is unique, the company has more control over pricing. However, the company still needsto make sure that the cost-plus price is not higher than what customers are willing to pay. Let's go back to our original ACDelco example. This time, let's assumethat the oil filters benefit from brand recognition, so the company has some control over the price it charges for its filters. Exhibit 8-12 takes a cost-plus pricing approach assumingthe current level of sales:
CalculatingCost-Plus Price
Calculations 250,000 unitsx $1.50perunit = Total ,t:
Current variable costs Plus: Current fixed costs Full product cost Plus: Desired profit Ta.rget revenue Divided by number of units Cost-plus orice per unit
10% x $1,000,000 ofassets
$375,000 325,000 $700,000 + 100,000 $800,000 250.000 $ 3.20

+
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If the current market price for generic oil filters is $3.00, as we assumed earlier, can ACDelco sell its brand-name filters for $3.20 apiece? The answer depends on how well the company has been able to differentiate its product or brand name. The company may use focus groups or marketing surveys to find out how customers would respond to its cost-plus price. The company may find out that its cost-plus price is too high, or it may find that it could set the price even higher without jeopardizingsales.
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Wh i c h c o s ti n g s y s tem (j ob costi ng or process costi ng) do you thi nk pri ce-s et t er s a n d p ri c e -ta k e rs typi cal l yuse? h,,t'tyt,,tr,il,r.:tu, Companies tend to be price-setters when their products are unique. U n i q u e p ro d u c tsa re produced as si ngl e i tems or i n smal l batches.Therefore, hese t c o mp a n i e s u s e j o b costi ng to determi ne the product' scost. H ow ever,companies a re p ri c e -ta k e rs when thei r products are hi gh-vol ume commodi ti es. P rocess costing better suits this type of product.
Notice how pricing decisions used our two keys to decision making: (1) focus on relevant information and (2) use a contribution margin approach that separates variable costs from fixed costs. In pricing decisions,all cost information is relevant becausethe company must cover all costs along the value chain before it can generatea profit. However, we still neededto consider variable costs and fixed costs separatelybecausethey behave differently at different volumes.
Short-Term Business Decisions 427
Our pricing decision rule is:
lf company a ., ;r : is fortheproduct:
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Decision Guidelines
Relevarur lruronumoN Busrruess FoR Decrsrorrrs
Nike makesspecialorder and regular pricing decisions. Even though it sellsmass-produced tennis shoesand sportsclothing, Nike has differentiatedits productswith advertising. Nike's managers considerboth quantitative and qualitative factors as they make pricing decisions. Here are key guidelinesthat Nike's managersfollow in makins their decisions.
Decision
\fhat information is relevant to a short-term soecial business decision?
Guideline
Relevant information: 1. Pertains thefwtwre to 2. Differs between alternatives
J,. Focus on releuant data. 2. Use a contribution margin approach that separates variable costs from fixed costs. If the revenue from the order exceedsthe extra variable and fixed costs incurred to fill the order, then accepting the order will increaseoperatrng rncome. Nike considers: 'S7hat 1. profit stockholders expect 2. \7hat price customerswill pay 'lThether 3. it is a price-setteror a price-taker Nike has differentiatedits products through advertisingits brand name.Thus, Nike tendsto be a price-setter. Nike's managers can emphasize cost-plusapproachto pricing. a PaylessShoeSourcesellsgeneric shoes (no-name brands) at low prices. Paylessis a price-taker, so managers use a target-pricing approach to pncrng.
\fhat are two key guidelines in making short-term specialbusiness decisions?
Should Nike accept a lower salesprice than the regular price for a large order from a customer in S5o Paulo, Brazil?
\7hat shouldNike consider settingits regular in productprices?
\7hat approachshouldNike take to pricing?
\7hat approach should discount shoe stores such as PaylessShoeSource take to pricing?
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SzigetyIndustriesmakestennis balls. Szigety's only plant can produce up to 2.5 million cans of balls per year. Current production is 2 million cans. Annual manufacturing, selling,and administrativefixed coststotal $700,000. The variable cost of making and selling each can of balls is $1. Stockholdersexpect a 12'h annual return on the company's$3 million of assets. Requirernearts 1. \fhat is Szigety'scurrent full cost of making and selling 2 million cans of tennis balls? \ifhat is the current hlll wnit cost of each can of tennis balls? 2. Assumethat Szigety Industriesis a price-takerand the current market price is $1.45 per can of balls (this is the price at which manufacturerssell to retailers).\7hat is the target full cost of producing and selling 2 million cans of balls? Given Szigety Industries'current costs, will the companyreachstockholders'profit goals? 3. If Szigety Industries cannot change its fixed costs, what is the target variable cost per can of balls? 4. SupposeSzigetyIndustries could spend an extra $100,000 on advertising to differentiate its product so that it could be a price-setter.Assuming the original volume and costs plus the $100,000 of new advertisingcosts,what cost-plus price will SzigetyIndustries want to charge for a can of balls? 5. Nike has just askedSzigety Industries supply400,000 cansof balls at a special to order price of $1.20 per can. Nike wants SzigetyIndustries packagethe balls to will imprint the Nike logo on each ball and can). under the Nike label (Szigety SzigetyIndustrieswill have to spend $10,000 to changethe packagingmachinery. Assuming the original volume and costs,should SzigetyIndustriesaccept this specialorder? (Unlike the chapter problem, assumethat Szigetywill incur variable sellingcostsas well as variable manufacturing costsrelated to this order.)
ffi,wtnlwnhilmnl*
Heq nniremrrenrlit .'11 The full unit cost is:
Fixedcosts
$ 70o,ooo Plus: Total variable costs(2 million cansx $1 per unit) ......... + 2,000,000 Totalfull costs ........... $2,700,000 * 2,000,000 Divided number cans........ by of Fullcostpercan....... 1.3s $
ffiequnrememtP The targetfull costis: Revenue marketprice(2,000,000 at units x $1.45price)..........$2,900,000 profit (12"/.X $3,000,000 assets) Less: Desired (3 6 0 , 0 0 0 ) of Targetfwll cost ......
$2,540,000
($2,700,000 Industries' Szigety currenttotal full costs from Requirement are 1) higherthanthe targetfull cost($2,540,000). Szigety If Industries can'tcur $160,000 costs,it won't be ableto meetstockholders' profit expectatrons.
Chapter 8
r.Beqrunneennonnit .B Assumingthat Szigety Industriescannot reduceits fixed costs,the target variable

cost pef can ls:
Target fwll cost (from Requirement2)............... L es s :F ix ed c os ts ........... Target total variable costs D iv ided by num b e r o f u n i ts ....... T ar get v ar iablec o s t p e r u n i t.............
$ 2,540,000 (700.000) $ 1,840,000 + 2,000,000 $ O.gZ
Since SzigetyIndustries cannot reduce its fixed costs,it needsto reduce variable co s t sby $0. 08 per c a n ($ 1 .0 0 - $ 0 .9 2 )to me e t i ts profi t goal s.Thi s w oul d requi re an 8"/" cost reduction in variable costs,which may not be possible. filetqLurntrernerat 4 If Szigety Industries can differentiate its tennis balls, it will gain more control over pricing. The company's new cost-plus price would be: C ur r ent t ot al c o s ts(fro m R e q u i re m e n t )..... ........... 1 PI us :A ddit iona l c o s t o f a d v e rti s i n g ................. Plus :Des ir edpro fi t (fro m R e q u i re me t 2 ).... .......... n Target revenue D iv ided by num b e r o f u n i ts ....... C os t - pluspr ic e p e r u n i t.............
$2,70o,ooo + 100,000 + 360,000 $3,160,000 + 2,000,000 1.58 $
SzigetyIndustries must study the market to determine whether retailers would p a y $1. 58 per c an o f b a l l s . Rt+ie1.U il I L'enrlr+Lll5 Nike's specialorder price ($1.201is iessthan the current full cost of eachcan of balls ($ 1. : S f r om Requ i re me n t 1 ). H o w e v e r, th i s s h oul d not i nfl uence management' s decision. Szigety Industries could fill Nike's special order using existing excess capacity.SzigetyIndustriestakes an incremental analysisapproach to its decision: comparing the extra revenue with the incremental costs of accepting the order. Variable costs will increaseif SzigetyIndustries acceptsthe order, so the variable costs are relevant. Only the additional fixed costs of changing the packaging machine ($10,000) are relevantsinceall other fixed costswill remain unchanged. Revenuefrom specialorder (400,000 x $1.20 per unit) Less:Variable cost of specialorder (400,000 x $1.00) Contribution margin from specialorder........... Less:Additional fixed costsof specialorder.......... O per at inginc o m ep ro v i d e d b y s p e c i a lo rd e r. ......... .. $480,000 (400,000) $ 80,000 (10,000) $ 70,000
SzigetyIndustriesshould acceptthe specialorder because will increase it operating income by $70,000. However, SzigetyIndustriesalso needsto considerwhether its regular customerswill find out about the specialprice and demand lower prices,too.
Short-Term Business Decisions
43(J
Chapter 8
Other Short-Term Special Business Decisions

In the second part of the chapter, we'll look at other short-term businessdecisions that managers face, including: . . . . '$7hen to drop a product, department, or territory. 'Sfhich products to emphasizein product mix decisions. '$fhen to outsource. When to sell as is or orocessfurther.
Decisionsto Drop Products, Departments, or Territories

M ak edr oppinga product,department, or territory decisions Managers often must decide whether to drop products, departments, or territories that are not as profitable as desired. Newell Rubbermaid-maker of Sharpie markers, Graco strollers, and Rubbermaid plastics-recently dropped some of its European products lines. Home Depot closed some of its Expo stores. Kroger food stores replaced some in-store movie rental departments with health food departments. How do managersmake these decisions?Exhibit 8-13 shows some questions managersmust consider when deciding whether to drop a product line, department, or terrltory.
Considerations for Dropping Products, Departments, Territories or

. Does the product provide a positive contribution margin? . \7ill fixed costs continue to exist even if we drop the product? . Are there any direct fixed costs that can be avoided if we drop the product? . Will dropping the product affect salesof the company's other products? . What could we do with the freed caoacitv?
Once again, we follow the two key guidelines for special business decisions: (1) focus on relevant data and (2) use a contribution margin approach. The relevant financial data are still the changesin revenuesand expenses, but now we are considering a decreasein volume rather than an increase, as we did in the special sales order decision. In the following example, we will consider how managers decide to drop a product. Managers use the same process in deciding whether to drop a department or territory. Earlier, we assumedthat ACDelco offered only one product-oil filters. Now, let's assumethat it makes and sells air cleaners,too. Exhibit 8-14 shows the company's contribution margin income statement by product line. Becausethe air cleaner product line has an operating loss of $19,074, management is considering dropping it. The first question management should ask is, does the product provide a positive contribution margin? If the product line has a negative contribution margin, the product is not even covering its variable costs. Therefore, the company should drop the product line. However, if the product line has a positive contribution margin, it is
431
MarginIncome Statements Contribution by ProductLine

Product Line Total
S a l e sr e v e n u e . . . ........... L e s s :V a r i a b l e . " o."r J Less: Fixed expenses: Manufacturing Marketing and adrninistratiye..... Total fixed expenses Operatir-rg income (loss)
Oil Filters $800,000

(375,000) 425,000
Air Cleaners
ut)_ QQ s )=QZ-QS_0.* _. PJ9,glgu ni1s (?Q, Q qnrt ) t.r "

$ 8 3 5 ,0 0 0 430,000 (200,000) (12s,000) (325,000) $105,000
i.i|,{l{liri
....................... (405,000)
C o n t r i b u t i o n m ar g in ............
(18s,18s ). (11.s,741)I (300,926)
= 50.74074 $14,875 x $0 462963= $9.2s9
helping to cover at least some of the company's fixed costs.In ACDelco's case,the air cleanersprovide a $5,000 positive contribution margin. ACDelco's managersnow need to consider fixed costs. SupposeACDelco allocatesfixed expensesbetween product lines in proportion to the number of units sold. Dividing the fixed manufacturing expenseof $200,000 b y 270, 000 t ot al u n i ts (o i l fi l te rs , 2 5 0 ,0 0 0 ; a ir cl eaners,20,000) yi el ds a fi xed manufacturing cost of $0.74074 per unit. Allocating this unit cost to the 250,000 oil filters assignsfixed manufacturing cost of $185,185 to this product, as shown in Exh ibit 8- 14. T he s a me p ro c e d u re a l l o c a te s$ 1 4,815 to the 20,000 ai r cl eaners. Fixed marketing and administrative expensesare allocated in the same manner. It is important to note that this allocation method is arbitrary. ACDelco could allocate fixed costs in many different ways, and each way would have allocated a different amount of fixed costs to each product line. Sincethe amount of fixed costs allocated to each product line will differ depending on the allocation method used, we need to look at fixed costs in a different light. What matters is this: 1. \fill the total fixed costs continue to exist euen if the product line is dropped? 2. Can any direct fixed costs of the air cleaners be avoided if the product line is dropped?
Fixed Costs Continue to Exist (UnavoidableFixed Costs)

Fixed costs that will continue to exist even after a product is dropped are often called unavoidable fixed costs.Unavoidable fixed costs are irrelevant to the decision becausethey will not differ between alternatives - they will be incurred regardless of whether the product line is dropped. Let's assumethat all of ACDelco's fixed costs ($325,000) will continue to exist even if the company drops the air cleaners. Perhaps ACDelco makes the air cleanersin the same manufacturing facilities as the oil filters and uses the same administrative overhead. If that is the case, only the contribution margin the air cleaners provide is relevant. If ACDelco drops the air cleaners,it will lose the $5,000 contribution margin that they provide. The incremental analysis shown in Exhibit 8-15 verifies the loss. If ACDelco drops the air cleaners,revenue will decreaseby $35,000; but variable expenseswill decreaseby only $30,000, resulting in a net $5,000 decreasein operating income. Becausethe company's total fixed costs are unaffected, they aren't included in the analysis.This analysis suggests that management should not drop the air cleaners.
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Chaoter8
Analysis Dropping Product for a Incremental WhenFixedCostsContinue Exist to

Expected decrease in revenues: Sal eof ai r cl eaners(20,000 x $1.75) Expected decrease in expenses: Variable manufacturing expenses(20,000 x $1.50)
$3s,000
Pxp,""ls!,4cqry!:9A
lncome
'We is could also verify that our analysis correctby looking at what would were dropped: remainif the air cleaners marginfrom oil filters.......... Contribution $ +2S,OOO (all (325,000) fixed expenses unavoidable)...................... Less: Company's income........ Remaining operating $ 100p00 ($100,000) incomeafter droppingthe air cleaners The company's operating ($105,000). This verifies our earlierconclusion: would be $5,000lessthan before Keepin by the incomewould decrease $5,000if it dropped air cleaners. ACDelco's have many product lines. Therefore,analyzingthe mind that most companies more easilyby performing decision drop a particularproductline is accomplished to (as an incremental analysis we did in Exhibit 8-15) rather than addingup all of the 'We revenues and expenses that would remain after dropping one product line. as of analysis a means proving our original result. simplyshow this second
Direct Fixed Costs That Can Be Avoided

Even though ACDelco allocatesits fixed costsbetweenproduct lines, some of the fixed costs might belong strictly to the air cleanerproduct line. Thesewould be direct fixed ACDelco employsa part-time supervisor costsof the air cleaners.lFor example,suppose jwst the air cleanerproduct line. The supervisor's to oversee $13,000 salary is a direct fixed cost that ACDelco can auoid if it stops producing air cleaners.Avoidable fixed costs, such as the supervisor'ssalary, are releuant to the decision becausethey differ betweenalternatives(they will be incurred if the company keepsthe product line; they will not be incurred if the company drops the product line). Exhibit 8-16 shows that in this situation, operating income wlll increaseby $8,000 if ACDelco drops air cleaners. \il/hy? Becauserevenues will decline by The result is a net $35,000 but expenseswill decline even more-by $+.l,OOO. that management increaseto operating income of $8,000. This analysis suggests should drop the air cleaners.
Other Considerations
Management must also consider whether dropping the product line, department, or territory would hurt other sales.In the examples given so far, we assumedthat dropping the air cleaners would not affect oil filter sales.However, think about a
1To aid in decision making, companies should separatedirect fixed costs from indirect fixed costs on their contribution margin income statements. Companies shot:,ldtrace direct fixed costs to the appropriate product line and allocate only indirect fixed costs among product lines. As in the ACDelco example, companies do not always make this distinction on the income statement.
Incremental Analysis Dropping Product for a WhenDirectFixedCosts Can Be Avoided
grocery store. Even if the produce department is not profitable, would managers drop it? Probably not, because if they did, they would lose customers who want one-stop shopping. In such situations, managers must also include the loss of contribution margin from other departments affected by the change when performing the financial analysis shown previously. Management should also consider what they could do with freed capacity. In the ACDelco example, we assumedthat the company produces oil filters and air cleanersusing the same manufacturing facilities. If ACDelco drops the air cleaners, could it make and sell another product using the freed capacity? Managers should consider whether using the facilities to produce a different product would be more profitable than using the facilities to produce air cleaners.
Assume that all of ACDelco's fixedcosts unavoidable.the company are lf dropsair cleaners, they could make sparkplugs with the freed capacity. The company expectssparkplugs would provide$50,000 sales, incur$30,000 variable of of costs, and incur$'10,000 new directfixed costs. of ShouldACDelcodrop the air cleaners usethe freedcapacity makesparkplugs? and to , 'r r lf all fixedcostsare unavoidable, ACDelco would lose$5,000 contribuof tion marginif it droppedair cleaners. ACDelco this losswith the shouldcompare expectedgain from producing and sellingsparkplugswith the freed capacity: Sales sparkplugs of Less: Variable costs spark plugs.......... of Less: Directfixedcosts sparkp1ugs.......... of Operating income gained from sparkplugs.......... $ 50,000 (30,000) (10,000) $ 10,000
The gainfrom producing sparkplugs($10,000) outweighs lossfrom dropping the ($5,000) air cleaners Thissuggests that management shouldreplace cleaner air production withsparkplug production.
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Chaoter8
Special decisions should take into account all costs affected by the choice of action. Managers must ask what total costs-variable and fixed-will change. As Exhibits 8-15 and 8-16 show, the key to deciding whether to drop products, departments, or territories is to compare the lost revenueagainst the coststhat can be saved and to consider what would be done with the freed capacity.The decision rule is:
Product Mix Decisions

Makeproduct m ix dec is ions
Companies not haveunlimitedresources. do Constraints that restrictproductionor For a manufacturer saleof a productvary from companyto company. suchas Dell, it's the production constraintis often (because not alwaysthe case)labor hours, machinehours, or availablematerials.For a merchandiser such as Wal-Mart, the primary constraintis cubic feet of displayspace. Other companies constrained are by sales demand. Competitionmay be stiff, so the companymay be ableto sellonly a limited numberof units. In suchcases, companyproduces the only as much as it can sell.However,if a companycan sellall of the units it produces, which products facingconstraints should it emphasize, make more of? Companies or considerthe questions Exhibit 8-17. in
ProductMix Considerations
. S7hat constraint(s) stops us from making (or displaying) all of the units we can sell? . $7hich products offer the highest contribution margin per unit of the constraint? . Would emphasizing one product over another affect fixed costs?
Consider Chazz, a manufacturer of shirts and jeans. The company can sell all of the shirts and jeans it produces, but it has only 2,000 machine hours of capacity. The company usesthe same machines to produce both jeans and shirts. In this case, machine hours is the constraint. Note that this is a short-term decision, becausein the long run, Chazz could expand its production facilities to meet salesdemand if it
435
made financial senseto do so. The following data suggestthat shirts are more profitable than jeans:
However,an important pieceof information is missing-the time it takesto or makeeachproduct.Let'sassume that Chazzcan produceeither20 pairs of ieans 10 shirts per machinehour. The com.pany will incur the sarnefixed costseither way, so fixed costs irreleuant. \7hich product shouldit emphasize? are follow the decision rule: To maximizeprofits when fixed costsare irrelevant,
Because to machine hoursis the constraint, Chazzneeds figureout which product has the highestcontributionmargin per machinehour.Exhibit 8-18 showsthe contributionmarginper machine hour for eachproduct.
to ProductMix-Which Product Emphasize
have a highercontribution margin per machinehour ($240) than shirts Jeans ($tSO1. ThereforeChazzwill earn more profit by producingjeans.Why? Because eventhough jeanshave a lower contributionmargin per wnit, Chazzcan make
436
8 Chapter
machinehours. Exhibit 8-18 also rwice as many jeansas shirtsin the available making jeans.Multiplying the contriprovesthat Chazzearnsmofe total profit by number of machinehours shows tution margin per machinehour by the available margin by producingjeansbut only that Chazz.u.r .urn $480,000of contribution shirts. by $360,000 producing (2,000machine hoursX 20 shouldmake40,000ieans profit, Chazz To maximize hour spent machine for every Because \7hy zeroshirts? jeans hour) andzeroshirts. per margin ($240per hour for makingshirts,Chazzwould giuewp $60 of contribution jeans versus $180per hour for shirts).
ChangingAssumptions:Product Mix When Demand ls Limited

'We made two assumptions about Chazz; (1,)Chazz's salesof other products, if any, won't be hurt by this decision and (2) Chazz can sell as many ieans and shirts as it can produce. Let's challenge these assumptions.First, how could making only jeans other production land not shirts) hurt salesof the company's other products? Using ties and knit sweaters that coordinate with their equipment, Chazz also makes shirtr. Ti. and sweater salesmight fallif Chazz no longer offers coordinating shirts. the Let's challengeour second assumption.A new competitor has decreased company can sell only 30,000 pairs of ieans.Chazz Now, the demand for Chazz'sjeans. should make only as many jeans as it can sell and use the remaining machine hours to profitability. oroduce shirts. Let's seehow this constraint in salesdemand changes Chazz will earn $480,000 of contribution marRecall from Exhibit 8-18 that gin from using all 2,000 machine hours to produce jeans. Howevet, if Chazz makes only 30,000 jeans,it will use only 1,500 machine hours (30,000 jeans + 20 ieans per'machine hour). That leaves 500 machine hours available for making shirts. Chazz'snew contribution margin will be:
Shirts
Contribution margin per machine h o u r (fro m E x hi bi t 8-18).' .........." . Machine hours devotedto product "...' Total contribution margin at full capacity
Jeans
Total
s
X
180 500
240 $ x 1,500 $360,000
2,000 $450,000
u!J99
Becauseof the change in product mix, Chazz'stotal contribution margin will fall from $480,000 to $4s0,000, a $30,000 decline. chazz had to give up $60 of contribution margin per machine hour ($240 - $180) on the 500 hours it spent producing shirts rather than ieans. However, Chazz had no choice-the company would hi,e incurred an actwal /oss from producing jeans that it could not sell. If Chazz had produced 40,000 ieans but sold only 30,000, the company would have spent $480,000 to make the unsold jeans (10,000 jeans x $48 variable cost per pair of jeans) yet would have received no salesrevenue from them. \(hat about fixed costs?In most cases,changing the product mix emphasis in the short run will not affect fixed costs, so fixed costs are irrelevant. However, fixed costs could differ when a different product mix is emphasized.'$7hatif Chazz had a month-to-month lease on a zipper machine used only for making jeans? If Chazzmade only shirts, it could auoid the leasecost. However, if Chazz makes any jeans, it needs the machine. In this case, the fixed costs become relevant because ihey differ between alternative product mixes (shirts only uersus jeans only or ieans and shirts).
Wo uld Chaz z ' s o d u c t m i x d e c i s i o nc h a n g e i f i t had a $20,000 pr cancel abl el easeon a zi pper m ac hine n e e d e d o n l y fo r j e a n p ro d u c ti on?A ssume that C hazzcan sel l as ma n y unit s as it m a k e s . ,i!,r"r:,.:"rr'ri*c"r We would compare the profitability as follows:
jeansis more profitable Evenconsidering zippermachine producing lease, the than producingshirts.Chazzwould prefer producingjeans over shirtsunless demand jeans for than$360,000 fromjeansis less dropsso lowthatthe net benefit (thebenefitgainedfrom solely producing shirts).
Notice that the analysis again follows the two guidelines for special business decisions: (1) focus on relevant data (only those revenuesand costs that differ) and (2) use a contribution margin approach, which separates variable from fixed costs.
SutsCIurailmg ffiecfisfi (fuTmke-mn'-ffiuy) mms

Recall from the chapter's opening story that Delta outsources much of its reservation work and airplane maintenance. Outsourcing decisions are sometimes called make-or-buy decisions becausemanagers must decide whether to buy a component product or service or produce it in-house. The heart of these decisions is bow best to wseauailable resources. Let's seehow managers make outsourcing decisions.Deflone, a manufacturer of music CDs, is deciding whether to make paper liners for CD jewel boxes (the plastic casesin which CDs are sold) in-house or whether to outsource them to MDz-Art, a company that specializesin producing paper liners. DefTone's cost to produce 250,000 liners rs: Makeoutsourcing (make-or-buy) deci si ons
438
Chapter 8
Muz-Art offers to sell DefTone the liners for $0.37 each. Should DefTone make the liners or buy them from Muz-Art? DefTone's $0.50 cost per unit to make the Iiner is $0.13 higher than the cost of buying it from Muz-Art. It first appears that DefTone should outsource the liners. But the correct answer is not so simple. Why? Becausemanufacturing unit costs contain both fixed and variable components. In deciding whether to outsource, managersmust consider fixed and variable costs separately.Exhibit 8-19 shows some of the questions management must consider when deciding whether to outsource.
Outsourcing Considerations
. How do our variable costs compare to the outsourcing cost? . Are any fixed costs avoidable if we outsource? . What could we do with the freed caoacitv?
Let's seehow these considerations apply to DefTone. By purchasing the liners, DefTone can avoid all variable manufacturing costs-$40,000 of direct materials, $20,000 of direct labor, and $15,000 of variable manufacturing overhead.In total, the company will save $75,000 in variable manufacturing costs, or $0.30 per liner ($75,000 + 250,000 liners). However, DefTone will have to pay the variable outsourcing cost of $0.37 per unit, or $92,500 for the 250,000 liners. Basedonly on variable costs, the lower cost alternative is to manufacture the liners in-house. However, managers must still consider fixed costs. Assume that DefTone cannot avoid any of the fixed costs by outsourcing.In this DefTone would case,the company's fixed costs are irrelevant to the decision because of continue to incur $50,000 of fixed costsregardless whether the company outsources the liners. The fixed costs are irrelevant becausethey do not differ between alternatives. DefTone should continue to make its own liners because variable cost of outsourcthe the ing the liners ($92,500) exceeds variable cost of making the liners ($75,000). However, what if DefTone can avoid some fixed costs by outsourcing can reducefixed overheadcost by $10,000 the liners?Let's assume that management by outsourcing the liners. DefTone will still incur $40,000 of fixed overhead ($50,000 - $10,000)evenif they outsource the liners.In this case, fixed costsbecome relevant to the decision becausethey differ between alternatives.Exhibit 8-20 shows the differencesin costs betweenthe make and buv alternativesunder this scenario.
Incremental Analysis Outsourcing for Decision
Variable costs: Direct materials Direct labor Variable overhead Purchasecost from Muz-Art
$ 40,000 20,000 15,000 $ 92,500
,i'.1'
(250,000 $0,37) x
Fixed overhead Total cost of liners
Exhibit 8-20 showsthat it would still costDefTonelessto makethe linersthan to buy them from MDz-Art,evenwith the $10,000reductionin fixed costs. The net from making250,000linersis $7,500. savings
439
Exhibit 8-20 also shows that outsourcingdecisionsfollow our two key guidelines (1) in for specialbusiness decisions: focus on relevantdata (differences costsin this case) and (2) usea contribution margin approachthat separates variablecostsfrom fixed costs. Note how the unit cost-which does not separate costs according to behavior-can be deceiving. If DefTone's managers made their decision by comparing the total manufacturing cost per liner ($0.50) to the outsourcing unit cost per liner ($0.37), they would have incorrectly decidedto outsource. Recall that the manufacturing unit cost ($0.S01contains both fixed and variable components whereas the outsourcing cost ($0.:21 is strictly variable. To make the correct decision, DefTone had to separatethe two cost components and analyzethem separately. Our decision rule for outsourcing is:
lftheincremental of costs making the elt,ilerril incremental costs outsourcing of
costs lf theincremental of making

i i ti r ti i ,i j i L the i nc r gm ental
costs outsourcing of
i
0ilrjtsr,l;Lirf f;
$top tv Think.,
Assuming DefTone in what that couldsave by $10,000 fixedcosts outsourcing, isthe production mostthe company of would be willingto pay per linerto outsource 250,000 liners? price at which ,lit,i't'tl\uitt,i:' To answer that question, must find the outsourcing we DefTone would 6e indifferent or the about makingthe liners outsourcing liners. DefTone would be indifferent the total costs werethe sameeitherway: if
Costsif making liners = Costsif outsourcingliners Variablemanufacturingcosts+ Fixed costs= Variable outsourcingcosts+ Fixed costs (250,000units x $0.30per unit) + $50,000= (250,000X outsourcing costper unit) + $40,000 costper unit) $75,000+ $50,000- $40,000= (250,000X outsourcing $85,000 = (250,000 X outsourcingcost per unit) costper unit $85,000+ 250,000= outsourcing costper unit $0.34= outsourcing Def To ne wou ld be indif f er ent about m ak ing or o u t s o u r c i n g t h e l i n e r s i f t h e o u t -
sourcing per wouldincurthe costpricewas$0.34 unit.At that price,DefTone samecostto manufacture outsource liners. DefTone wouldsavemoney or the onlyif the outsourcing pricewasless per than$0.34 unit.Therefore, most the DefTone wouldpayto outsource $0.33 liner. shown[gle'n,a+(n ?? ^6r per is As liner, DefTone wouldsave$2,500 from outsourcing:
Liner Costs Variablecosts Make Liners Buy Liners
Difference
(250,000 per unitsx $0.30 unit) $ 75,000 Plus: Fixed costs 50,000 Total costs $125,000
(250,000 $0.33 unit) ($7,500) x per $ 82,500 40,000 10,000 $122,500 @
440
Chapter8
\Jfe haven't consideredwhat DefTone could do with the freed capacity it would have if it decided to outsource the liners. The analysis in Exhibit 8-20 assumesno other use for the production facilities if DefTone buys the liners from MDz-Art. But suppose DefTone has an opportunity to use its freed capacity to make more CDs for an additional profit of $18,000. Now, DefTone must consider its opportunity cost-the benefit forgone by not choosing an alternative course of action. In this case, DefTone's opportunity cost of making the liners is the $18,000 profit it forgoes if it does not free its production facilities to make the additional CDs. Let's seehow DefTone's managers decide among three alternatives: 1. Use the facilities to make the liners 2. Buy the liners and leave facilities idle (continue to assume$10,000 of avoidable fixed costs from outsourcing liners) 3. Buy the liners and use facilities to make more CDs (continue to assume$10,000 of avoidable fixed costs from outsourcing liners) The alternative with the lowest net cost is the best use of DefTone's facilities. Exhibit 8-21 compares the three alternatives.
BestUseof Facilities GivenOpportunity Costs

Liners Facilities Make il Idle Addi[onal CPs 11 $132,500 $132,500 I 1; r4,.500
Make Liners
Expected costof 250,000liners (from Exhibit 8-20) profit fuomadditional CDs Expected Expected costof obtaining250,000liners net
$125,000 $12s,000
DefToneshould buy the liners from M[z-Art and usethe vacatedfacilitiesto make more CDs. If DefTonemakesthe linersor buysthe linersfrom Muz-Art but idle,it will forgothe opportunity earn$18,000. leaves production its facilities to
,*ffiryo< Think,r
How will the $18,000 opportunity cost change the maxirnum amountDefTone is willing payto outsource eachliner? to fir,v,11'1,t,;11.;ii1'n'1, DefTone will now be willingto pay more Io outsource liners.In its is to essence, company willing payfor the opportunity makemoreCDs the to
DefTone's managers should consider qualitative factors as well as revenue and cost differences in making their final decision. For example, DefTone managers may believe they can better control quality or delivery schedules by making the liners themselves. This argues for making the liners. Outsourcing decisions are increasingly important in today's globally wired economy. In the past, make-or-buy decisionsoften ended up as "make" because coordination, information exchange, and paperwork problems made buying from suppliers too inconvenient. Now, companies can use the Internet to tap into information systems of suppliers and customers located around the world.
Short-Term BusinessDecisions
441
Paperwork vanishes, and information required to satisfy the strictest JIT delivery scheduleis available in real time. As a result, companies are focusing on their core competenciesand outsourcing more functions.
Sel!As ls or ProcessFurthenDecisions
At what point in processing should a companysell its product?Many companies, especiallyin the food processingand natural resourceindustries,face this business decision.Companiesin theseindustriesprocessa raw material (milk, corn, livestock,crude oil, lumber, and so forth) to a point before it is saleable. For example, Kraft pasteurizes raw milk before it is saleable.Kraft must then decidewhether it should sell the pasteurized milk as is or processit further into other dairy products (reduced-fatmilk, butter, sour cream, cottage cheese, yogurt, blocks of cheese, shreddedcheese, and so forth). Managersconsider the questionsshown in Exhibit 8-22 when deciding whether to sell as is or process further.
Makesel las i s or process further deci si ons
SellAs ls or Process Further Considerations

. How muchrevenue we receive we sellthe productasis? will if . How much revenue will we receiveif we sell the product after processing further? it . How muchwill it costto process productfurther? the
Let's look at one of Chevron'ssell or processfurther decisions. Suppose Chevron spent $125,000 to processcrude oil into 50,000 gallons of regular gasoline, shownin Exhibit 8-23.After processing as crudeoil into regulargasoline, should Chevron sell the regular gas as is or should it spendmore to processthe gasoline into premiumgrade? makingthe decision, In managers Chevron's consider the following relevantinformation:
SellAs ls or Process Decision Further
442
Chapter8
. o
Chevron could sell regular gasoline for $3 per gallon, for a total of
x (5o,oo0 $3.00). $150,000

Chevron could sell premium gasoline for $3.20 per gallon, for a total of
x (50,000 $3.20). $160,000 gallons would haveto spend $0.11per gallon,or $5,500(50,000 Chevron gas. into premium-grade regulargasoline process x $0.11),to further
managers not considerthe $125,000spenton prodo Notice that Chevron's Why? It is a sunkcost.Recallfrom our previcrudeoil into regulargasoline. cessing regardless of that a sunk cost is a past cost that cannot be changed ous discussion which future action the companytakes.Chevronhas incurred$125,000regardless it of whether it sellsthe regular gasolineas is or processes further into premium to the Therefore, cost is not rclevant the decision. gasoline. IncrementalAnalysis for Sell As ls or Process Further Decision
Process Further
SellAs Is $150,000
Difference
$160,ooo (s,500 )
$150.000
$ 154,500
see costsin Exhibit 8-24, managers that theycan the By analyzingonly relevant into premiumgasoline. if they convertthe regulargasoline profit by $+,S00 increase ($160,000 $150,000) the outweighs incremental The $10,000extra revenue processing. $5,500costof the extra rule is: Thus,the decision
Recall that our keys to decisionmaking include (1) focusing on relevant informavariable costs from tion and (2) using a contribution margin approach that separates The analysisin Exhibit 8-24 includes only those future costsand revenues fixed costs. 'We assumedthat Chevron already has the equipment that differ between alternatives. to labor necessary convert regular gasolineinto premium-gtadegasoline.Because and fixed costs would not differ between alternatives, they were irrelevant. However, if
443
chevron has to acquire equipment or hire employees to convert the gasoline into premium-gradegasoline,the extra fixed costs would be relevant. once again, we see that fixed costs are relevant only if they differ between alternatives.
supposeone of chevron's customers wantsto buy the 50,000 gallons, in the but form of regular gasoline, premiumgasoline. not The customeiis wiliingto pay more than $3 a gallon for the regulargasoline. what is the minimumprice Chevron shouldcharge? Affisuqdwr; Exhibit8-24showsthat if Chevron does not process gasoline the into premium grade, willgiveup $154,500 net revenue it ($160,000 of revenues givenup - $5,500 further processing not incurred). obtainat least sameincome cost To the fromselling gasoline regular the as grade, Chevron mustsellthe reqular gasoline for at least per ($154,500 50,000 + $3.09 gallon gallons regular of gasofne). $3.09 At per gallon, Chevron wouldbe indifferent aboutthe two alternatiues. customer lf the offers to paymorethan$3.09 gallon, per Chevron be betteroff selling will regular gasoline to this customer. the customer lf offerslessthan$3.09, Chevron be bJtteroff will further processing gasoline premium-grade the into gasoline.
Decision Guidelines
Sxonr-Tenu Speclal Busrruess Decrslols
Amazon'com has confronted most of the special businessdecisions we've covered. Here are the key guidelines Amazon.com's managers follow in making their decisions.
Decision
ShouldAmazon.comdro@
Guideline
If the costsavings exceed lost revenues the from dropping the electronics productline,thendroppingwill increase operating income. Amazon.com shouldfocuson selling products the with the highest contribution marginper unit of the constraint. which is cubicfeetof warehouse space.
If the incremental costs of operating its own warehouses exceedthe costs of outsourcing, then outsourcing will increaseoperating income. Processfurther only if the extra salesrevenue (from processingfurther) exceedsthe extra costs of additional processing.
Givenlimited warehouse space, which productsshould Amazon.com focuson selline?

Should Amazon.com outsource its warehousing operations?
How should a company decide whether to sell a product as is or processfurther?
ffi ffimwfuffiwrc ffiwffiffiffiffi&fl

Reqttrfrremen-nts standardand deluxesunglasses: 1. Aziz produces Per Pair
Standard Saleprice Variable expenses
Deluxe
$20 16
$30 21,
The company has 15,000 machine hours available.In one machine hour, Aziz can produce 70 pairs of the standard model or 30 pairs of the deluxe model. Assuming machine hours is a constraint, which model should Aziz emphasize? 2. Just Do It! incurs the following costs for 20,000 pairs of its high-tech hikine socks:
D i re c t ma te ri a l s..... D i re c t Ia b o r........... overhead Varia ble mar.rufacturing Fixed nanufacturing overhead cost............ T o ta l ma n u fa c tu ri ug C o s t p e r p a i r ($ 2 20,000:20,000) . .....' ........'
$ 20,000 80,000 40,000 8 0 , 0 00 $220,000
rr
Another manufacturer has offered to sell Just Do It! similar socks for $10 a and leavesits plant pan, a total purchasecost of $200,000. If Just Do It! outsources i d l e . i t c a n s a v e $50,000 of fi xed overhead cost. Or the company can use t he facilitiesto make other products that will contribute $70,000 to profits. In released rhis case,the company will not be able to avoid any fixed costs. Identify and analyze What is the best courseof action? the alternatives.
Y:n il4,/'Y"[^H,W ffi #ttflt ! ll{er'4[,rireffimeini
Styleof Sunglasses
Standard S a l ep ri c e p e r p ai r....... per pai r...... Va ri a b l e e x p e n se Contribution margin per Pair Units produced each machine hour ..............
Deluxe
$zo$:o
(16) (21)
$+$s
x70x30 x 15,000 270 x 15,000
C o n tri b u ti o n m argi n per machi nehour........ $280$ Capacity-number of machine hours ........... Total contribution margin at full capacity....
$4,200,000 $4,050,000
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Chapter 8
Decision: Emphasizethe standard model becauseit has the higher contribution margin per unit of the constraint-machine hours-resulting in a higher contribution margin for the company.
Requirement 2
Bwy Socks
Make Socks Relevantcosts: Dir ec t m at er i a l s ..... Dir ec t labor ........... Variable overhead F ix ed ov er he a d ............... Purchasecost from outsider Facilities ldle Make Other Products
$ 20,000 90,000 40,000 80,000 $ i0,000 200,000

230,000
$ 80,000 200,000 280,000 (70,000) $210,000
( 20 ,00x $10) 0
Total costof obtaining socks...... 220,000 Profitfrom otherproducts ......... Net costof obtaining 20,000 pairsof socks ..........
$220,000 $Z30,OOO
Decision: from the outsidesupplierand usethe JustDo It! shouldbuy the socks released facilitiesto makeother oroducts.
RgVigW
Decisions Business Short-Term
wAccounting Vocabulary
Gonstraint. (p. 434) A factor that restricts production or sale of a product. Cost-Plus Pricing. $. a25l An approachto pricingthat beginswith the oroduct'sfull costs and adds a desiredprofitto determinea cost-plusPrice. Opportunity Gost. (p. 440) The benefitforgoneby not choosingan courseof action. alternative Outsourcing. (p. 437) decide decision:Managers A make-or-buy whetherto buy a componentproductor service or oroduceit in-house. Relevant Information. (p. 415) Exoected future datathal differs among alternatives. Sunk Gost. (p. 4t6) A past cost that cannot be changedregardless of which futureaction is taken. Target Full Cost. (p. 423) The total cost to develop,design,produce, and servicea product. market,deliver,
wQ,uickCheck
you decisions, should L. In making short-termspecial a. focuson total costs variablefrom fixed costs b. separate costingapproach c. usea traditional absorption factors d. focusonly on quantitative a to decision accept special to 2. \flhich of the following is relevant Amazon.com's in order at a lower saleprice from a largecustomer China? in warehouses the United States a. the costof Amazon.com's in its \Web site investment b. Amazon.com's c. the costof shippingthe order to the customer salary d. founderJeff Bezos's wouldconsider product line,Amazon.com to whether dropits electronics 3. In deciding a. the costsit could saveby droppingthe product line it b. the revenues would losefrom droppingthe product line of productline would affectsales its other c. how droppingthe electronics products,suchas CDs d. all of the above Amazon.comshould focus on 4. In decidingwhich product lines to emphasize, the productline that hasthe highest factor a. contributionmarginper unit of the constraining b. contributionmarginper unit of product marginratio c. contribution d. profit per unit of product
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5. When making outsourcing decisions

a. b. c. d. the manufacturing full unit cost of making the product in-house is relevant the variable cost of producing the product in-house is relevant avoidable fixed costs are irrelevant
expected use of the freed capacity is irrelevant 'When 6. companies are price-setters,their products and services a. b. c. d. are priced by managers using a target-pricing emphasis tend to be unique tend to have a great many competitors tend to be commodities
7. \7hen pricing a product or servrce, managers must considerwhich of the following?

a. b. c. d. only variable costs only period costs only manufacturing costs all costs
8. \fhich of the following costs are irrelevant to businessdecisions?

a. b. c. d. sunk costs costs that differ between alternatives variable costs avoidable costs
9. When deciding whether to sell as is or process a product further, managers

should ignore which of the following?
a, the revenue the product is processed if further b. the costof processing further c. the costsof processing productthus far the d. the revenue the product is sold as rs if 10. When making decisions, managers should a. consider sunk costs b. consider coststhat do not differ between alternatives c. consider only variablecosts d. consider revenues that differ between alternatives
Ouick CheckAnswers
p'0[ ?'6 p'8 p'l q ' 9 q ' s p ' f p' t )' 7 q' [
For lnternet Exercises,Excel in Practice, and additional online activities, go to this book's Web site at www.prenhall.com/bamber.
Assess Your Progress

mLearning Objectives
decisions M Describeand identifyinformationrelevantto short-termbusiness MTMake specialorder decisions M Make pricingdecisions
wtMake droppinga product,department,or territory decisions

&TMake product mix decisions
m
M
(make-or-buy) decisions Make outsourcing further decisions Make sell as is or process
roShort Exercises
s8-1
Determine relevance of information (Learning Obiectiue 7) You are trying to decidewhether to trade in your ink-jet printer for a more recent but patternwill remainunchanged, the old and new printersuse model.Your usage to or Are the following itemsrelevant irrelevant your decision? differentink cartridges. a. The price of the new printer b. The priceyou paid for the old printer c. The trade-invalueof the old printer d. Papercosts the between costof ink cartridges e. The difference
s8-2
Special order decision given revised data (Leaming Obiectiue2) Suppose Considerthe ACDelco specialsalesorder exampleon pages41.9-421,. of cost is $1.35 per oil filter (instead $1.20).In variablemanufacturing ACDelco's stampingmachinethat costs$9,000 addition,ACDelcowould haveto buy a special oil logo on the special-order filters. The machinewould be to mark the customer's order is complete. when the special scrapped order underthese conditions? the that ACDelcoaccept special \fould you recommend Showyour analysis. Determine pricing approach and target price (Leaming Obiectiue3) a operates Rocky Mountain ski resort.The companyis planningits lift SnowDreams returnon the Investors would like to earna l5o/o ticketpricingfor thecomingski season. to The incursprimarilyfixedcosts groomthe company's $100million of assets. company projects for fixedcosts be $33,750,000 the ski to the runsandoperate lifts. SnowDreams Variable each about750,000skiersand snowboarders season. The season. resortserves reputation the costsare about $10 per guest.Currently, resorthas sucha favorable controloverthe lift ticketprices. that and snowboarders it hassome amongskiers pricing.'Sfhy? targetpricing or cost-plus emphasize l. \(ould SnowDreams 2. If other resortsin the areacharge$70 per day,what price should charge? SnowDreams
s8-3
Chapter 8
s8-4
Use target pricing to analyze data (Learning Objectiue 3) Consider SnowDreamsfrom S8-3. Assumethat SnowDreams'reputationhas diminished and other resorts in the vicinity are charging only $65 per lift ticket. SnowDreamshas become a price-taker and won't be able to charge more than its competitors.At the market price, SnowDreamsmanagersbelievethey will still serve 750,000 skiers and snowboarders eachseason. 7. If SnowDreamscan't reduce its costs,what profit will it earn? Stateyour answer in dollars and as a percent of assets. Will investors be happy with the profit level? S ho w y o u r a n a l y s i s . 2. Assume that SnowDreams has found ways to cut its fixed costs to $30 million. lVhat is its new target variable cost per skier/snowboarder? Compare this to the current variable cost per skier/snowboarder.Comment.
s8-5
Decide whether to drop a depanment (Learning Objectiue 4) Knight Fashion in New York operates three departments: Men's, \fomen's, and Accessories.Knight Fashion allocates all fixed expenses (unavoidable building depreciationand utilities) basedon each department'ssquare footage. Departmental operating income data for the third quarter of 2007 are as follows: ' Dchartrnpni
Women's
Total
The store will remain in the samebuilding regardless whetherany of the of departments dropped.ShouldKnight Fashiondrop any of the departments? are Give your reason.
58-6 Drop a department: revised information (Learning Objectiue 4) Consider Knight Fashion from S8-5. Assume that the fixed expensesassignedto each department include only direct fixed costs of the department (rather than unavoidable fixed costsas given in S8-5): . Salary of the department's manager o Cost of advertising directly related to thar department If Knight Fashion drops a department,it will not incur thesefixed expenses, Under thesecircumstances, shouldKnight Fashiondrop any of the departments? Give your reason. S8-7 Replace a department (Learning Objectiue 4) Consider Knight Fashion from S8-5. Assume once again that all fixed costs are unavoidable. If Knight Fashion drops one of the current departments, it plans to replace the dropped department with a shoe department. The company expects the s hoe dep a rtm e n t to p ro d u c e $ 8 0,000 i n sal es and have $50,000 of variable costs. Becausethe shoe business would be new to Knight Fashion, the company would have to incur an additional $7,000 of fixed costs (advertising, new shoe display racks, and so forth) per quarter related to the departmenr. What should Knight Fashion do now?
449
s8-8
Product mix decision: unlimited demand (Learning Objegtiue 5) StoreAll produces plastic storage bins for household storage needs. The company makes two sizes of bins: large (50 gallon) and regular (35 gallon). Demand for the product is so high that StoreAll can sell as many of each size as it can produce. The company uses the same machinery to produce both sizes.The machinery can be run for only 3,000 hours per period. StoreAll can produce 10 large bins every hour compared to 15 regular bins in the same amount of time. Fixed expensesamount to $100,000 per period. Salesprices and variable costs are as follows:
\il/hy? 1. Which product shouldStoreAllemphasize? 2. To maximizeprofits,how many of eachsizebin shouldStoreAllproduce? incomebe? operating 3. Giventhis productmix, what will the company's
s8-9
5) Product mix decision: limited demand (LearningObjectiue for in S8-8. Assume demand regular that binsis limitedto 30,000units StoreAll Consider for and demand largebinsis limitedto 25,000units. L. How many of eachsizebin shouldStoreAllmakenow? operatingincome? 2. Giventhis productmix, what will be the company's 3. Explainwhy the operatingincomeis lessthan it was when StoreAllwas producing its optimal productmix.
S8-10
1, Outsourcing production decision (LearningObiectiues 6) is whetherto (1) bake breadfor its Suppose Olive Gardenrestaurant considering an that restaurant in-house (2) buy the breadfrom a local bakery.The chef estimates or variablecostsof makingeachloaf include$0.50of ingredients, $0.25of variableoverhead(electricity run the oven),and $0.75 of directlabor for kneadingand forming to (depreciation the kitchenequipment on and Allocatingfixed overhead the loaves. per building)basedon directlabor assigns $1.00 of fixed overhead loaf. None of the The local bakerywould charge Olive Garden$1.75per loaf. fixed costsare avoidable. (useabsorption in-house costing)? 1. \7hat is the unit cost of makingthe bread or 2. ShouldOlive Gardenbakethe breadin-house buy from the local bakery? \7hy?
3. In addition to the financial analysis,what else should Olive Garden consider when making this decision?
s8-11
Relevant information for outsourcing delivery function (Leaming Obiectiues 7,6) U.S. Food in Lexington, KentuckS manufactures and markets snack foods. Betsy Gonzalez manages the company's fleet of 200 delivery trucks. Gonzalez has been charged with "reengineering" the fleet-management function. She has an important decision to make. . Should she continue to manage the fleet in-house with the five employeesreporting to her? To do so, she will have to acquire new fleet-managementsoftware to streamline U.S. Food's fleet-managementprocess.
450
Chapter8
o Should she outsource the fleet-management function to Fleet Management Services, a company that specializes managing fleets of trucks for other companies?Fleet in Management Services would take over the maintenance,repair, and siheduling of U.S. Food's fleet (but U.S. Food would retain ownership). This alternative would require Gonzalezto lay off her five employees.However, her own job would be secure,as she would be u.S. Food's liaison with Fleet Management Services. Assumethat Gonzalez's recordsshow the following data concerningU.S. Food'sfleet:
Suppose FleetManagement that Services offersto manage U.S.Food'sfleetfor an annualfeeof $290,000. NThich alternative will maximizeU.S.Food'sshort-termoperatingincome? s8-12 outsourcing qualitative considerations (Learuingobiectiues1, 6) \X/hat Referto U.S.Foodin S8-11. qualitative factorsshould Gonzalezconsider before making a final decision? Scrap or process further decision (LearningObjectiue7) Auto Components an inventoryof 500 obsolete has remoteentry keys that arecarried in inventoryat a manufacturing cost of $80,000.ProductionSupeivisor Terri Smith must decide do one of the following: to o Process inventoryfurther at a costof $20,000,with the the expectation selling of it for $28,000 r Scrapthe inventoryfor a saleprice of $6,000 what shouldSmithdo? Present figuresto supportyour decision. Determine most profitable final product (Learningobjectiue 7) Chocolite processes cocoabeans into cocoapowderat a processing of $10,000 cost per batch. Chocolitecan sell the cocoapowder as is, oi it can plocessthe cocoa powder further into chocolatesyrup or boxed assorted chocolates. Once processed. eachbatchof cocoabeans would resultin the following sales revenue:
58-13
s8-14
$15,000 $100,000 $200,000

The cost of transforming the cocoa powder into chocolatesyrup would be $20,000. Likewise, the company would incur $180,000 to transfor- ih.-.o.oa powder into boxed assortedchocolates.The company presidenthas decidedto make boxed assorted chocolatesowing to its high salesvalue and to the fact that the $10,000 cosr of process, ing cocoa beans"eats up" most of the cocoa powder profits. Has the presidentmade the right or wrong decision?Explain your answer.Be sure to include the correct financial analysisin your response. Short-Term Business Decisions 451
w Exercises
EB-1S Determine relevant and irrelevant information (Learning Obiectiue 7) Fabricut, invested in computer-controlled Joe Roberts, production manager for last year.He purchasedthe machinery from AdvancedDesign at a production -u.hin.ry from AdvancedDesignrecentlycontactedJoe because .ort of $2 million. A representative an even more efficient piece of machinery. The new design the company has designed would double the production output of the year-old machinery but cost Fabricut another president's $3 million. Roberis is afraid to bring this new equipment to the company persuadedthe president to invest $2 million in the machinery attention becausehe last year. Requirement Expiain what is relevant and irrelevant to Roberts's dilemma. What should he do? EB-16 Special order decisions given two scenarios (Learning Obiectiue 2) Supposethe Baseball Hali of Fame in Cooperstown, New York, has approached Splrts-Cardz with a special order. The Hall of Fame wants to purchase 50'000 baseball card packs for a special promotional campaign and offers $0'40 per pack, a Sports-Cardz's total production cost is $0.60 per pack, as follows: total of $ZO,ObO.
order. capacityto handlethe special sports-cardzhasenoughexcess Requirements should whetherSports-Cardz to analysis determine an 1. Prepare incremental by fixed costswould not be affected the order assuming sales the special "..ip, order' special cards' hologrambaseball that the Hall of Famewants special 2. Now, assume hologram,whichwill be usethis must spend$5,000to develop Sporis-Cardz the accept special ShouldSports-Cardz order is completed. Iess after the special Showyour analysis' order underthesecircumstances?
452
8 Chapter
E8-17
Special order decision and considerations (LearningObjectiue 2) Maui JaneSunglasses for about $150 per pair. Suppose company sell incursthe the followingaverage per costs palr:
total fixed manufacturing overhead $2,000,000 100,000pairs of sunglasses
Maui Jane has enough idle capacity to accept a one-time-only special order from LensCrafters for 20,000 pairs of sunglasses $76 per pair. Maui Jane will not incur at any variable marketing expensesfor the order. Requirements 7. How would acceptingthe order affect Maui Jane'soperating income? In addition to the specialorder's effect on profits, what other (longer-termqualitative) factors should Maui Jane'smanagersconsider in deciding whether to acceptthe order? 2. Maui Jane'smarketing manager,Jim Revo, argues against accepting the special order because the offer price of $76 is lessthan Maui Jane's$84 cost to make the sunglasses. Revo asks you, as one of Maui Jane'sstaff accountants, to write a memo explaining whether his analysis is correct. E8-18 Pricing decisions given two scenarios (Learning Objectiue 3) Bennett Builders builds 1,500-square-foot starter tract homes in the fast-growing suburbs of Atlanta. Land and labor are cheap, and competition among developersis fierce. The homes are "cookie-cutter," with any upgrades added by the buyer after the sale.BennettBuilders'cost per developedsublot are as follows:
BennettBuilderswould like to eatna profit of 15"/" of the variablecost of each homesale.Similarhomesofferedby competing builderssellfor $200,000each. Requirements 1. \X/hich approach pricing shouldBennettBuilders to emphasize? Why? 2. Nfill Bennett Buildersbe ableto achieve targetprofit levels? its Show
YOUr COmDUtaflOnS.
continwed .
453
3. Bathrooms and kitchens are typically the most important sellingfeaturesof a home. Bennett Builders could differentiate the homes by upgrading bathrooms and kitchens. The upgrades would cost $20,000 per home but would enable Bennett Builders to increasethe selling prices by $35,000 per home (in general,kitchen and bathroom upgrades typically add at least 150% of their cost to the value of any home). If BennettBuildersupgrades,what will the new cost-plusprice per home be? Should the company differentiateits product in this manner? Show your analysis. E8-19 Decide whether to drop a product line (Learning Objectiue 4) Top managersof Video Avenue are alarmed by their operating losses.They are considering dropping the VCR-tape product line. Company accountants have prepared the following analysisto help make this dectston:
if Total fixed costswill not change the companystopssellingVCR tapes. Requirements to analysis show whetherVideo Avenueshoulddrop the 1. Prepare incremental an VCR-tapeproduct line. Ifill droppingVCR tapesadd $30,000to operating income? Explain. can avoid $30,000of fixed expenses dropping by 2. Assume that Video Avenue costsare directfixed costsof the VCR product VCR-tapeproduct line (these the should analysis showwhetherVideo Avenue to Iine).Prepare incremental an sellingVCR tapes. stop to that all $70,000of fixed costsassigned VCR tapesare direct 3. Now, assume fixed costsand canbe avoidedif the companystopssellingVCR tapes. that DVD sales would be adversely affected However,marketinghasconcluded want to buy both from the same the by discontinuing VCR line (retailers would decline1'0'/".What shouldthe DVD productionand sales supplier). do? company
Chapter 8
E8-20
Dropping a product ltne (Learning Objectiue4) Suppose Kellogg's considering productline. Assume is droppingits Special-K that during the pastyea! Special-K's productline incomestatement showed following: the
Fixedmanufacturing overhead costs account 40o/o thecostof goods, for of whileonly 30% of the operating expenses fixed.Since Special-K is only oneof Kellogg's are the line (themajorityof whichis advertising) breakfast cereals, $750,000 directfixedcosts only of will beeliminated theproductlineis discontinued. remainder the fixedcosts if The of will still be incurred Kellogg's. the company If by decides drop the productline,what will to happen the company's to operating income? Kellogg's Should drop theproductline?
E8-21 ldentify constraint, then determine product mix (Leaming Objectiue5)

produces Lifemaster Regular two typesof exercise treadmills: and Deluxe.The exercise crazeis suchthat Lifemaster could use all of its availablemachinehours producing eithermodel.The two modelsareprocessed productiondepartment. throughthe same
*Allocated on the basis of machine hours.
product mix will maximize operating income? (Hint:Use the allocation of fixed manufacturing overhead to determine the proportion of machine hours used by each product.)
'!7hat
E8-22
Determine product mix for retailer (Learning Objectiue 5) Vivace sells both designer and moderately priced fashion accessories. Top management is deciding which product line to emphasize.Accountants have provided the followine data:
Designer Average price........;'.,............;......,;,,.,. sale $200
Priced
'$g+,
The Vivacestore in Reno,Nevada,has 10,000 squarefeet of floor space. If priced goods,it can display650 itemsin the store.If moderately Vivaceemphasizes Vivaceemphasizes designer wear,it can displayonly 300 designer itemsto create Thesenumbersare also the average more of a boutique-like atmosphere. monthly sales units. in Prepare analysis show which productto emphasize. an to
E8-23 Determineproduct mix for retailer-two stocking scenarios (Learning Obiectiue 5)

Eachmorning,Max Imery stocksthe drink caseat Max's Beach Hut in Myrtle Beach, Hut has 100 linearfeet of rcfuigerated displayspace for SouthCarolina.Max's Beach plastic cansor four 2O-ounce cold drinks.Eachlinearfoot canhold eithersix 12-ounce Hut sells threetypesof cold drinks: or glass bottles. Max's Beach in'J.2-oz. cansfor $1.50per can L Coca-Cola for 2. A6a\7Root Beerin20-oz.plasticbottles $1.75per bottle bottlesfor $2.20per bottle 3. MountianDew in 20-oz.glass Max's Beach Hut paysits suppliers: 1,. $0.25per 12-oz. canof Coca-Cola 2. $0.40per 20-oz.bottleof A&\f Root Beer 3. $0.75per 20-oz.bottleof MountainDew include: Max's Beach Hut's monthly fixed expenses Hut rental .. $ 375
IJ
Max's Beach Hut can sell all drinks stocked in the display caseeach morning. Requirements 'lfhat 'Sfhat 7. is Max's Beach Hut's constraining factor? should Max stock to maximize profits?'What is the maximum contribution margin he could generate from refrigerated drinks each day?
456
Chapter 8
2 . To provide variety to customers, supposeMax refusesto devote more than 60

linear feet and no less than 10 linear feet to any individual product. Under this condition, how many linear feet of each drink should Max stock? How many units of each product will be available for sale each day?
3. Assuming the product mix calculated in Requirement 2, what contribution margin will Max generatefrom refrigerated drinks each day? E8-24 Make-or-buy product component (Learning Objectiue 6) Fiber Systemsmanufactures an optical switch that it uses in its final product. Fiber Systemsincurred the following manufacturing costs when it produced 70,000 units last year:
Fiber Systems doesnot yet know how many switchesit will needthis year; the however,anothercompanyhas offeredto sell Fiber Systems switch for $14 per the unit. If Fiber Systems buys the switch from the outsidesupplier, manufacturing facilitiesthat will be idle cannot be usedfor any other purpose,yet none of the fixed costsare avoidable. Requirements makeor buy the switch? shouldFiberSystems L. Giventhe samecost structure, Showyour analysis. can 2. Now, assume that FiberSystems avoid $100,000of fixed costsa yearby are Fiber Systems production.In addition,because sales increasing, outsourcing needs a yearratherthan 70,000.\X/hatshouldFiberSystems 75,000switches do now? would be willing to pay what is the most Fiber Systems 3. Giventhe last scenario, to outsource switches? the
E8-25 Make-or-buy with alternative use of facilities (LearningObjectiue6)

next year (assume same Referto E8-24.Fiber Systems needs80,000optical switches can By them,FiberSystems useits idle facilitiesto manurelevantrange). outsourcing factureanotherproduct that will contribute$220,000to operatingincome,but none make or buy the switches? of the fixed costswill be avoidable. ShouldFiber Systems Showyour analysis.
E8-26 Determine maximum outsourcing price (LearningObiectiue6)

lin400,000jewel-case DefTone's sales haveincreased; a result,the companyneeds as ersratherthan 250,000.DefTonehasenoughexistingcapacityto makeall of the linits In ers it needs. addition, due to volume discounts, variablecostsof making each DefTonecan reduce liner will decline $0.28 per liner.Assume that by outsourcing, to use for the its current fixed costs($50,000)by $10,000.There is no alternative factory spacefreed through outsourcing, it will just remain idle. What is the so productionof its CD liners? maximumDefTonewill pay to outsource
Business Decisions 457 Short-Term
E8-27
Sell as is or process further (Learning Obiectiue 7) organic milk into plain yogurt. Dairymaid sellsplain yogurt to hosDairymaid processes pitals, nursing homes, and restaurants in bulk, one-gallon containers. Each batch, processed a cost of $800, yields 500 gallons of plain yogurt. Dairymaid sellsthe oneat gallon tubs for $6.00 each and spends$0.10 for eachplastic tub. Dairymaid has recently Dairymaid wonders if it would be more profitable to sell begun to reconsiderits strategy. individual-sizeportions of fruited organic yogurt at local food stores.Dairymaid could further processeach batch of plain yogurt into 10,667 individual portions (3/4 cup each) of fruited yogurt. A recent market analysisindicatesthat demand for the product exists. Dairymaid would sell each individual portion for $0.50. Packagingwould cost $0.08 per portion, and fruit would cost $0.10 per portion. Fixed costs would not change.Should plain yogurt (sellas is) or convert the plain Dairymaid continue to sell only the gallon-size 'Why? further)? fruited yogurt (process yogurt into individual-sizeportions of
w Problems (Probtem A) set

(Leaming 2) Obiectiue P8-28ASpecialorder decisionand considerations margin in Florida.Buoy's contribution flotationvests Tampa, Buoymanufactures
income statement for the most recent month contains the following data:
of Overton'swantsto buy 5,000 vestsfrom Buoy.Acceptance the order Suppose or expenses any of its Buoy'svariablemarketingand administrative will not increase the The Buoy plant has enoughunusedcapacityto manufacture fixed expenses. additionalvests.Overton'shas offered $10 per vest,which is below the normal sale priceof $14. Requirements this to whetherBuoy shouldaccept analysis determine l. Prepare incremental an sales order. special in whetherto accept 2. Identify long-termfactorsBuoy shouldconsider deciding order. sales the soecial
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P8-29A Pricing of nursery plants (Learning Objectiue3) plants for GreenThumboperatesa commercialplant nursery where it propagates has gardencenters Its throughoutthe region.GreenThumb $5 million in assets. yearly fixed costsare $600,000,and the variablecostsfor the potting soil, container, label, plant total $1.25. GreenThumb's volume is seedling, and labor for eachgallon-size currently500,000units. Competitors offer the samequality plantsto gardencenters for $3.50 each.Gardencenters then mark them up to sellto the public for $8 to $10, depending the type of plant. on Requirements 1. GreenThumb's assets. ownerswant to earna !2"/" returnon the comDany's \Whatis GreenThumb's targetfull cost? 2. Giventhat GreenThumb's their currentcosts,will its ownersbe ableto achieve targetprofit? Showyour analysis. 3. Assume has waysto cut its variable coststo $1.10per that GreenThumb identified 'Iilfill in unit. \fhat is its new targetfixed cost? this decrease variable costsallow the company achieve targetprofit?Showyour analysis. its to 4. GreenThumbstartedan aggressive advertisingcampaignstrategyto differenMonrovia Plantsmade tiate its plants from thosegrown by other nurseries. this strategywork, so GreenThumbhas decidedto try it, too. GreenThumb doesn'texpectvolume to be affected,but it hopesto gain more control over pricing. If GreenThumbhas to spend$100,000this year to advertiseand its price be? variablecostscontinueto be $1.10per unit, what will its cost-plus Do you think GreenThumbwill be able to sell its plants to gardencentersat price?'Why why not? the cost-plus or P8-30A Prepare and use contribution margin statements for dropping a lanedecision (Learning Obiectiue4) have received following Membersof the board of directorsof SecuritySystems the operatingincomedatafor the yearjust ended:
continued. . . Business Short-Term Decisions 459
Members of the board are surprised that the industrial systemsproduct line is losing money. They commission a study to determine whether the company should drop the line. Company accountants estimate that dropping industrial systems will decreasefixed cost of goods sold by $80,000 and decreasefixed marketins and administrative expensesby $12,000.
Requirements
1'. Prepare an incremental analysis to show whether Security Systemsshould drop the industrial systemsproduct line. 2. Prepare contribution margin income statementsto show Security Systems'total operating income under the two alternatives: (a) with the industrial systemsline and (b) without the line. Compare the difference between the two alternatives' income numbers to your answer to Requirement 1. Ifhat have you learned from this comparison? P8-31A Product mix decision under constraint (Learning Obiectiue S) Brun, located in St. Cloud, Minnesota, produces two lines of electric toothbrushes: deluxe and standard. BecauseBrun can sell all of the toothbrushes it produces, the owners are expanding the plant. They are deciding which product line to emphasize. To make this decision, they assemblethe following data:
After expansion, the factorywill have a production capacity 4,500 machine of hoursper month. The plant can manufacture either60 standard electrictoothbrushes per or 24 deluxeelectric toothbrushes machine hour. Requirements l. Identify the constraining factor for Brun. 2, Prepare analysis show which productline to emphasize. an to
P8-32A outsourcing decision given alternative use of capacity (Learningobiectiue 6)

X-Perience manufactures snowboards. cost of making 1,800 bindingsis: Its
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Chapter 8
Suppose O'Brien will sell bindings to X-Perience for $14 each. X-Perience will pay $1.00 per unit to transport the bindings to its manufacturing plant, where it will add its own logo at a cost of $0.20 per binding.
Requirements
predictthat purchasing bindingsfrom O'Brienwill the X-Perience's accountants Prepare analysis an to enablethe companyto avoid $2,200of fixed overhead. show whetherX-Perience shouldmakeor buy the bindings. 2. The facilitiesfreed by purchasingbindingsfrom O'Brien can be usedto manufactureanother product that will contribute $3,100 to profit. Total had producedthe bindings. fixed costswill be the sameas if X-Perience facilities: Show which alternativemakesthe bestuseof X-Perience's (a) make bindings,(b) buy bindingsand leavefacilities idle, or (c) buy bindingsand make another product. l. P8-33A Sell or process further decisions (LearningObjectiue7) which can be Vision Chemical spent$240,000to refine72,000gallonsof acetone, has can the further. Vision Chemical process acetone sold for $Zle a gallon.Alternatively, This processing yield a total of 60,000gallonsof lacquerthinnerthat can be sold will will for $3.20 a gallon.The additionalprocessing cost $0.62 per gallonof lacquer must pay shippingof $0.22 a thinner.To sell the lacquerthinner,Vision Chemical gallonand administrative of expenses $0.10a gallonon the thinner. Requirements l. Diagram Vision's decision, usingExhibit 8-23asa guide. rVhy or 2. Identifythe sunk cost.Is the sunk costreleyantto Vision'sdecision? why not? or it 3, ShouldVision sellthe acetone process into lacquerthinner?Showthe net between two alternatives. the expected revenue difference
rHt P1qf,lgfilS
(Probrem B) set
2) P8-34B Special order decision and considerations (LearningObjectiue follows: United Packaging's contributionmargin incomestatement
Variableexpenses:
continued . . . Business Decisions Short-Term 461
\flallace Farms wants to buy 5,000 produce boxes from United Packaging. Acceptanceof the order will not increaseany of United Packaging'svariable marketing and administrative expensesor any of its fixed expenses. United Packaging'splant has enough unused capacity to manufacture the additional boxes. \Tallace Farms has offered $0.80 per box, which is considerably below the normal sale price of $1.20.
Requirements
Prepare incremental an analysis determine to whetherUnitedPackaging should accept this special sales order. 2. Identify long-termfactorsthat United Packaging shouldconsider deciding in whetherto accept special the sales order. l.
P8-35B Pricing of facial tissues (LeamingObjectiue3)

produces Softies facial tissues. Softies has $50 million in assets. yearlyfixed costs Its are$L2 million, and the variablecost of producingand sellingeachbox of tissues is currentlysells30 million boxesof tissues. Generic facialtissues $0.25.Softies suchas Softies'productgenerally to retailersfor $0.75 per box, while namebrandssuch sell as Kleenexand Puffssellto retailers $1.00 per box. for Requirements 1. Softies'stockholders expecta 1,0o/" return on the company's assets. What is Softies' targetfull cost? 2. GivenSofties' currentcosts,will its ownersachieve their targetprofit? Show your analysis. 3. Softies identifiedwaysto cut its fixed costsby $SOO,OOO. is its new has What targetvariable costper unit? Will Softies ableto reachits targetprofit? be 4. Softies startedan aggressive advertising campaign transformits product into to a namebrand ableto compete with Kleenexand Puffs.Softies doesn'tthink volume will be affected, it hopesto gain more control overpricing.If Softies but spends million a yearto advertise, what will its cost-plus price be?(Continue $3 to assume that fixed costshavedeclined $500,000but that Softies by was unableto reduceits variablecostper unit below $0.25).Do you think Softies will be ableto sellits facialtissues retailers the cost-plus to price?\fhy or at why not? P8-36B Prepare and use contribution margin statements for dropping a line decision (Learning Objectiue 4) The following operatingincome data of.AbaloneSeafood highlight the losses the of freshseafood productline:
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Chapter 8
productline. The the AbaloneSeafood considering is discontinuing freshseafood company'saccountants estimatethat dropping the fresh seafoodline will decrease fixed marketingand administrative fixed cost of goodssold by $16,000and decrease expenses $rO,OOO. by Requirements shoulddrop t. Prepare incremental an analysis show whetherAbaloneSeafood to product line. the freshseafood to 2, Prepare contributionmargin incomestatements compareAbaloneSeafood's productline and (b) without income(a) with the freshseafood total operating incomenumbers to the it. Comparethe difference between two alternatives' your answerto Requirement What haveyou learnedfrom this comparison? 1. 5) P8-378 Product mix under constraint (Leaming Objectiue in EasyLiving of Charlotte,North Carolina,specializes outdoor furniture and spas. Owner Linda Spring is expandingthe store. Sheis decidingwhich product line to the emphasize. makethis decision, assembles following data: To she
continued . . .
After renovation, the store will have 8,000 square feet of floor space.By devoting the new floor spaceto patio sets,Easy Living can display 60 patio sets.Alternativelg Easy Living could display 30 spas.Spring expectsmonthly salesto equal the maximum number of units displayed. Requirements L. Identify the constraining factor for Easy Living. 2. Prepare an analysisto show which product line to emphasize.
P8-388 Outsourcing: alternative use of capacity (Learning Objectiue 6)

Morning Grain makes organic cereal. Costs of producing 140,000 boxes of cereal each year follow:
Kellogg's Suppose will sell Morning Grain the cerealfor $4 a box. Morning Grain would alsopay $0.19 a box to transportthe cereal its warehouse. to Requirements predictthat purchasing cereal 1. Morning Grain'saccountants the from Kellogg's will enable companyto avoid $140,000of fixed overhead. the Prepare an analysis show whetherMorning Grain shouldmakeor buy the cereal. to 2. Assumethat the Morning Grain facilitiesfreed up by purchasingthe cereal from Kellogg'scan be usedto manufacturesnackbars that will contribute $180,000to profit. Total fixed costswill be the sameas if Morning Grain usedthe plant to make cereal.Preparean analysisto show which alternative (a) (b) makesthe bestuseof Morning Grain'sfacilities: makecereal, buy cerealand leavefacilitiesidle, or (c) buy cerealand make snackbars. P8-398 Seff or process further decision (LearningObjectiue7) Acme Petroleum spent$200,000to refine 60,000gallonsof petroleumdistillate. has Suppose Acme Petroleum can sell the distillatefor $6 a gallon. Alternatively, can it process distillatefurther and produce60,000 gallonsof cleanerfluid. The addithe tional processing cost another$1.2Sa gallon,and the cleaner will can be sold for fluid, Acme Petroleum must pay a sales commission $8.S0a gallon.To sellcleaner of chargeof $0.15 a gallon. $0.t0 a gallon and a transportation Requirements DiagramAcmePetroleum's alternatives, usingExhibit 8-23 (sellas is or process further) as a guide. 2. Identify the sunk cost.Is the sunk costrelevantto AcmePetroleum's decision? 'Why or why not? l. 3. Prepare analysis indicatewhetherAcmePetroleum an to shouldsellthe distillate it or process into cleaner fluid. Showthe expected revenue net difference between two alternatives. the
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Chapter8
Apply Your Knowledge

sm DecisionCase
Gase 8-40. Outsourcing e-mail (Learning Obiectiue 6) BKFin.com provides banks access to sophisticated financial information and analysissystemsvia the'Web. The company combines thesetools with benchmarking including e-mail and wirelesscommunications,so that banks can instantly data access, evaluateindividual loan applicationsand entire loan portfolios. BKFin.com's CEO, Jon'Wise, is huppy with the company's growth. To better focus on client service,Wise is considering outsourcing some functions. CFO Jenny Lee suggeststhat the company's e-mail may be the place to start. She recently attended a conferenceand learned that companies such as Continental Airlines, 'Wise asks Lee to DellNet, GTE, and NBC were outsourcing their e-mail function. identify costs related to BKFin.com's in-house Microsoft Exchange mail application, which has 2,300 mailboxes. This information follows:
Requirements 1. Compute the total cost per mailbox per month of BKFin'com's current e-mail function. 2. Suppose Mail.com, a leading provider of Internet messaging outsourcing services, offers to host BKFin.com's e-mail function for $9 per mailbox per month. If BKFin.com outsources its e-mail to Mail.com, BKFin.com will still need the virus protection software; its computer hardware; and one information technology staff member who would be responsible for maintaining virus protection, quarantining suspicious e-mail, and managing content '$7ise accept (e.g., screening e-mail for objectionable content). Should CEO Mail.com's offer?'Why or why not? 3. Supposefor an additional $5 per mailbox per month, Mail.com will also provide virus protection, quarantine, and content-management services' Outsourcing these additional functions would mean that BKFin.com would not need an e-mail information technology staff member or the separatevirus protection license. Should CEO \fise outsource these extra servicesto Mail.com? Whv or whv not?
mEthical lssue
fssue 8-41. Outsourcing and ethics (Leaming Objectiue6) Mary Tan is the controllerfor Duck Assocrares,propertymanagement a company in Portland,Oregon.Eachyear,Tan and payroll clerk Toby Stockmeetwith the external auditorsabout payroll accounting. This year,the auditorssuggest that Tan consider outsourcing Duck Associates' payroll accounting a company to specializing payroll in processing services. This would allow Tan and her staff to focus on their primary responsibility: accounting the properties for under management. present, At payroll requires1.5 employee positions-payroll clerk Toby Stock and a bookkeeper who spends her time entering half payrolldatain the system. Tan considersthis suggestion, and she lists the following items relating to outsourcing payroll accounting: a. The current payroll softwarethat was purchased $4,000 three yearsago for would not be needed payroll processing if were outsourced. b. Duck Associates' bookkeeper would spendhalf her time preparingthe weekly payroll input form that is given ro the payroll processing service. she is paid $450 a week. c. Duck Associates would no longerneedpayroll clerk Toby stock,whoseannual salary $42,000. is d. The payroll processing service would charge$2,000a monrh. Requircments 1. Would outsourcing payroll function increase decrease the or Duck Associates, operating income? 2. Tan believes that oursourcing payroll would simplify her job, bur shedoesnot like the prospectof havingto lay off stock, who has becomea closepersonal friend. Shedoesnot believe thereis anotherposition available Stockat his for currentsalary. Can you think of other factorsthat might supportkeeping Stock rather rhan outsourcing payroll processing? How should eaih of th. factorsaffectTan'sdecision shewantsto do what is bestfor Duck Associates if and act ethically?
**Team Project
Project8-42. Relevant information outsourcing to decision(Leaming Obiectiue 6) Menardis the founder and soleownerof Menards. John Analysts haveestimated
that his chain of home improvement stores scatteredaround nine midwestern states generateabout $3 billion in annual sales.But how can Menards compete with giant Home Depot? suppose Menard is trying to decide whether to invest $45 million in a state-of-the-art manufacturing plant in Eau Claire, 'sTisconsin. Menard expects the plant would operate for 15 years, after which it would have no residual value. The plant would produce Menards' own line of Formica counrerrops, cabinets, and picnic tables.
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Chapter 8
Suppose Menards would incur the following unit costs in producing its own oroduct lines:
l .
'.
'' :].i..
ouitbrtops
Dir ec t m at er ials.,... Dir ec t I abor . . . . . ......
: picnic Cabinets", 'Tables
variablemanufacturing oveihead
$1s 10 ,.t
$10 5 ,)
L
$25 ,15 6
Rather than Menard making theseproducts, assumethat he can buy them from outside suppliers. Supplierswould charge Menards $40 per countertop, $25 per cabinet,and $65 per picnic table. N7hether Menard makes or buys these products, assume that he expects the following annual sales: r Countertops-487,200 at $130 each o o Picnic tables-100,000 at $225 each Cabinets-150,000 at $75 each
If "making" is sufficiently more profitable than outsourcing, Menard will build the new plant. John Menard has asked your consulting group for a recommendation. Menard usesthe straight-line depreciation method. Requirements 1. Are the following items relevant or irrelevant in Menard's decision to build a new plant that will manufacture his own products? a. b. The unit sale prices of the countertops, cabinets, and picnic tables (the sale prices that Menards chargesits customers) The prices that outside suppliers would charge Menards for the three products if Menards decidesto outsource the products rather than make them The $45 million to build the new plant The direct materials, direct labor, and variable overhead that Menards would incur to manufacture the three oroduct lines Menard's salary
c. d. e.
2. Determine whether Menards should make or outsource the countertops, cabinets, and picnic tables asswmingthat the company bas already buih the plant and, therefore, has the manwfactwring capacity to prodwce these prodwcts. In other words, what is the annual difference in cash flows if Menards decidesto make rather than outsource each of these three products? 3. Write a memo giving your recommendation to Menard. The memo should clearly state your recommendation and briefly summarize the reasonsfor your recommendation.
Business Short-Term Decisions
467

Managerial Accounting 08

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hard at work to make 3_.'r: your travelexperience an enloyable one,

we n.,, rii"l crose,in prio tll.1.:^"::.,,:,

F\t S& fi!jblt$,:r+{*s

V"t" special orderdecisions

Vrt" pricing decisions

a department, territory or decisions ffil V.t" dropping product,

V"t" product decisions mix

How ManagersMake Decisions

Business Decisions Short-Term

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Relevant Nonfinancial Information

Keysto Nlaking$hort-Terrn SpecialDecisions

\7e'll use these two keys in each decision.

Two Keysto MakingShort-Term Decisions Special

SalesOrder and Regular Special PricingDecisions

Business Decisions Short-Term

(Absorption Traditional Formatand Contribution Costing) Margin FormatIncomeStatements

$800,000 $(300,000) (7s,000) (37s,000 ) 425,000

$(200,000) administrative (125,000) (325,000) $100,000

Incremental Analysis Special of SalesOrder

Regular Pricing Decisions

Pricing Regular Considerations

Business Decisions Short-Term

250,000 unitsX $3.00price= 10% x $1,000,000 assets of

Calculating TargetUnitVariable Cost

ylrllDrego:l pgl llll "talsgt

Business Decisions Short-Term

10% x $1,000,000 ofassets

$375,000 325,000 $700,000 + 100,000 $800,000 250.000 $ 3.20

Short-Term Business Decisions 427

Our pricing decision rule is:

. 'r . : is lf companya fortheprod uct:

\fhat are two key guidelines in making short-term specialbusiness decisions?

\7hat shouldNike consider settingits regular in productprices?

\7hat approachshouldNike take to pricing?

ffiwffiffiffiffi3r ffimwfuffiwmre -ffi

r.Beqrunneennonnit .B Assumingthat Szigety Industriescannot reduceits fixed costs,the target variable

$ 2,540,000 (700.000) $ 1,840,000 + 2,000,000 $ O.gZ

$2,70o,ooo + 100,000 + 360,000 $3,160,000 + 2,000,000 1.58 $

Short-Term Business Decisions

Other Short-Term Special Business Decisions

Decisionsto Drop Products, Departments, or Territories

Considerations for Dropping Products, Departments, Territories or

Business Decisions Short-Term

MarginIncome Statements Contribution by ProductLine

Oil Filters $800,000

ut)_ QQ s )=QZ-QS_0.* _. PJ9,glgu ni1s (?Q, Q qnrt ) t.r "

(18s,18s ). (11.s,741)I (300,926)

= 50.74074 $14,875 x $0 462963= $9.2s9

Fixed Costs Continue to Exist (UnavoidableFixed Costs)

Analysis Dropping Product for a Incremental WhenFixedCostsContinue Exist to

Direct Fixed Costs That Can Be Avoided

Short-Term Business Decisions 433

Incremental Analysis Dropping Product for a WhenDirectFixedCosts Can Be Avoided

Product Mix Decisions

Business Decisions Short-Term

to ProductMix-Which Product Emphasize

ChangingAssumptions:Product Mix When Demand ls Limited

240 $ x 1,500 $360,000

Short-Term Business Decisions 437

SutsCIurailmg ffiecfisfi (fuTmke-mn'-ffiuy) mms

Incremental Analysis Outsourcing for Decision

$ 40,000 20,000 15,000 $ 92,500