Chapter 4

Chapter 04 - Fundamentals of Cost Analysis for Decision Making
Chapter 4
Fundamentals of Cost Analysis for Decision Making
Learning Objectives
1. Use differential analysis to analyze decisions.
2. Understand how to apply differential analysis to pricing decisions.
3. Understand several approaches for establishing prices based on costs for long-run pricing
decisions.
4. Understand how to apply differential analysis to production decisions.
5. Understand the theory of constraints.
Chapter Outline
I.
II.
DIFFERENTIAL ANALYSIS
A. Differential costs versus total costs
B. Differential analysis and pricing decisions
The full-cost fallacy in setting prices
C. Short-run versus long-run pricing decisions
D. Short-run pricing decisions: Special orders
E. Long-run pricing decisions
F. Long-run versus short-run pricing: Is there a difference?
G. Cost analysis for pricing
1. Life-cycle product costing and pricing
2. Target costing from target pricing
H. Legal issues relating costs and sales prices
1. Predatory pricing
2. Dumping
3. Price discrimination
4. Peak-load pricing
5. Price fixing
USE OF DIFFERENTIAL ANALYSIS FOR PRODUCTION DECISIONS
A. Make-it or buy-it decisions
B. Make-or-buy decisions involving differential fixed costs
C. Opportunity costs of making
D. Decision to add or drop a product line or close a business unit
Nonfinancial considerations of closing a business unit
E. Product choice decisions
4-1
2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
III.
IV.
THE THEORY OF CONSTRAINTS

SUMMARY
Key Concepts
LO 4-1 Use differential analysis to analyze decisions.
Some common business decisions require an understanding of
(1) the effect of the decision on the organizations revenues and costs, and
(2) the business and competitive environment.
The decisions under consideration include:
How much business was required to be profitable?
How to price special orders?
Whether to do something in-house or outsource it to another firm?
Whether to drop one of the products?
What was the right product mix?
Differential analysis refers to the process of estimating revenues and costs of alternative
actions available to decision makers and of comparing these estimates to the status quo.
Every decision that a manager makes requires comparing one or more proposed
alternatives with the status quo.
Differential analysis may be applicable for both short-run and long-run decisions.
Short run is defined as the period of time over which capacity will be unchanged,
generally one year. Beyond that time frame, long-run considerations will apply.
Both short-run and long-run decisions are concerned with the amount of cash flow.
Short-run decisions usually ignore the timing issues because the time value of money is
immaterial. For long-run decisions, the timing of cash flow is a significant factor. Time
value of money will be discussed in the Appendix to the book.
The In Action box considers the impacts of cost analysis on the choice of office space
for a small business.
Differential costs are costs that differ among alternatives. Differential costs change in response
to alternative courses of action.
4-2
whole or part.
Both variable and fixed costs may be differential costs. All relevant facts for each
alternative should be examined to determine which costs will be affected, and therefore
differential.
Variable costs are differential when a decision involves possible changes in volume.
All of the affected costs are considered differential.
Sunk costs are costs incurred in the past that cannot be changed by present or future
decisions. Sunk costs are not differential and, therefore, not relevant for decision making.
For decision making purposes, the information for alternatives may be presented to managers
using either the total format, in which the detailed costs are included, or the differential format,
in which only the differences between alternatives are shown.
There are two major advantages of using the total format:
(1) All the information is available so it is easy to derive the differential format if desired;
(2) When a particular alternative is chosen, the information about the resources required
for implementation is readily available.
The advantage of the differential format is that it highlights the differences between
alternatives.
LO 4-2 Understand how to apply differential analysis to pricing decisions.

Prices are determined by supply and demand. Pricing decisions, which impact profits, allow
managers to determine whether to sell goods and/or provide services in the market, thereby
contributing to the supply curve.
Full (product) cost is defined as the sum of the fixed and variable costs of manufacturing and
selling a unit.
Full cost includes both
(1) the variable costs of producing and selling the product, and
(2) a share of the organizations fixed costs.
From the cost equation (TC = F + VX) in CVP analysis, full cost can be expressed as
4-3
whole or part.
F VX
F
=
+ V, where
X
X
V = Variable cost per unit,
X = Units of output, and
F = Fixed costs.
In this setup, the fixed costs are unitized (i.e., divided by the units of output) and added
to the variable cost per unit to come up with the full cost. For short-run decisions (such as
whether to accept special orders), the fixed cost component generally is not differential
and should not be considered. The use of full cost for some short-run decisions will
erroneously render the alternative option less attractive, creating what is known as the
full-cost fallacy.
In the long run, all costs must be covered or the company will fail.
Example 1: On a particular month, U-Develop receives a special order from an out-oftown merchant who is willing to pay $4,000 for 10,000 photo prints developed, or
$0.40 per print. An analysis of U-Develops cost structure shows that it incurs variable
cost of $0.36 per print and $1,500 monthly fixed cost. U-Develop can handle the
special order without affecting its regular business.
The full cost of the special order is calculated by an employee as follows.
$1,500 $0.36 10, 000
= $0.51 per print.
10, 000
By unitizing the fixed cost, the full cost calculation gives the impression that the
special order is not a profitable one as the unit cost of $0.51 per print is higher than the
unit price offered of $0.40.
However, since the monthly fixed cost of $1,500 remains the same with or without the
special order, the differential cost relevant for this decision context is the variable cost
of $0.36 per print. Therefore, the special order should be accepted, netting an additional
profit of $400 (= ($0.40 - $0.36) 10,000 prints) for the month. The full-cost fallacy
is avoided.
Short-run pricing decisions include
(1) pricing for a one-time-only special order without long-term implications, and
(2) adjusting product mix and volume in a competitive market.
4-4
whole or part.
Long-run pricing decisions include pricing a main product in a large market in which
price setting has considerable leeway.
Special order represents an order that will not affect other sales and is usually a short-run
occurrence. Exhibit 4.1 provides a framework for decision making in this context. Two options
are presented: status quo (reject special order) vs. alternative (accept special order). The option
that provides the highest economic value should be chosen.
As seen in Exhibit 4.2, both the differential format and the total format work well to
resolve the special-order problem.
For typical short-run decisions, fixed costs are not differential and therefore not
relevant.
The differential approach leads to correct short-run pricing decisions.
The differential approach indicates only a minimum acceptable price for both the short
run and the long run. Given the market conditions, the firm may choose to charge a
higher price.
A special order is usually acceptable when idle capacity is adequate for the job and
when the regular sales are not affected. If idle capacity is not available, then the costs of
additional personnel and machinery to tackle the job, both variable and fixed, must be
considered. If accepting the special order may adversely influence the regular sales, then
the lost sales due to the special order should also be considered.
Financial analyses only look at factors that can be quantified. Nonfinancial issues must
be considered as well before a final decision is reached.
======================
Demonstration Problem 1
Nationwide Windows can produce 10,000 windows per year. Its normal year of operations
involves the following:
Sales (8,000 units @ $220)
Manufacturing cost
Variable per unit
Fixed
Selling and administrative cost
Variable (commission) per unit on
sales
$1,760,000
150
260,000
12
4-5
whole or part.
Fixed
60,000
During the year, Nationwide is approached by a contractor to buy 1,500 windows for $165 each.
The variable sales commission is set to be a flat fee of $12,000 for the special order. The fixed
costs are not affected by the decision.
Required:
1. Should Nationwide Windows accept the special order? Explain.
2. If the contractor needs instead a total of 2,500 windows and still pays $165 each (all other
information remains the same), should Nationwide accept the special order? Explain.
Solution:
1. The special order should be accepted, because it generates the additional profit of
$10,500.
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit
Status Quo
(Do not accept)
$1,760,000
(1,296,000)
$464,000
(320,000)
$144,000
Alternative
(Accept)
$2,007,500
(1,521,000)
$486,500
(332,000)
$154,500
Difference
$247,500
(225,000)
$22,500
(12,000)
$10,500
2. The special order should be rejected because of the net loss of $3,500 relative to the
status quo. By accepting the special order, Nationwide can only sell 7,500 windows at the
regular price of $220 each. The rest (up to its capacity limit of 10,000 windows per year)
will be delivered to the contractor for $165 each.
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit
Status Quo
(Do not accept)
$1,760,000
(1,296,000)
$464,000
(320,000)
$144,000
Alternative
(Accept)
$2,062,500a
(1,590,000)b
$472,500
(332,000)c
$140,500
Difference
$302,500
(294,000)
$8,500
(12,000)
$(3,500)
$220 7,500 + $165 2,500 = $2,062,500

$162 7,500 + $150 2,500 = $1,590,000
c
$260,000 + $60,000 + $12,000 = $332,000
======================
b
4-6
whole or part.
LO 4-3 Understand several approaches for establishing prices based on costs

for long-run pricing decisions.
Full cost includes all costs incurred by the activities that make up the value chain to produce
and sell a unit. The marketing department receives cost reports from the accounting department,
and then adds markups to determine benchmark or target prices for all products the firm
normally sells. This approach is known as the cost-plus pricing.
Pricing decisions based on full cost may be appropriate when
(1) a long-term contractual relationship is established to supply a product and both the
variable and the fixed costs are specified in the contract,
(2) dealing with government procurements, customized products or regulated industries
in which full cost plus a markup determines product prices, or
(3) full-cost-based prices are adjusted upward or downward to reflect short-term market
conditions.
For unique products in construction, defense, custom orders, and many new products,
full costs plus a markup become the basis for pricing as well as bidding on a job.
Based on the differential analysis, short-run prices may be low enough just to cover the
variable costs of providing one additional unit of goods or services, much like the concept of
marginal cost in economics. On the other hand, long-run prices have to be much higher so that
both the variable and fixed costs can be recovered and still make a profit. This will ensure a
firms long-term survival.
A common saying in business: I can drop my price to just cover variable costs in the
short run, but in the long run, my prices have to cover full product costs.
In addition to the full cost or cost-plus approach, other cost-based pricing approaches include
(1) life-cycle product costing and pricing, and
(2) target costing for target pricing.
These approaches are especially useful in making long-run pricing decisions.
Product life cycle covers the time from initial research and development to the time at which
support to the customer ends.
Life-cycle costing (or cradle-to-grave costing), the important basis for pricing, tracks
costs from start to finish for each product.
4-7
whole or part.
A product life-cycle budget highlights for managers the importance of setting prices that
will cover costs in all value-chain categories to be profitable.
Manufacturers of environmentally sensitive products have to meet the recent takeback requirement by paying for the recycling and disposal costs at the end of the
products useful life. The additional costs must be considered in making pricing
decisions. This in turn influences how products are designed to tradeoff the cost of
manufacture and disposal.
Most of the firms in a competitive market are price takers. A target price is the price based on
customers perceived value for the product and the price that competitors charge. A target cost
equals the target price minus desire profit margin. That is,
Target cost = Target price Desired profit margin.
A firm constrained by the price it can charge, with a desire to make a healthy profit,
must limit the costs it incurs to manufacture the product in the long run in the spirit of
price-based costing.
Legal issues regarding costing and pricing get a lot of attention as competition heats up and as
companies move more goods and provide services around the globe.
Predatory pricing is the practice of setting a selling price below cost with the intent to
harm competition by driving competitors out of the market or by creating a barrier to
entry for new competitors.
Predatory pricing is considered anti-competitive and illegal under antitrust laws.
Marginal cost (in theory) or average variable cost (in practice) is used as the floor below
which predatory pricing practice is established in courts.
Example 2: Two companies, P(redator) and C(ompetitor), produce similar products
while employing similar technologies. The variable cost per unit is $5.10 for both.
Company C adopts an industry practice of adding 10% markup to the variable cost to
come up with a selling price of $5.61 per unit.
In order to dominate the market, Company P decides to charge a price of $5 per unit for
the same product, resulting a loss of $0.10. Over a short period time, the strategy of
predatory pricing attracts customers old and new, eventually driving Company C out of
the market. Company P then raises its price to $6.63, enjoying a markup of 30% and
recouping its losses many times over.
4-8
whole or part.
Dumping occurs when a company exports its product to consumers in another country
at an export price below its domestic price.
Dumping benefits consumers in the short run at the expense of the producers in the
importing country, who usually seek protection in the form of tariffs on the dumped
products to bring up the prices and to level the playing field.
Policy makers disagree on the merits of prohibiting dumping: protection of domestic
industries for national security reasons vs. practice of free trade and free markets.
Price discrimination is the practice of selling identical goods or services to different
customers at different prices.
Price discrimination requires market segmentation based on price sensitivity.
Price discrimination on the basis of race, religion, disability, or gender is illegal.
Peak-load pricing is the practice of setting prices highest when the quantity demanded
for the product approaches the physical capacity to produce it (and lower at other times).
Price fixing represents the agreement among business competitors to set prices at a
particular level.
The prices being fixed are at a level higher than the equilibrium prices in competitive
markets.
Pricing fixing is not universally illegal. However, when it is considered illegal, mere
informal or unspoken agreements may result in jail time and/or huge fines.
LO 4-4 Understand how to apply differential analysis to production decisions.

Differential analysis helps managers address ongoing production and operating issues,
including
(1) make-or-buy decisions,
(2) whether to add or drop a product line or close a business unit,
(3) production choices, and
(4) product mix decisions.
The keys are to identify relevant costs and revenues under different alternatives and
to choose the course of action that provides the best economic value for the firm.
4-9
whole or part.
Make-or-buy decision involves any decision concerning whether to make the needed goods
internally or purchase them from outside sources.
A sourcing decision is often strategic and long-run, as the firm chooses to either
integrate vertically upstream and/or downstream to exercise more control, or develop
long-term relationships with suppliers and only specialize in certain areas of the total
manufacturing process.
A make-or-buy decision is ultimately a question of which firm in the value chain can
produce the product or service at the lowest cost.
In addition to quantitative considerations (i.e., differential costs and revenues), other
factors (such as market structure, suppliers dependability and quality control) may also
play a role.
In make-or-buy decisions, the relevant costs include the variable manufacturing costs
(direct materials, direct labor, variable overhead) that can be saved, the fixed overhead
that may be eliminated, and the purchase price of the parts under consideration. Exhibit
4.3 illustrates an example.
Make-or-buy decisions are sensitive to volume. When the cost information can be
separated into variable and fixed components in the accounting system, a unique volume
may exist that makes the firm indifferent as to whether to outsource or not. Above or
below that volume, the decision will be reversed. That is, setting VX + F = PX will lead
to
X=
F
, where
PV
X = The indifferent volume between make or buy,

V = Variable cost per unit,
F = Fixed costs, and
P = Purchase price per unit.
(VX + F) represents the costs of Make, while PX represents the costs of Buy. See
Exhibit 4.4 for an illustration.
The Goal Seek formula in Microsoft Excel can also be used to find the volume where
the cost to make is the same as the cost to buy. Exhibit 4.5 shows how the spreadsheet is
set up.
Opportunity costs are the forgone returns from not employing a resource in its best
alternative use and are not routinely reported with other accounting cost data. The fact
that they are difficult to estimate or subject to considerable uncertainty does not mean
4-10
whole or part.
that opportunity costs should be ignored. Exhibit 4.6 extends the case to consider the
opportunity cost of alternative facility use.
======================
Cube Manufacturing usually produces its own parts for assembly. The following monthly data
are available for one of the parts, Part A31:
Manufacturing costs
Variable per unit
Fixed costs
Nonmanufacturing costs
Variable per unit
Fixed costs
$6
15,000
$1
9,000
Cube needs 2,000 units of Part A31 every month. An outside supplier offers to deliver that part
for $11.5 each. By accepting the offer, Cube can save half of the fixed manufacturing costs and
all variable costs, but the fixed nonmanufacturing costs are not affected.
Required:
1. Should Cube Manufacturing accept the offer and outsource Part A31?
2. If the facility used to produce Part A31 can be leased out to generate a monthly rental
income of $3,000, what should Cube Manufacturing do?
Solution:
1. Cube Manufacturing should reject the offer and continue to make the part itself, because
the total costs will be higher.
Variable costs
Fixed costs
Purchase price
Total costs
Status Quo
(Make)
$14,000
24,000
$38,000
Alternative
(Buy)
Difference
$0 $14,000 lower
16,500
7,500 lower
23,000 23,000 higher
$39,500 $1,500 higher
2. In this scenario, Cube should accept the offer. The $3,000 monthly rental income
represents an opportunity cost for producing Part A31 internally, making outsourcing
more attractive.
Variable costs
Fixed costs
Status Quo
(Make)
$14,000
24,000
Alternative
(Buy)
Difference
$0 $14,000 lower
16,500
7,500 lower
4-11
whole or part.
Purchase price
Opportunity cost
Total costs
23,000
3,000
$41,000
$39,500
23,000 higher
3,000 lower
$1,500 lower
The $3,000 monthly rental income may be treated as cost savings as a result of
outsourcing. The conclusion remains the same.
Variable costs
Fixed costs
Purchase price
Opportunity cost
Total costs
======================
Status Quo
(Make)
$14,000
24,000
$38,000
Alternative
(Buy)
Difference
$0 $14,000 lower
16,500
7,500 lower
23,000 23,000 higher
(3,000)
3,000 lower
$36,500 $1,500 lower
Unprofitable product lines and noncompetitive business units may be subjected to increased
scrutiny. Managers have to decide whether to keep or drop them.
Financial statements prepared in accordance with generally accepted accounting
principles do not routinely provide differential cost information. Differential cost
estimates depend on unique information that usually requires separate analysis.
In deciding whether to eliminate a product line or a business unit, the differential
analysis should look at the CVP income statement with the emphases on the contribution
margin made by the division under consideration and on the disposition of that divisions
fixed costs.
The divisional profits reported in income statement (see Exhibit 4.7) can be misleading
because all costs, not just differential ones, are present. Differential cost estimates depend
on unique information that usually requires separate analysis (see Exhibit 4.8).
Other considerations include the potential opportunity costs of keeping the product lines
(such as the alternative use of the shelf space), the impacts on related products or units
which will stay, and nonfinancial factors such as the potential impacts on employees and
communities.
======================
Cube Manufacturing produces three different products: Platinum, Gold, and Silver. The financial
statement from last quarter is shown below.
4-12
whole or part.
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit (loss)
Platinum
$500,000
(350,000)
$150,000
(80,000)
$70,000
Gold
$400,000
(300,000)
$100,000
(60,000)
$40,000
Silver
$200,000
(160,000)
$40,000
(50,000)
$(10,000)
Total
$1,100,000
(810,000)
$290,000
(190,000)
$100,000
The general manager is thinking of eliminating the Silver product line to improve the financial
results. The cost accountant cautions that the fixed costs allocated to Silver have to be absorbed
by the remaining two products if the decision is finalized.
Required:
What should the general manager of Cube Manufacturing do? Please explain.
Solution:
The general manager should keep the Silver product line. If Silver is dropped, the total fixed
costs of $190,000 remain the same while the contribution margin from Silver will be lost,
resulting a net loss of $40,000 for the company as a whole.
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit (loss)
======================
Status quo
(Keep Silver)
$1,100,000
(810,000)
$290,000
(190,000)
$100,000
Alternative
(Drop Silver)
$900,000
(650,000)
$250,000
(190,000)
$60,000
Difference
$200,000 decrease
160,000 decrease
$40,000 decrease
$40,000 decrease
In the short run, capacity is fixed and limited. In general, firms face constraints, such as
activities, resources, or policies that limit or bound the attainment of an objective.
Given the constraints, a firm has to choose what products to offer that will maximize its
contribution margin. This is a product choice decision, or a decision to optimize the
product mix offered.
The important measure of profitability is based on the contribution margin per unit of
scarce resource, a particular input with limited availability. By concentrating on the
product(s) that yield the higher contribution margin per unit of scarce resource, a firm can
maximize its profit.
4-13
whole or part.
Microsoft Excels Solver function can be used to find the optimal product mix when
there are constraining resources.
LO 4-5 Understand the theory of constraints.

Theory of constraints (TOC) focuses on revenue and cost management when faced with
bottlenecks, defined as operations where the work required limits production.
Dependencies among multiple parts and processes to produce goods give rise to
bottlenecks as the constraining resources.
Maximizing the output of the constrained resources is the best route to increased
marginal revenues.
The three components in the theory of constraints are
(1) throughput contribution: sales dollars minus direct materials costs and other
variable costs such as energy and piecework labor,
(2) investments: inventories, equipment, buildings, and other assets used to generate
throughput contribution, and
(3) other operating costs: all operating costs other than direct materials and other variable
costs incurred to earn throughput contribution, including most salaries and wages,
rent, utilities, and depreciation.
The theory of constraints assumes a short-run time horizon and considers only
materials, purchased parts, piecework labor, and energy to run machines to be variable;
everything else is assumed fixed and will be expensed in the period in which they are
incurred.
The objective of the theory of constraints is to maximize throughput contribution while
minimizing investments and other operating costs, therefore maximizing the contribution
margin per unit of the constraining resource.
Example 3: The following illustrates the manufacturing process in a factory. Every unit
of the finished product has to go through three departments as identified by the
machines used, A, B, and C. There are three A machines (capacity: 1,200 units each
per hour), one B machine (capacity: 3,000 units per hour), and two C machines
(capacity: 1,600 units each per hour).
4-14
whole or part.
1,200 units each

1,600 units each
A
3,000 units
Raw
Materials
C
Finished
Goods
B
C
When A machines are utilized at full capacity, their output results in inventory
buildup in front of B machine because its capacity can not keep pace. B machine is
identified as the bottleneck of the whole operation.
The full-capacity output from B machine can be handled with ease by the
downstream C machines. Theory of constraints dictates maximizing the output from
B machine while subordinating the other two departments to the pace of B
machine in order to optimize the operations.
Matching
A.
B.
C.
D.
E.
F.
Bottleneck
Differential analysis
Full cost
Dumping
Make-or-buy decision
Peak-load pricing
G.
H.
I.
J.
K.
L.
Price discrimination
Product life cycle
Special order
Sunk cost
Target price
Throughput contribution
_____ 1.
Occurs when a company exports its product to consumers in another country at an

export price below its domestic price.
_____ 2.
Sales dollars minus direct materials costs and other variable costs such as energy and
piecework labor.
_____ 3.
Involves any decision concerning whether to make the needed goods internally or
purchase them from outside sources.
_____ 4.
Refers to the process of estimating revenues and costs of alternative actions available
to decision makers and of comparing these estimates to the status quo.
4-15
whole or part.
_____ 5.
Represents an order that will not affect other sales and is usually a short-run
occurrence.
_____ 6.
The sum of the fixed and variable costs of manufacturing and selling a unit.
_____ 7.
Covers the time from initial research and development to the time at which support to
the customer ends.
_____ 8.
The practice of selling identical goods or services to different customers at different

prices.
_____ 9.
The practice of setting prices highest when the quantity demanded for the product
approaches the physical capacity to produce it (and lower at other times).
_____ 10. Operations where the work required limits production.

_____ 11. The price based on customers perceived value for the product and the price that
competitors charge.
_____ 12. Costs incurred in the past that cannot be changed by present or future decisions.
Answers
1. D
2. L
3. E
4. B
5. I
6. C
7. H
8. G
9. F
4-16
whole or part.
10. A
11. K
12. J
Multiple Choice
1.
a.
b.
c.
d.
2.
Which of the following statements is correct?

Life-cycle costing tracking costs from start to finish.
Product life cycle ends when the product is delivered to customers.
Product price must be set to cover the costs of manufacturing activities only.
Take-back requirement for product recycle and disposal is customers responsibility.
A division has the following data: Sales $320,000, Variable costs $200,000, and Fixed
costs $140,000. If the division were eliminated, the fixed costs would be allocated to other
divisions. What will be the net impact on the companys overall profit?
a. $20,000 increase.
b. $60,000 decrease.
c. $120,000 decrease.
d. Can not be determined from the data provided
3.
Two alternative projects are under consideration:

Revenues
Variable costs
Fixed costs
Project A
$360,000
210,000
90,000
Project B
280,000
180,000
90,000
Which of the following are relevant in choosing between the projects?

a. Revenues.
b. Variable costs.
c. Fixed costs.
d. Both a and b.
4.
a.
b.
c.
d.
Which of the following statements is correct?

Predatory pricing is illegal.
Dumping hurts consumers in the long run.
Price discrimination requires market segmentation.
All of the above.
4-17
whole or part.
5.
a.
b.
c.
d.
For differential analysis,

Differential costs are relevant costs.
No fixed costs are differential.
Most variable costs are differential.
Both a and c.
a.
b.
c.
d.
Full cost is
The sum of variable and fixed cost per unit.
Always relevant for short-run decisions.
Useful for long-run pricing decisions.
Both a and c.
a.
b.
c.
d.
In a competitive market where firms are price takers,

Each firm can set its own prices.
Target pricing is appropriate.
Target cost must be achieved in the short run.
Cost-based pricing should be adopted.
6.
7.
The following information is for questions 8 9.

Company B is considering whether to outsource Part#375 needed to produce finished products.
If manufactured internally, it will cost direct materials $2 per unit, direct labor $1.20 per unit,
variable overhead $1.50 per unit, and fixed overhead $18,000. An outside supplier is available to
provide between 5,000 and 50,000 units of Part#375 at $6.20 per unit.
8.
a.
b.
c.
d.
9.
At what volume will Company B become indifferent to the make-or-buy choice?

8,000 units.
12,000 units.
20,000 units.
31,000 units.
If Company B needs 8,000 units of Part#375, and outsourcing saves only 25% of the
fixed overhead, then Company Bs make-or-buy decision and cost advantage are
a. Make, $7,500.
b. Make, $6,000.
c. Buy, $2,000.
d. Buy, $4,000.
10.
a.
b.
c.
d.
Theory of constraints (TOC)

Applies to long-run cost management.
Is concerned with improving bottleneck operations.
Tries to minimize throughput contribution.
Considers most salaries and wages, rent, utilities and depreciation to be variable costs.
4-18
whole or part.
11.
A company currently manufactures a subassembly for its main product. The unit costs for
the subassembly are:
Prime costs $25, Variable overhead $10, and Fixed overhead $8.
The fixed overhead is an allocated amount shared by other operations. What is the relevant
cost of the subassembly?
a. $25.
b. $35.
c. $43.
d. $33.
12.
a.
b.
c.
d.
Differential analysis is suitable for the following situations except

Make-or-buy decisions.
Whether to close a business unit.
Cost behavior analysis.
Product mix decisions.
Answers
1. a
LO3
2. c
LO4
Contribution margin from the division ($120,000 = $320,000 - $200,000) will be lost.
3. d
LO1
4. d
LO3
5. d
LO1
6. d
LO2
7. b
LO3
4-19
whole or part.
8. b
LO4
Assume the unknown volume to be X.

($2.00 + $1.20 + $1.50) X + $18,000 = $6.20 X
X = 12,000 units.
9. a
LO4
Make: ($2.00 + $1.20 + $1.50) 8,000 + $18,000 = $55,600.

Buy: $6.20 8,000 + $18,000 (1 25%) = $63,100.
$63,100 - $55,600 = $7,500 cost savings.
10. b
LO5
11. b
LO4
Only the variable costs ($25 + $10) are relevant in this case.
12. c
LO1, LO4
4-20
whole or part.

Chapter 4

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Chapter 4

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Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

THE THEORY OF CONSTRAINTS

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

LO 4-2 Understand how to apply differential analysis to pricing decisions.

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

$220 7,500 + $165 2,500 = $2,062,500

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

LO 4-3 Understand several approaches for establishing prices based on costs

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

LO 4-4 Understand how to apply differential analysis to production decisions.

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

X = The indifferent volume between make or buy,

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

LO 4-5 Understand the theory of constraints.

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

1,200 units each

Occurs when a company exports its product to consumers in another country at an

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

The practice of selling identical goods or services to different customers at different

_____ 10. Operations where the work required limits production.

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Which of the following statements is correct?

Two alternative projects are under consideration:

Which of the following are relevant in choosing between the projects?

Which of the following statements is correct?

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

For differential analysis,

In a competitive market where firms are price takers,

The following information is for questions 8 9.

At what volume will Company B become indifferent to the make-or-buy choice?

Theory of constraints (TOC)

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Differential analysis is suitable for the following situations except

Chapter 04 - Fundamentals of Cost Analysis for Decision Making

Assume the unknown volume to be X.

Make: ($2.00 + $1.20 + $1.50) 8,000 + $18,000 = $55,600.

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