Chapter 9

Decision Making with Relevant Costs and a Strategic Emphasis

Teaching Notes for Cases
9-1. Product Promotion Strategies; Use of Probabilities
1. Option One: Expected Value (EV) = $230,000
Option Two:
500,000 x.1
600,000 x.25
700,000 x.35
800,000 x.2
900,000 x .1
EV =

=
=
=
=

$50,000
150,000
245,000
160,000
90,000
$695,000

Contribution Margin = .65 x $ 695,000 =

$451,750
Less coupon cost
195,000
Less consultant fee
5,000
Less Redemption 695,000 x .15 x .25 26,062.50
Net Contribution
$225,687.50
Option Three:
400,000 x.1 =
450,000 x.3 =
500,000 x.35 =
550,000 X .2 =
600,000 X .05 =
EV =
Contribution Margin: .65 x $490,000 =
Less: consultant fee
Less: coupon; .07 x 500,000
Less: Redemption:
490,000 x .50 x .1 =
Net Contribution

$ 40,000
135,000
175,000
110,000
30,000
$490,000
$318,500
5,000
35,000
24,500
$254,000

The analysis above supports Option three.

2. Other factors to consider:
the effect on potential sales in future years
the effect on brand image; how a strategy my affect the long term competitiveness of the firm
risk aversion
the quality of the research and analysis that produced the probabilities for strategies two and three
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potential alternative strategies in addition to the three already considered

9-2. Profitability Analysis; Strategy

1. In order to maximize the company's profitability, Sportway Inc. should purchase 9,000 tackle boxes
from Maple Products, manufacture 17,500 skateboards, and manufacture 1,000 tackle boxes. This
combination of purchased and manufactured goods maximizes the contribution per direct labor hour
available, as calculated in Tables 1 and 2.
Table 1

Selling price
Less:
Material
Direct labor
Manufacturing
overhead*
Selling & administrative cost**
Contribution
Direct labor
hours per unit
Contribution per hr

Calculate unit contribution

Purchased
Tackle
Boxes
$86.00

Manufactured
Tackle
Boxes
$86.00

SkateBoards
$45.00

68.00
n/a

17.00
18.75

12.50
7.50

n/a

6.25

2.50

4.00
$14.00

11.00
$33.00

3.00
$19.50

none
n/a

1.25
$26.40

.5
$39.00

*Calculation of variable overhead per unit (given fixed mfg. overhead is $50,000):
Tackle boxes:
Direct labor hours
= $18.75 / $15.00 = 1.25 hours
Overhead/DLH
= $12.50 / 1.25 = $10.00
(DLH = direct labor hours)
Total DLH
= 8,000 x 1.25 = 10,000 hours
Total overhead
= 10,000 hrs x $10 = $100,000
Total variable overhead = $100,000 - $50,000
Variable overhead per box = $50,000/8,000 = $6.25
Skateboards:
Direct labor hours = $7.50/$15.00 = .5 hours
Variable overhead = $6.25 x (.5/1.25) = $2.50
**For calculating contribution, $6.00 of fixed overhead cost per unit for distribution must be deducted
from selling and administrative cost.

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Table 2

The optimal use of Sportway's available direct labor.

Unit
Contribution

Item
Quantity
Total DLH
Skateboards 17,500
$19.50
Make boxes 1,000
33.00
Buy Boxes
9,000
14.00
Total Contr.
Less:
contribution from manufacturing
8,000 boxes (8,000 X $33.00)
Improvement in contribution margin

DLH/
UNIT
.50
1.25

Total
DLH

Balance
Total
of DL h Contribution
10,000
8,750 1,250 $341,250
1,250
33,000

126,000
500,250
264,000
$236,250

2. Some of the possible strategic factors to consider are:

Re: The skateboards:
Will the sale of skateboards introduce Sportway to new markets and new customers that might benefit
other product lines?
Can Sportway compete in the skateboard market? How competitive is this market, and what are the
CSFs that are likely to lead to success for Sportway?
How reliable are the estimates used to develop the predictions for revenues and costs for the
skateboards? How reliable is the market research that predicted growth in skateboard sales.
Will the sale of skateboards affect Sportways image in either a positive or negative fashion. For
example, will Sportways current customers view Sportway as a high quality/innovative
manufacturer of skateboards?
How long is the expected growth in skateboard sales expected to continue?
Re: The purchase of tackle boxes from Maple Products:
What are the alternative uses of Sortways production capacity, in addition to skateboards and tackle
boxes that might produce high contributions?
How reliable is Sportways information that Maple is a reliable producer of quality products?
How will Sportways customers react, if at all, to know that the tackle boxes are not manufactured by
Sportway?

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9-3 Special Order; Profitability Analysis; Strategy; Ethics

This case is presented as a somewhat longer, real-world example of textbook problems on
contribution margin analysis and relevance in decision-making. The approach taken by Superior Valve's
managers was very traditional. Both operating and selling and general administration costs were separated
into two cost pools: costs expected to vary with short-run changes in production levels, and costs
expected not to vary with those changes. Variable overhead costs were applied to individual products on
the basis of direct labor cost. Fixed costs in each functional category were designated as either
discretionary or committed, and some committed fixed costs were assigned to product lines (but not
individual products) using arbitrary allocation bases.
The case does not mention any search for fundamental cost drivers or any attempt to identify the
activities caused by changes in those drivers. Students should question Jerry Conrad's belief that the full
absorption costs computed for his division's products were accurate, which can lead to a discussion of the
symptoms that often accompany a poorly designed or obsolete cost system. You might use this discussion
to introduce the activity-based approach to contribution margin analysis, in which costs are traced to
resources consumed by unit-level activities, batch-level activities, product-sustaining activities, product
line activities, plant-level activities, and, if desired, activities associated with individual customers,
distribution channels, or other cost objects. This approach gives managers much better insights into the
nature of their costs than those provided by the traditional volume-based system used at Superior Valve. It
also allows them to better match the revenue-generating and cost-causing activities of their organizations.
1. Figure 1 shows contribution approach income statements for each product line based on the
data given in the case. An additional line, perhaps labeled "contribution to committed fixed costs and
operating income," could be shown after discretionary fixed costs. For purposes of analysis, this
statement is an improvement over the full absorption statement that it replaces in the management
reporting system. However, there is reason to question the accuracy of the cost attributions.
Field studies have demonstrated that many "fixed" costs are driven by diversity in products,
product lines, customers, and distribution channels. Superior Valve had a small number of product lines
but offered made-to-order valves as well as a full line of products within the standard Hydro-Con and
Pneu-trol lines. Differences in selling prices, machine hours per unit, and unit variable costs among the
three lines imply the substantial degree of product diversity that did in fact exist. Also, there may have
been unrevealed diversity in customers or channels. The marginal income system adopted by Superior
Valve's management would be unlikely to accurately reflect this diversity in the costs attributed to
products and product lines.

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2. The Superior Valve staff conducted the following relevant income analysis of the Wadsworth
Company order:
Revenue (6,000 x $160)
Marginal costs:
Material
Direct labor
Variable overhead
Adjustments
Variable other operating cost
Commission
Total relevant cost
Contribution Margin

$960,000
$390,000
72,000
180,000
60,000
24,000
48,000
774,000
$186,000

If the order were accepted, the Hydro-Con return on sales would increase from 12.5% ($2 million
$16 million) to 12.9% ($2.186 million $16.960 million).
These figures indicated that the Wadsworth order represents an opportunity to increase HydroCon operating income by more than 9%. From the financial perspective, to accept the order is apparently
the proper decision. However, its contribution to operating income may be considerably less than
$186,000. Because the order represents a new application for Hydro-Con valves, acceptance may add
another model to the product line, thereby increasing diversity.
Research has shown that short-run incremental business makes disproportionate demands on a
company's support resources, so that costs that appear to be fixed in the short-run tend to increase. This is
particularly true if incremental orders are accepted on a regular basis. Organizational resources are
required to design, purchase, schedule, produce, sell, deliver, and service special orders, and to the extent
that traditional marginal income analysis fails to accurately reflect the magnitudes and costs of demands
for those resources, managers are less likely to make good decisions on pricing and resource allocation.
3. The analysis conducted by the Superior Valve Division staff indicated that the MTO product
line should not be eliminated unless its dedicated capacity could be reallocated to one of the standard
lines. Although the division's return on sales would increase by .2% if the line were dropped, operating
income would decrease by $310,000:
Total
Division
$34,000,000
24,780,000
$ 9,220,000

Less
MTO
$5,000,000
4,465,000
$ 535,000

Division
w/o MTO
$29,000,000
20,315,000
$ 8,685,000

Revenue
Variable Costs
Cont. Margin
Fixed costs:
Discretionary
1,710,000
225,000
1,485,000
Committed
5,010,000
---5,010,000
Total fixed costs
$ 6,720,000
$ 225,000
$ 6,495,000
Operating Income
$ 2,500,000
$ 310,000
$ 2,190,000
ROS
7.4%
7.6%
As before, these numbers are questionable. The costs saved annually by eliminating the MTO line
may very well exceed $4,690,000 at the current volume level. By decreasing diversity in product lines,
products, customers, and perhaps distribution channels, the division would save the costs of product line,
product-sustaining, and batch-level activities as well as unit-level-activities attributable to made-to-order
products. Costs associated with handling custom orders and designing and producing customized valves
do not vary proportionally with the number of valves produced in an order. Some of the these may be
classified as "committed fixed" costs in the division's marginal income system.
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To improve the profitability of the MTO product line, Jerry Conrad and his staff should consider
conducting a multi-level activity analysis of the costs of producing customized products. They then could
determine whether certain types of customized valves, certain customers, or certain distribution channels
were profitable and others were not. This activity-based information would enable the Superior Valve
management to accept only those orders with sufficient revenue to cover the costs of resources devoted to
handling the order and designing and producing valves to customer specifications
4. In addressing this question, the division staff conducted the following analysis:

Cont. margin/unit
Mach. hrs./unit
Cont. margin/mach.hr.
Addt'l units produced
with MTO capacity
Addt'l revenue
Addt'l cont. margin

Hydro-Con

Pneu-trol

MTO

$59.00
6
$9.833

$15.25
2
$7.625

$26.75
5
$5.350

16,667
$3,333,333
$ 983,333

50,000
$2,500,000
$ 762,500

(20,000)
($5,000,000)
($ 535,000)

If MTO capacity were used to produce Hydro-Con:

Division
w/o MTO
Revenue
Cont. margin
Fixed costs
Operating income

Additional
Volume

$29,000,000
$ 8,685,000
6,495,000
$ 2,190,000

Adjusted
Division

$3,333,333
$ 983,333
--$ 983,333

$32,333,333
$ 9,668,333
6,495,000
$ 3,173,333

Division operating income would increase by $673,333, or 26.9%, from the $2,500,000 budgeted
with MTO.
If MTO capacity were used to produce Pneu-trol:

Revenue
Cont. margin
Fixed costs
Operating income

Division
w/o MTO

Additional
Volume

Adjusted
Division

$29,000,000
$ 8,685,000
6,495,000
$ 2,190,000

$2,500,000
$ 762,500
--$ 762,500

$31,500,000
$ 9,447,500
6,495,000
$ 2,952,500

Division operating income would increase by $452,500, or 18.1%, from the amount budgeted
with MTO.
The analysis suggests that the MTO line should be dropped and its dedicated machinery retooled
to produce additional Hydro-Con units. However, the computations are based on the familiar assumption,
stated in this case, that fixed costs will not increase as volume of output increases, in this instance even up
to the stated maximum capacities for each product line. Indeed, in budgeting no additional fixed costs for
the production and sale of additional standard products with MTO machinery, the analysts assumed that
Hydro-Con fixed costs would not increase if volume increased from the 80,000 units budgeted for fiscal
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year 1983 to 116,667 units (the present maximum capacity plus the additional 16,667 computed above),
an increase of 45.8%. For Pneu-trol, the increase would be from 260,000 to 400,000, or 53.8%!
Superior Valve was a fast-growing division with an organizational infrastructure that was
undoubtedly growing to meet increasing needs. The blanket assumption regarding cost behavior is
unlikely to hold for many of the division's "fixed" costs. A comprehensive activity analysis of those costs
that do not vary proportionally with units of production or sales volume would enable Jerry Conrad and
his staff to better predict the increases or decreases in those costs that would result from various changes
in their drivers. The managers then would have the information needed to consider a wide variety of
actions to raise the overall profitability of the division.

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FIGURE 1
Superior Valve Division
Contribution Margin by Product Line
($000)

Hydro-Con
% Total

% Pneu-trol

MTO

260,000

100.0

20,000

$13,000

100.0

$5,000

Units
80,000
360,000
Revenue
$16,000
100.0 $34,000 100.0
Variable Costs
Material
$65.00
$5,200
$10,400
Direct Labor
12.00
960
3,195
Variable Ovhead 30.002,400
5,101
Adjustments
10.00
800
1,874
Var. Other Op.
4.00
320
810
Var. SGA
20.00
1,600
3,400
Total VaCost
$141.00 $11,280
89.3
$24,780 72.9
Contrib. Margin
$ 4,720
10.7
$ 9,220 27.1
Fixed Costs
Discretionary:
Mfg.
$ 5.00 $ 400
725
Other Op.
5.00
400
700
SGA
2.00
160
285
Total
12.00
$ 960
4.5 $1,710
5.0
Committed:
Mfg.
$ 9.00 $720
$2,215
Other Op.
11.00
880
2,400
SGA
2.00 160
395
Total
$22.00
$ 1,760
20.9
$5,010 14.7

100.0

6.50

$15.00

$3,900

$65.00

$1,300

4.75

1,235

50.00

1,000

1,690

50.55

1,011

2.00

520

27.70

554

1.50

390

5.00

100

5.00

1,300

70.5

$34.75

29.5

25.00

500

$9,035

69.5

$223.25

$3,965

30.5

$ 225

$4,465
$

$ 100
200

100

100
6.0

25
$ 525

4.0

$1,075

550

160

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$2,205

9-8

225

$ 420
970

11.0

535

17.0

$1,045

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Total Fixed
$34.00
25.4
$6,720 19.7
Operating Inc
$25.00
(14.7) $2,500 7.4

$ 2,720

17.0

$2,730

21.0

$ 2,000

12.5

$1,235

9.5

$1,270
$

(735)

5. The Superior Valve Division is an established business which has been part of the parent company for
many years. Its products are at the mature phase of the product life cycle, and one product line, the madeto-order hydraulic controls (MTO), is being considered for withdrawal from the market. For the case
information, it does not appear that innovation is important in this market. While sales are fast growing,
the parent company has not invested significantly in the division, and profits have been variable. It
appears the parent company has a harvest strategy for the division, and the division is profitable
through cost advantage together with low investment in new products or manufacturing equipment.
Additional support for this strategy comes from the fact that the division is operating at excess capacity
(from the case information, including the tables, we know that sales of Hydro-Con, Pneu-trol and MTO
are 80,000 units, 260,000 units, and 20,000units respectively, which is considerable less than the capacity
figures in Table B).
Consistent with the harvest strategy, there is a focus on cost reduction, as reflected in the use of
standard costing and the effort to classify costs as variable and fixed, and for the fixed cost, whether they
are committed or discretionary.
In this environment, the key strategic factors are to maintain profitability and a cost advantage
through:
1) a cost system that will properly support the divisions efforts at cost advantage
2) a cost system that will properly support the divisions decision making regarding pricing
(especially for special orders) and regarding withdrawal of products from the market
6. The suggested solutions for parts 1-4 above have pertinent comments regarding the divisions attempt
to classify costs and analyze cost behavior. Division managements assumptions in the case regarding
cost behavior are incomplete and potentially misleading. In particular, what is needed is an activity
analysis that takes into account the complexity of the manufacturing environment and performs a proper
identification of cost drivers. Superior Valve products appear to have considerable diversity in the use of
machine time (Table B), in the custom line (MTO), in selling prices, and other factors, as noted in the
solutions note for part 1 above. Moreover, the division has experienced variable profits at a time when
revenues are increasing significantly. This points to the need for better product cost information,
particularly if there have been shifts in product mix. Thus, an activity-based costing approach would be
called for in this context. The more accurate product costs from ABC would support the strategic
objectives noted in part 5 above.
7. The MTO line is a significant part of Superior Valves operations, as noted in the data in Tables A and
B. Thus, closing the line could be very disruptive to plant employees and supervisors, even if the
capacity is re-oriented for production to other products. The potential ethical issues would be to consider
the divisions responsibility for any employees who would have to be let go, or who would choose to
leave if MTO were deleted. Perhaps some of the employees, over a number of years, had developed a
loyalty or commitment to the MTO line, and would not easily be relocated to other work areas. Also, for
those employees who would be moved to new work areas, what training programs would be provided,
and how easy would it be for the employees to attain the needed new skills?

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9-4 OmniSport Inc

In order to maximize OmniSport Inc.'s profitability, OmniSport should manufacture 12,000 snowboard
bindings, manufacture 1,000 pairs of skates, and purchase 6,000 pairs of skates from Colcott Inc. This
combination of manufactured and purchased goods maximizes the contribution per available machine
hour, which is the limiting resource, as shown below.
Since snowboard bindings have a higher contribution per machine hour than in-line skates, OmniSport
should manufacture the maximum number of snowboard bindings. Since the contribution per
manufactured pair of in-line skates is higher than the contribution from a purchased pair of in-line skates,
total contribution will be maximized by using the remaining manufacturing capacity to produce in-line
skates and then purchasing the remaining required skates. This optimal combination is calculated below.
Strategic issues relevant to OmniSport include being sure that it maintains the quality reputation that it
has developed in prior years. While Colcott has been a steady supplier of quality products for some time,
it is important that OmniSport continue to insist on quality and regularly check to make sure that its
outsourced products are up to OmniSports high quality standards.
Also, the fact that demand continues to exceed production capacity at the firm should cause
OmniSport to consider plant expansion. Factors to consider here include the desired level of operating
leverage for the firm that is, how sure is OmniSport that sales will continue to increase before making
an investment in additional plant capacity.

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OmniSport Inc.
Contribution Analysis
Machine
Hours
Per
Quantity Unit

Total
Machine
Hours
Used

Machine
Hour
Unit
Balance Contribution
7,500
6,000
1,500
$20
1,500
33
19

Total
Product
Contribution

Machine hours available

Snowboard bindings
12,000
0.5
In-line skates-manufacture
1,000
1.5
In-line skates-purchase
6,000
Total contribution
Less original contribution of (5,000 pairs of skates x $33.00 per pair)
(165,000)
Improvement in contribution

Total Units
Selling price

$222,000

Purchased
Manufactured
Manufactured
In-line Skates
In-line Skates
Snowboard Bindings
6,000
1,000
12,000
Per Unit
Total
Per Unit
Total
Per Unit
Total
$98
$588,000
$98
$98,000
$60
$720,000

Variable costs
Material
Machine cost
Manufacturing overhead (1)
Selling & administrative cost (2)
Variable costs
Contribution margin

75
4
79
19

Fixed costs
Manufacturing overhead (1)
Selling & administrative cost (2)
Fixed costs
Profit

6
6
$13

Machine hours per unit

Contribution per machine hour

$240,000
33,000
114,000
387,000

450,000
24,000
474,000
114,000
36,000
36,000
$78,000

20
24
12
9
65
33

20,000
24,000
12,000
9,000
65,000
33,000

20
8
4
8
40
20

6
6
12
$21

6,000
6,000
12,000
$21,000

2
6
8
$12

1.5
$22

240,000
96,000
48,000
96,000
480,000
240,000
24,000
72,000
96,000
$144,000

0.5
$40

Supporting calculations:
(1)
Manufacturing overhead
Manufactured in-line skates
Machine hours
Manufacturing capacity
Overhead per machine hour
Total overhead
Total variable overhead

=$24.00 per pair/$16 per hour = 1.5 hours per pair

=5,000 pairs x 1.5 hours per pair = 7,500 hours
=$18.00 per pair/1.5 hours per pair = $12.00 per hour
=7,500 hours x $12.00 per hour = $90,000
=$90,000 (total) - $30,000 (fixed) = $60,000 (variable)

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Variable overhead per machine hour =$60,000/7,500 hours = $8.00 per hour
Fixed overhead per pair of skates =$30,000 fixed overhead/7,500 hours = $4.00 per hour
Variable overhead per pair of skates =1.5 hours x $8.00 per hour = $12.00 per pair
Fixed overhead per pair of skates =1.5 hours x $4.00 per hour - $6.00 per pair
Snowboard bindings
Machine hours
=$8 per board/$16.00 per hour = 0.5 hours per board
Variable overhead per snowboard =$8.00 per hour x 0.5 hours per board = $4.00 per board
Fixed overhead per snowboard
=$4.00 per hour x 0.5 hours per board = $2.00 per board
(2)

Selling & administrative cost

Each unit has $6.00 allocated fixed cost. Variable cost = total cost fixed cost
Total Cost Fixed Cost
Purchased in-line skates
$10
$6
Manufactured in-line skates
15
6
Manufactured snowboards
14
6

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Variable Cost
$4
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Teaching Strategy for Article

9-1: Relevance Added: Combining ABC with German Cost Accounting.
This article describes ABC costing and German cost accounting (GPK) and provides a comparison of the two
methods. GPK is presented as a superior method for relevant cost analysis.

Discussion Questions:
1. What is GPK?
GPK is the acronym for German cost accounting, which is an enterprise system-based cost accounting approach
that uses cost information from cost centers at a detailed level, and determines costs using variable costing.
2. How does GPK compare to ABC costing?
Since it is based on variable costing, GPK it is considered useful for relevant cost decisions such as those
encountered in chapter 9: the special order decision, make or buy, profitability analysis, and the process-further
decision. Also, GPK develops costs at a very detailed level, so that it has the advantage of providing the additional
information and accuracy in decision making. A contrast of the two methods is presented in Table 5 in the article.

3. What are the key elements of GPK?

The two key elements of GPK are variable costing and the use of the cost center approach. See Table 5 above.
4. What are the two types of cost centers used in GPK? Explain the difference.
There are two types of cost centers, the primary cost centers and the final cost centers. Primary costs centers
are somewhat removed from the manufacturing process, as for example, plant management and maintenance.
Final cost centers are the manufacturing cost centers.

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