Vous êtes sur la page 1sur 33

Questions 11-1 through 11-10

111 What are relevant costs? Provide several examples for the decision to repair or
replace a piece of equipment.

11-1 Relevant costs are costs to be incurred at some future time and differ for each
option available to the decision maker.
Relevant costs in replacing equipment would include the cost of purchasing
and installing the new equipment, the operating costs of the new equipment, and
the disposal costs of the old equipment, the cost of repair of the old equipment,
and so on. The purchase price of the old equipment would not be relevant to the

112 List at least four different decisions for which the relevant cost analysis model can
be used effectively.

11-2 Decisions where relevant cost analysis might be used effectively include:
1. The special-order decision
2. Make, lease, or buy
3. Outsourcing
4. Sale before or after additional processing
5. Keep or drop products or services
6. Profitability analysis: evaluating programs
7. Determining the optimum short-term product (or service) mix

11-3 What is the relevant cost when determining whether or not to process a product

11-3 The relevant cost is the incremental cost incurred for the additional processing. In a
joint manufacturing process, this would include on separable processing costs.

114 List four to six strategic factors that are often important in the make-or-buy decision.

11-4 Strategic factors include:

1. The level of capacity usage of the plant
2. The time value of money
3. Quality
4. Functionality
5. Timeliness of delivery
6. Reliability in shipping
7. Service after the sale

115 How do short-term evaluations affect a managers incentives and performance?

11-5 A well-known problem in business today is the tendency of managers to focus on

short-term goals and neglect the longer-term strategic goals, because their
compensation is based upon short-term accounting measures such as net income.
This issue has been raised by many critics of relevant cost analysis. As noted
throughout the chapter, it is critical that the relevant cost analysis be supplemented
by a careful consideration of the long-term, strategic concerns of the firm. Without
strategic considerations, management could improperly use relevant cost analysis
to achieve a short-term benefit and potentially suffer a significant long-term loss.
For example, a firm might choose to accept a special order because of a positive
relevant cost analysis, without properly considering that the nature of the special
order will have a significant negative impact on the firm's image in the marketplace,
and perhaps a negative effect on sales of the other products. The important
message for managers is to keep the strategic concerns in mind, and to start with
the strategic objectives in any decision situation.

116 List four or five important limitations of relevant cost analysis.

11-6 The limitations of relevant cost analysis include:

1. Excessive focus on short-term decisions
2. Tendency to focus on quantitative factors only, and to not include the important
strategic factors
3. Managers tendency to include irrelevant costs, such as sunk costs, in the decision
4. Tendency to focus on a single product or department in isolation of others, and there to
perhaps not find the strategically correct analysis

117 How do strategic factors affect the proper use of relevant cost analysis?

11-7 Strategic management principles require a more integrative focus, as noted in the


Financial Focus Customer Focus

Not Linked to Strategy Linked to the Firm's Strategy

Precise and Quantitative Broad and Subjective

Focused on Individual Integrative; Considers all

Product or Decision Customer-related Factors

Short-term Focus Long-term Focus

118 List some of the behavioral, implementation, and legal problems to be anticipated in
the use of relevant cost analysis.

11-8 Some of the behavioral, implementation, and legal issues in using relevant cost
analysis include:
1. The tendency of managers to focus on short term goals, and to not attend
satisfactorily to longer-term strategic goals of the firm. The techniques described in
relevant cost analysis can have the effect of encouraging this bias, unless specific steps
are taken, such as to use the balanced scorecard in management evaluation (see chapter
2. If variable costs are given too much focus, as suggested in relevant cost analysis,
managers can tend to ignore fixed costs. Moreover, some managers might replace
variable costs with fixed costs where possible, to improve the evaluation of their unit. The
result might be higher overall costs for the firm.
3. Researchers have shown a strong human tendency to rely upon and use irrelevant
factors such as sunk costs in decision making. Thus, the proper use of relevant cost
analysis requires the management accountant to carefully explain the techniques and to
carefully present the relevant cost reports to management.
4. Predatory pricing, the lowering of prices to where the effect may be to substantially
damage the competition in an industry is unlawful under the provisions of the Robinson
Patman Act.

119 How does the presence of one production constraint affect the relevant cost analysis
model? Two or more production constraints?
11-9 When there is only one production constraint and excess demand it is generally best
to produce only one of products to maximize income, and that is the product with the
highest contribution margin per unit of scarce resource. When the production process
requires two or more production activities, the choice of sales mix involves a more
complex analysis, and in contrast to the case of one production constraint, the
solution can include both products. The determination of best product mix in this
case involves mathematical programming techniques, which are employed using
either a graphical analysis or a computer-based solution technique.

1110 What is the relationship, if any, between the relevant cost analysis method and cost-
volume-profit analysis (Chapter 9)?

11-10 Relevant cost analysis and cost-volume-profit (CVP) analysis (Chapter 9) are similar
in that they both rely on the distinction of variable versus fixed costs and they both
use the contribution margin (price less unit variable cost) as the focal point of the
analysis. Both CVP analysis and relevant cost analysis focus on the relationship of
profit to volume, and therefore on the unit contribution margin for the product or
Brief Exercises 11-11 through 11-20
11-11 Sales price is $35 for a part that can be manufactured for $33; the $33
manufacturing costs includes $5 per unit fixed cost. What is the savings to
make rather than to buy?

11-11 $35 ($33 - $5) = $7

11-12 Adams Furniture receives a special order for 10 sofas for a special price of
$3000. The materials and direct labor for each sofa amount to $100. In addition,
the setup, supervision and other overhead costs amount to $150 per sofa.
Should Adams accept the special order? Why or why not? Would it make a
difference to your answer if Adams is at full capacity and its current line of
sofas sell for $500 each.
11-12 The contribution on the order is $3,000 10 x $100 = $2,000, or $200 per
sofa; Therefore, Adams should accept the order.

If Adams is at full capacity, then the opportunity cost for lost sales is $500 -
$100 = $400 per sofa; the opportunity cost is higher than the contribution on
the special order, $200; so now the special order should not be accepted.
11-13 Wings Diner has a box lunch that it sells on football games days at the local
university. Each box lunch sells for $6.00 which is made up of $2.50 of
variable costs and packaging, and $2.50 of fixed cost, plus a $1 markup.
What is the lowest price Wings can sell its box lunch so that Wings will still
make a profit?

11-13 Lowest price = variable (i.e., the incremental) cost of $2.50

11-14 Williams Auto has a machine that installs tires. The machine now is in need of
repair. The machine originally cost $10,000 and the repair will cost $1,000, but
the machine will then last 2 years. The variable (labor) cost of operating the
machine is $0.50 per tire. Instead of repairing the old machine, Williams could
buy a new machine at a cost of $5,000 that would also last 2 years; the labor
price per tire would be reduce to $0.25 per tire. Should Williams repair or
replace the machine if it is installing 10,000 tires in the next 2 years?

11-14 Relevant Costs:


Variable Costs:
Labor = $0.50 10,000 = $5,000
Fixed Costs:
Repair Cost = $1,000
Total Costs: $6,000
Variable Costs:
Labor = $0.25 10,000 = $2,500
Fixed Costs:
New Machine = $5,000
Total Costs = $7,500

Relevant Cost Difference = $7,500 - $6,000 = $1,500 more to replace than


11-15 Jamison Health Care is trying to decide if it should eliminate its orthopedic
care division. The last year, the orthopedic division had a contribution margin
of $100,000 and allocated overhead costs of $200,000, of which $90,000 could
be eliminated if the division is dropped. Should Jamison keep the division?

11-15 Contribution Margin = $100,000

Overhead that can be eliminated = $90,000
Change in Income if Division is eliminated = ($10,000)

\ Jamison should keep the division.

11-16 ElecPlus Batteries has two different products, AAA and AA batteries. The AA
batteries have a contribution margin of $1 per package, and the AAA batteries
have a contribution margin of $2 per package. ElecPlus has a capacity for
1,000,000 batteries per month, and both batteries require the same amount of
processing time. If a special order for 10,000 AAA exceeds the monthly
capacity, should ElecPlus accept the special order?

11-16 The AAA batteries have a higher contribution per unit and since both the
AAA and AA batteries require the same processing time, ElecPlus should accept the special
order, and reduce the production/sales of AA batteries, if needed.

11-17 Jackson Inc. disposes of other companies toxic waste. Currently Jackson
loads the waste by hand into the truck, which requires labor of $20 per load.
Jackson is considering a machine that would reduce the amount of time
needed to load the waste. The machine would cost $200,000, but would reduce
labor cost to $5 per load. Should Jackson buy the machine if it averages
10,000 loads per year?
11-17 Cost with machine: $200,000 + ($5 10,000) = $250,000
Cost without machine: $20 10,000 = $200,000

Jackson would recover the cost in 1 and 1/3 years

$200,000 + $5Q = $20 Q
\ Q = 13,333 loads or 13,333 10,000 = 1.33 years

Note: there are also ethical and sustainability issues that arise in this question.

11-18 Durant Co. manufactures glass bottles for dairy products. The contribution margin is $0.10 per
bottle. Durant just received notification that one of their orders for 100,000 bottles contained
misprinted labels, and were required to recall and reprint the labels. If it will cost $0.05 per
bottle to reprint the labels, and $1,000 to re-ship the bottles, what will the net contribution
margin be after the recall?

11-18 Total Contribution Margin:

($0.10 100,000) (0.05 100,000) $1,000 = $4,000

11-19 Lances Diner has a hot lunch special each weekday and Sunday afternoon.
The cost of food and other variable costs for the lunch is $3.50, and the daily
fixed costs are $1,000. Lance has an average of 500 customers per day. What is
the lowest price Lance should charge for a special group of 200 that wants to
come on Saturday for a family reunion? What should be the lowest price Lance
charges on a normal weekly basis?

11-19 The special-order price should cover variable costs, so it should be greater
than $3.50 per meal or $3.50 200 = $700. The regular weekly lunch should
cover fixed and variable costs: $3.50 + ($1,000 500) = $5.50 per meal.

11-20 Sweet Dream Hotel has labor costs that are mostly fixed, including registration
desk, maintenance and general repairs and cleaning. The housekeeping staff
is hired in sufficient numbers so that it is sufficient to clean the number of
rooms that need cleaning, so that housekeeping is a variable cost for the
number of occupied rooms. Which of these costs is relevant for determining
the price of a room?

11-20 In the longer term, all of these costs are relevant, but in the short term the only
costs that are relevant are the variable costs, in this case housekeeping. If a room
goes unoccupied, the only cost that is saved is that of housekeeping.
Exercise 11-21: Special Order; Opportunity Cost

CHECK: Is there sufficient capacity so that opportunity cost = zero?

Current Total Capacity (in units) =
Current Capacity Usage (in units) =
Available Capacity (in units) =

Grant Industries, a manufacturer of electronic parts, has recently received an invitation to bid on a special order for 20,000
units of one of its most popular products. Grant currently manufactures 40,000 units of this product in its Loveland, Ohio,
plant. The plant is operating at 50 percent capacity. There will be no marketing costs on the special order. The sales
manager of Grant wants to set the bid at $9 because she is sure that Grant will get the business at that price. Others on the
executive committee of the firm object, saying that Grant would lose money on the special order at that price.

Output Levels
Manufacturing costs: 40,000 60,000

Direct materials $80,000 $120,000

Direct labor $120,000 $180,000
Factory overhead $240,000 $300,000
Total manufacturing costs $440,000 $600,000
Unit cost $11.00 $10.00

Special-order volume (units) = 20,000

Current plant output (units) = 40,000

Current operating level (% of capacity) = 50.00%
Recommended bid price, special order = $9.00
Normal selling price per unit = $20.00
Lost sales (Part 4) = 5,000
1. Why does the unit cost decline from $11 to $10 when production level rises from 40,000 to 60,000 units?
2. Is the sales manager correct? What do you think the bid price should be?
3. List some additional factors Grant should consider in deciding how much to bid on this special order.

1. Why does the unit cost decline from $11 to $10 when production level rises from 40,000 to 60,000 units?

Costs fall from $11 to $10 because of the fixed overhead costs, which are the same (in total) at each level of
production, so that the per-unit fixed costs decrease as production level increases.

2. Is the sales manager correct? What do you think the bid price should be?

The relevant costs are:

Materials $2.00 ($80,000 40,000)
Labor $3.00 ($120,000 40,000)
Variable overhead $3.00 ($300,000-$240,000) (60,000-40,000)
Total $8.00 per unit
Alternatively, minimum bid price = ($600,000 - $440,000) 20,000 units = $8.00 per unit

Thus, the bid price should be any price above this amount. The selling price recommended by the sales
manager would generate a contribution margin = $20,000

80,000 units
40,000 units
40,000 units

Are opportunity costs = zero? Yes--there is sufficient excess capacity to accept the special order

3. List some additional factors Grant shold consider in decising how much to bid on this special order.

(a) Is the order likely to lead to further regular business with this customer?
(b) Is the order in the strategic best interest of the firm, for example, will it support or undermine
Grant Industry's desired image in the market?
(c) While Grant has enough capacity to complete the special order, will there be other costs in addition to the
variable manufacturing costs in order to complete the order, that is, special tooling or set-up costs, etc.
Also, are there alternative uses of the capacity, which might produce an even greater contribution margin?

4. Total opportunity cost if sales to regular customers of 5,000 units were lost by accepting the special sales

Lost contribution margin, sales to regular customers:

Selling price per unit = $20.00
Variable cost per unit:
Direct materials = $2.00
Direct labor = $3.00
Contribution margin per unit = $15.00
x Lost sales (in units) = 5,000
Opportunity cost = $75,000
Exercise 11-22: Special Order; Opportunity Costs
Alton, Inc. is working at full production capacity producing 20,000 units of a unique product. Manufacturing costs
per unit for the product are as follows:

Direct Materials $9.00

Direct Labor $8.00

Manufacturing overhead $10.00
Total manufacturing cost $27.00

Current capacity (units) = 20,000

Current production volume (units) = 20,000

Current production volume (Part 2) = 16,000
Variable overhead cost per unit = $4.00
Total fixed overhead cost = $120,000
Variable non-manufacturing costs per unit = $8.00
Selling price per unit = $45.00
Special-order request (units) = 5,000

Percent of nonmfg costs reimbursed by SHC = 50.00%

Special order selling price per unit = $35.00

Required Prepare an Excel spreadsheet to answer the following questions.

1. Should Alton produce the special order for SHC? Why or why not?
2. Suppose that Alton Inc. had been working at less than full capacity to produce 16,000 units of the product when SHC
made the offer. What is the minimum price that Alton should accept for the modified product under those conditions?

1. Should Alton produce the special order for SHC? Why or why not?

Current Special Order

Revenue per unit $45.00 $35.00

Variable costs per unit:
Direct materials $9.00 $9.00
Direct labor $8.00 $8.00
Variable factory overhead $4.00 $4.00
Variable nonmanufacturing costs $8.00 $4.00
Total variable costs per unit $29.00 $25.00
Contribution margin per unit $16.00 $10.00
Contribution margin for 5,000 units $80,000 $50,000

The difference in favor of contunuing with current production and turning down the special order is $30,000
($80,000 $50,000).

Thus, the special sales order should be turned down

Alternatively, the following relevant cost analysis can be used:

Revenue from the special sales order (@ $35 per unit offering price) = $175,000

Less: Relevant cost to fill the special sales order:

Out-of-pocket costs ($9 + $8 + $4 + $4 = $25 per unit) = $125,000
Opportunity costs:
# units of lost sales (to regular customers) = 5,000
cm per unit on regular sales ($45.00 $29.00) = $16.00 $80,000
Impact on operating income, accepting the special order = ($30,000)

2. Suppose that Alton Inc. had been working at less than full capacity to produce 16,000 units of the product when
SHC made the offer. What is the minimum price that Alton should accept for the modified product under those

At 16,000 units of current output and 20,000 units of capacity, Alton does not have enough capacity to produce the entire order for
SHC. But, the contribution margin on regular sales ($16.00 per unit) exceeds the contribution margin on sales to SHC ($10.00 per
unit), so Alton should try to reduce or delay 1,000 units of the SHC order to get an order for 4,000 units. Then the special order
could be accepted without a loss of regular sales.

If SHC insists on the full order of 5,000 units, then Alton must figure the contribution margin on lost sales ($ 16.00 1,000 units =
$16,000). This loss of contribution margin is less than the contribution margin on the special order ($50,000), so the special order
would still be accepted at the $35.00 offering price.

The minimum price would be $28.20 per unit, the total variable cost per unit ($25.00) plus the contribution margin of lost sales,
allocated per-unit to the special order ($3.20 = $16,000 5,000 units).

In general, the minimum acceptable price = total relevant costs = out-of-pocket costs + opportunity costs, as shown below:

Out-of-Pocket Costs:
Direct materials $9.00
Direct labor $8.00
Variable mfg overhead $4.00
Variable nonmanufacturing costs $4.00 $25.00
Opportunity Cost:
No. units of lost sales 1,000
Cm per unit--regular sales
($45.00 $9 $8 $4 $8) $16.00
Total opportunity cost $16,000
No. units in special order 5,000 $3.20
Minimum acceptable price $28.20

Note that instead of incurring the opportunity cost Alton might try to reduce the order from SHC or to delay 1,000 units of the SHC
order. This way, the special order can be done without loss of regular sales.

3. Goal Seek Solution

Revenue from special sales order:

# units in special sales order = 5,000

selling price per unit = $28.20 $141,000
Total cost from special sales order:

No. of units in special order = 5,000

Relevant cost to fill the order:
Out-of-pocket cost/ unit = $25.00 $125,000
Opportunity cost:
Total lost units = 1,000
cm/unit, reg. sales = $16.00 $16,000
Revenue relevant costs: Special Order = $0
Exercise 11-23: Special Order; Use of Opportunity Cost Information
Sharman Athletic Gear, Inc. (SAG) is considering a special order for 15,000 baseball caps with the logo of
East Texas University (ETU) to be purchased by the ETU alumni association. The ETU alumni association
is planning to use the caps as gifts and to sell some of the caps at the alumni events in celebration of the
universitys recent national championship by its baseball team. Sharmans cost per hat is $3.50 which
includes $1.50 fixed cost related to plant capacity and equipment. ETU has made a firm offer of $35,000 for
the hats, and Sharman, considering the price to be far below production costs, decides to decline the offer.

1. Did Sharman make the wrong decision? Why or why not?
2. Consider the management decision-making approach at Sharman that resulted in this decision. How was
opportunity cost included or not included in the decision? What decision biases are apparent in this decision?

Special order quantity = 15,000

Cost per unit = $3.50

Allocated fixed costs = $1.50
Special order offering price = $35,000

Solution (15 min)

1. Analysis of special sales order:

Incremental Cost per Unit:

Full cost per Unit = $3.50
Less: Allocated fixed cost = $1.50
Incremental Cost per Unit = $2.00
Total Incremental Cost:
Incremental Cost per Unit = $2.00
x No. of Units in Order = 15,000
Total = $30,000
Offering price = $35,000

Effect of special order on short-term operating income =


Therefore, this is a missed opportunity for Sharman, caused by a mistaken reliance

on full cost, rather than relevent cost, data.

2. Research studies have consistently found that decision makers often ignore opportunity costs. For this
reason, it is particularly important that the development of decision-making skills place particular
emphasis on identifying and incorporating opportunity costs. Interestingly, a recent study found that
decision makers with greater expertise in developing comparative income statements appeared to ignore
fixed costs more than those with less experience.This was interpreted as resulting in part from the
experienced decision makers strong focus on computing and comparing net income. The problem is that
the calculation of accounting net income does not include opportunity costs, thus, a focus on accounting
net income could have caused the decision makers to ignore opportunity costs.

Other studies have shown that the decision makers cognitive style, the presence of unused capacity,
or the relative amount of the opportunity cost can affect the use of opportunity cost information by the
decision makers in experimental studies. Overall, these results show that in practice, decision makers
have a difficult time using opportunity cost information properly and consistently.

References: Sandra C. Vera-Munoz, The Effects of Accounting Knowledge and Context on the Omission of
Opportunity Costs in Resource Allocation Decisions, The Accounting Review, January 1998, pp. 4772.
Steve Buchheit, Reporting the Cost of Capacity, Accounting, Organizations and Society, August 2003, p.
549; Robert E. Hoskin, Opportunity Cost and Behavior, Journal of Accounting Research, Spring 1983, p.
78; Robert Chenhall, Deigan Morris,
The Effect of Cognitive Style and Sponsorship Bias on the Treatment of Opportunity Costs in Resource
Allocation Decisions, Accounting, Organizations and Society 16, Issue 1, pp. 2746.
Exercise 11-24: Special Order

Earth Baby, Inc. (EBI) recently celebrated its tenth anniversary. The company produces organic baby products for health-
conscious parents. These products include food, clothing, and toys. Earth Baby has recently introduced a new line of
premium organic baby foods. Extensive research and scientific testing indicate that babies raised on the new line of foods
will have substantial health benefits. EBI is able to sell its products at prices higher than competitors because of its
excellent reputation for superior products. EBI distributes its products through high-end grocery stores, pharmacies, and
specialty retail baby stores.
Joan Alvarez, the founder and CEO of EBI recently received a proposal from an old business school classmate, Robert
Bradley the vice president of Great Deal, Inc. (GDI), a large discount retailer. Mr. Bradley proposes a joint venture between
his company and EBI, citing the growing demand for organic products and the superior distribution channels of his
organization. Under this venture EBI would make some minor modifications to the manufacturing process of some of its
best-selling baby foods and the foods would then be packaged and sold by GDI. Under the agreement EBI would receive
$3.10 per jar of baby food and would provide GDI a limited right to advertise the product as manufactured for Great Deal by
EBI. Joan Alvarez set up a meeting with Fred Stanley, Earth Babys CFO, to discuss the profitability of the venture. Mr.
Stanley ran some initial calculations and determined that the direct materials, direct labor, and other variable costs needed
for the GDI order would be about $2 per unit as compared to the full cost of $3 (materials, labor, and overhead) for the
equivalent EBI product.

Should Earth Baby, Inc. accept the proposed venture from GDI? Why or why not?

To begin the analysis, Fred Stanley, the Earth Baby CFO, should recognize that the $3.00 full cost for its product
includes $1.00 of irrelevant fixed overhead. Only the variable costs of $2.00 per unit are relevant. From this
standpoint, GDIs proposal makes sense, since there would be a contribution of $1.10 ($3.10 price less $2.00
relevant cost) per unit sold.
However, the agreement with GDI could be a potentially serious strategic liability for Earth Baby. Earth Babys
reputation is built upon differentiation and product superiority, features which make it attractive to a small, but
important segment of the baby products market. To sell its products through a discount retailer, even under another
brand name, could harm the differentiated image of Earth Babys product line, and cause it to lose market share in its
usual distribution channels (the high-end grocery stores and specialty baby retail stores). This is especially true given
that GDI has the limited right to market the product as manufactured by Earth Baby. For this agreement to make
sense, this limited right would have to be fairly strict. Earth Baby could be trading a short-term gain for a potential
long-term competitive damage in this potential venture with GDI. It should look for business partners that are more in
line with its strategy and image.
Exercise 11-25: Make or Buy; Continuation of Problem 9-25
Calista Company manufactures electronic equipment. In 2012, it purchased the special switches used in each
of its products from an outside supplier. The supplier charged Calista $2 per switch. Calistas CEO considered
purchasing either machine X or machine Y so the company can manufacture its own switches. The CEO
decided at the beginning of 2013 to purchase Machine X. The projected data for 2013 are:

Machine X Machine Y

Annual fixed cost $135,000 $204,000

Variable cost per switch $0.65 $0.30

Supplier charge per switch = $2.00

1. For machine X, what is the indifference point between purchasing the machine and purchasing from the outside vendor?
2. At what volume level should Calista consider purchasing Machine Y?


1. For machine X, what is the indifference point between purchasing the machine and purchasing from the outside vendor?

From 9-25:
Relevant outside purchase price per unit:
Annual Fixed cost component = $0
Variable component (per unit) = $2.00
Cost to Make (insourcing):
Annual Fixed Cost Component = $135,000
Variable component (per unit) = $0.65
Breakeven volume (point of indifference) = FC variable cost per unit = 100,000 units

Thus, if anticipated volume > 100,000 units per year, then purchasing Machine X made sense.

Ex. 9-25:
This situation is different: the cost of Machine X is now a sunk cost; thus, the unit cost of $0.65 is always
preferred to the outside price of $2.00 per unit, irrespective of anticipated volume (even for very low volume levels).

2. At what volume level should Calista consider purchasing Machine Y?

Note that, as explained above in 1, the $135,000 purchase cost of Machine X is irrelevant (i.e., it is a sunk cost).

Breakeven volume level (indifference point between using Machine X and purchasing Machine Y):

Relevant Cost of Using Machine X:

Annual Fixed Cost $0
Variable Cost per unit $0.65
Relevant Cost of Using Machine Y:
Annual Fixed Cost $204,000
Variable Cost per unit $0.30
Breakeven volume (point of indifference) = FC variable cost per unit =
582,857 units

Note that the indifference point is much higher than it was in 9-25 (197,143 units per year) because of the fact that
the purchase cost of Machine X is now a sunk cost and the cost of purchasing Machine Y is significant.

3. Using Goal Seek to Solve for the Annual Indifference Volume

Annual Volume (units) = 0

Annual Cost of Using Machine X:
Fixed cost component (per year)
Variable cost component (total) $0
Annual Cost of Using Machine Y:
Fixed cost component (per year) $204,000
Variable cost component (total) $0
Difference in Annual Total Cost ($204,000)
Exercise 11-26: Sell-or-Process Further; Product Mix


Cantel Company produces cleaning compounds for both commercial and household customers. Some of these
products are produced as part of a joint manufacturing process. For example, GR37, a coarse cleaning powder meant
for commercial sale, costs $1.60 a pound to make, and sells for $2.00 per pound. A portion of the annual production of
GR37 is retained for further processing in a separate department where it is combined with several other ingredients to
form a SilPol, which is sold as a silver polish, at $ 4.00 per unit. The additional processing requires pound of GR37
per unit; additional processing costs amount to $2.50 per unit of SilPol produced. Variable selling costs for this product
average $0.30 per unit. If production of the SilPol were discontinued, $5,600 of costs in the processing department
would be avoided. Cantel has, at this point, unlimited demand for, but limited capacity to produce, product GR37.


Selling price per pound = $2.00

Cost to make (per pound) = $1.60
SilPol (Silver Polish):

Selling price per unit = $4.00

Addional processing cost/unit = $2.50
Amount of GR37 needed per unit = 0.25 lb.
Variable selling costs/unit = $0.30
Avoidable fixed costs = $5,600
Current max. output (GR37) (Part 2) = 5,000 lbs.


1. Calculate the minimum number of units of SilPol that would have to be sold in order to justify further
processing of GR37.
2. Assume that the cost data reported for GR37 is obtained at a level of output equal to 5,000 pounds., which is the
maximum that the company can produce at this time. Prepare an income statement under each of the following
scenarios: (a) all available capacity is used to produce GR37, but no SilPol; (b) 4,000 units of SilPol are produced,
with the balance of capacity devoted to the production/sale of GR37; 8,000 units of SilPol are produced, with the
balance of capacity devoted to the sale of GR37; and (d) 10,000 units of SilPol are produced, with the balance of
capacity devoted to the sale of GR37.


1. The key is to identfiy the relevant costs and revenues associated with any GR37 diverted for production of
Incremental Fixed Costs (SilPol) = $5,600
Incremental Contribution Margin/Unit Sold:
Selling price per unit = $4.00
Less: Relevant Costs:
Opportunity cost: lost revenue from GR37:
GR37 selling price/lb. = $2.00
Coversion rate = 0.25 $0.50
Out-of-Pocket Costs:
Additional processing/unit = $2.50
Variable selling cost/unit = $0.30 $2.80
Contribution Margin/unit of Silver Polish Sold = $0.70

Thus, to justify diversion of GR37 to produce SilPol (thereby incurring additional fixed costs
of $5,600),
we would have to sell at least $5,600 $0.70 per unit = 8,000 units of SilPol
2. Comparative Income Statement--Different Product Mixes Units of SilPol Produced/Sold

Sales: 0 4,000 8,000 10,000

Pounds 5,000 4,000 3,000 2,500
Selling price per pound $2.00 $2.00 $2.00 $2.00
Revenue from GR37 $10,000 $8,000 $6,000 $5,000
Units 0 4,000 8,000 10,000
Selling price per unit $4.00 $4.00 $4.00 $4.00
Revenue from Sale of SilPol $0.00 $16,000 $32,000 $40,000
Total Sales Revenue $10,000 $24,000 $38,000 $45,000
GR37 (5,000 lbs. $1.60/lb.) $8,000 $8,000 $8,000 $8,000
Incremental Costs--SilPol:
Avoidable Fixed Costs 0 $5,600 $5,600 $5,600
Variable costs:
Processing costs (@ $2.50/unit) $0.00 $10,000 $20,000 $25,000
Selling costs (@ $0.30/unit) $0.00 $1,200 $2,400 $3,000
Total Costs $8,000 $24,800 $36,000 $41,600
Operating Income (Total Revenue Total Costs) $2,000 ($800) $2,000 $3,400

Note that at volume levels below 8,000 units, it is not worthwhile to incur the additional fixed processing
costs of $5,600. The breakeven volume, as indicated by the answer to #1 above, is 8,000 units of SilPol.
Exercise 11-27: Product Profitability Analysis

Barbour Corporation, located in Buffalo, New York, is a retailer of high-tech products known for their
excellent quality and innovation. Recently the firm conducted a relevant cost analysis of one of its product
lines that has only two products, T-1 and T-2. The sales for T-2 are decreasing and the purchase costs are
increasing. The firm might drop T-1 and sell only T-2. Barbour allocates fixed costs to products on the
basis of sales revenue. When the president of Barbour saw the income statement, he agreed that T-2
should be dropped. If this is done, sales of T-1 are expected to increase by 10 percent next year; the
firms cost structure will remain the same.


T-1 T-2

Sales $200,000 $260,000

Variable cost of goods sold $70,000 $130,000

Contribution margin $130,000 $130,000
Fixed corporate costs $60,000 $75,000
Variable selling and administration $20,000 $50,000
Fixed selling and administration $12,000 $21,000
Total expenses $92,000 $146,000
Operating income $184,000 ($16,000)

Projected increase in sales of T-1 of T-2 is dropped = 10.00%

Part 3: Reduction in total fixed costs = $45,000

1. Find the expected change in annual net income by dropping T-2 and selling only T-1.
2. By what percentage would sales from T-1 have to increase in order to make up the financial loss from dropping T-2?

3. What is the required % increase in sales from T-1 to compensate for lost margin from T-2 if total fixed costs can be
reduced by $45,000?
4. What strategic factors should be considered?
1. Change in annual income:

Product T-1:

Last year's contribution margin = $200,000 $70,000 $20,000 = $110,000

Contribution margin ratio (%) = 0.55
Product T-2:
Last year's contribution margin = $260,000 $130,000 $50,000 = $80,000
Contribution margin ratio (%) = 0.31
Incremental CM from T-1 if T-2 is dropped = $110,000 0.10 = $11,000

The net effect of discontinuing T-2 is the incremental CM for T-1 reduced by the CM lost from T-2:

= $11,000 $80,000 = ($69,000)

2. Required % increase in sales for T-1, to compensate for the loss of T-2:

Loss of CM, T-2 = Gain in CM, T-1

$80,000 = X% $110,000
X= 72.73%
Last year's total CM = $190,000
Projected (1.7273% $110,000) = $190,000

3. Required % increase in sales for T-1 to compensate for the loss of T-2 accompanied by a decrease
in total fixed costs by $45,000?

Loss of CM, T-2 = Gain in CM, T-1

$80,000 $45,000 = X% $110,000
X = $35,000 $110,000 = 31.82%
Last year's total operating income = $168,000
Projected = $168,000 ($184,000 $16,000) + (31.82% $110,000)
$80,000 + $45,000

4. The following strategic factors should be considered:

a) what will be the effect on the firm's image if T-2 is dropped?
b) will this result in an unfavorable reaction from key customers of T-1 and of other product lines?
c) can the production capacity released by T-2 be used for new products?
Exercise 11-28: Product-Mix Analysis

Sandalwood Company produces various lines of high-end carpeting in its Ashville, NC plant. This question pertains
to two different grades of carpet in its Symphony line: commercial and residential. The former sells for $16 per
square yard, while the latter sells for $25 per square yard (wholesale). Variable costs are $10 per square yard and
$15 per square yard for the commercial and residential grade products, respectively. On average, it takes 12 labor
hours to produce 100 square yards of commercial carpeting, and 18 labor hours for each 100 square yards of
residential carpeting. The number of available labor hours at the plant is limited to 4,600 hours per week. Current
sales forecasts indicate that weekly sales for the commercial line and the residential line, respectively, are 30,000
square yards and 8,000 square yards. Fixed manufacturing costs, allocated to products on the basis of 4,600 total
labor hours per week, amount to $1.50 and $2.25 for each square yard of commercial versus residential carpet,

Data Product

Commercial Residential
Selling price per square yard $16.00 $25.00
Variable costs per square yard $10.00 $15.00
Allocated fixed mfg. costs per square yard $1.50 $2.25
Labor hours per 100 square yards 12 18
Weekly sales forecasts (square yards) 30,000 8,000
Weekly labor hour constraint (total) 4,600

1. What is the gross profit (margin) for each of the two products, in total and per square yard?

2. What is the contribution margin for each of the two products, in total and per square yard?

3. Given the labor constraint and the product demand constraints, what is the optimum product
mix, on a weekly basis, for each of the two products? (Show calculations.)
4. In general, what is the rule to be followed when attempting to determine the optimum short-
term product (or service) mix?
5. What is the primary role of the management accountant in terms of addressing the short-
term product (or service) mix problem?

1. Gross profit calculations, by product, and per square yard Product

Commercial Residential
Sales (@ $16, $25) $480,000 $200,000
Less: CGS:
Variable (@ $10, $15) $300,000 $120,000
Fixed (@$1.50, $2.25) $45,000 $18,000
Gross profit (margin) $135,000 $62,000
Gross profit per square yard $4.50 $7.75

Note that the above profitability measures are not pertinent to the short-term product-mix decision
because they include an allocated portion of fixed costs which, in this example, are not relevant--
they are "sunk" (i.e., in total, they are independent of product mix).

2. Contribution margin, by product, and per square yard

Commercial Residential
Sales (@ $16, $25) $480,000 $200,000
Less: Variable costs (@ $10, $15) $300,000 $120,000
Contribution margin $180,000 $80,000
Contribution margin per square yard $6.00 $10.00

Note that the above profitability measures are not relevant/useful for determining the optimum
short-term product mix because they do not relate to the relevant demands of the two
products in terms of the scare resource (labor hours).

3. Optimum product mix, given labor-hour constraint and demand constraints

Commercial Residential
Contribution margin per square yard $6.00 $10.00
Labor hours per square yard 0.12 0.18
Contribution margin per labor hour $50.00 $55.56

Optimum Mix:
Residential Grade Carpet: Hours Sq. Yards
Total demand = 8,000 sq yds. 0.18 hr./sq. yd. = 1,440 8,000
Commercial Grade Carpet (balance of production): 3,160 17,556 OK
4,600 hours 1,440 hours = 3,160 hours 0.12 hour/sq. yd =
4,600OK Note the builtin

4. Conceptual Lesson check

(conditional IF

The primary conceptual lesson is that neither of the profit measures reported in 1 or 2 are
useful for determining the short-term optimum product mix in the presence of resource constraints (labor
hours in the present example). For this purpose it is necessary to allocate available labor hours on the
basis of the contribution margins expressed on a per-labor-hour basis. In the present case, the
residential-grade carpet is the more profitable of the two product lines when measured on this basis.
Thus, labor hours should be devoted to the production of this product up to whatever is needed to meet
weekly demand. Any remaining labor hours should be used to produce commercial carpet. Finally, note
that in this case the contribution margin per labor hour figures are much closer than either of the
alternative profitability measures. Basing production decisions solely on these alternative profitability
figures could lead to a suboptimal deployment of available capacity.

5. Primary Role of the Management Accountant

The primary role of the management accountant in this context is to develop accurate estimates
of the contribution margins for each each product and to work with engineers to determine labor-
hour consumption of each product. Together, these inputs allow us to provide an optimum short-
term product mix.
Exercise 11-29: Solar Panels--Lease vs. Buy?


As indicated in the Real-World Focus (RWF) item on page XXX, consumers (including businesses and
local governments) interested in using solar power generally have an option to purchase or to lease the
solar panels. To adequately address the questions below, you will have to first do some research on the
web. Please remember to document the website (or other source) from which you obtained information
related to this exercise.


1. In general, what are the relevant costs associated with the lease decision and the purchase decision as
regards the acquisition of solar panels?
2. What are the primary non-financial considerations associated with this particular lease-vs.-purchase
decision? Address this question from the standpoint of individual consumers, businesses, and society at
large (i.e., the environment).


1. Relevant Costs--Leasing vs. Purchasing: Solar

Panels a. Purchase
(1) original cost, including installation
(2) annual maintenance contract?
(3) annual maintenance expense?
(4) future repair expense?
(5) financial incentives:
i. Federal income tax credits (see: http://www.energysavers.gov/financial/70010.html )
ii. State and local financial incentives (see: http://www.dsireusa.org/ )
iii. Financing incentives/subsidies
iv. Utility rebates
v. loan guarantee programs
(in short, there is an almost bewildering array of financial-incentive
programs available at both the government [federal and state] level
and at the level of the local utility provider)

b. Lease:
(1) Lease terms:
i. fixed payment plan per month
ii. Variable-cost payment plan (also known as "Power Purchase
Agreements" or PPAs)--generally, these are slightly below
current charges per kilowatt hour by the local utility
iii. Mixed-cost agreements: monthly fixed charge plus variable
charge based on usage
iv. Excess electricity generated during the day--in some cases, consumers
receive a credit, which is used to offset night-time electic consumption
(2) Cancellation fee/penalty (if lease is terminated before its expiration date)
(3) Price escalation:
i. what is the annual increase in the contractual rate paid?
ii. Is there a limit, during the term of the lease, to the monthly charge?
(4) Length of the lease?

Note: in a leasing arrangement, the lessor (third party) receives any financial
incentives (rebates, tax credits, etc.) associated with the installation

2. Other considerations:

a. Individual

i. Risk--by leasing, the basic risk is that the cost of (purchasing) solar panels would fall in
the future and/or the level of government subsidy for such would increase significantly
(which effectively reduces the cost): with the lease, the lessee is locked in to the
agreement until the expiration of the lease
ii. Under a lease, capital is not tied up
iii. The availability of solar power may increase the value of the home and/or make the
home more marketable; note that this applies to the "purchase"option only
iv. Are major appliances in the home already "energy star" rated (i.e., energy efficient)? In
many cases upgrading appliances would be a worthwhile first step prior to installing
solar energy panes
v. Solar energy could conceivably be used in the future to charge electic cars.

b. Buisnesses

1. use of solar-generated power may make businesses more competitive (due

to decreased operating costs)
2. a leasing contract would allow the buiness/organization to more accurately predict
electric energy costs (because the costs are specfied in the lease itself)
3. under a leasing arrangement, capital (that could be used elsewhere in the organization) is
not tied up
4. use of solar (i.e., renewable) energy could help the business comply with Greenhouse Gas
Emissions (GGE) legislation, both current and future (under "cap and trade" rules, for
example, a business could trade its credits based on the amount of solar energy the
business generated during the perio
5. Image--are the customers more likel to buy from a business that is viewed as
more "environmentally responsible"?

c. Society:
i. Cleaner air/lower levels of pollutants/reduction in level of Greenhouse Gas Emissions (GGE)
ii. Decreased reliance on foreign sources of energy/energy independence
iii. More diverse "energy portfolio" (decreased risk)
Ex. 11-30: Relevant Cost Exercises
Part a: Make-or-Buy Decision

Data Input
Subcontractor Bid: Part OP89
Number of units 2,000 (given)
Subcontractor bid price $120,000 (given)
Full production cost information: Cost/Unit

Direct materials $28.00 (given)

Direct labor $18.00 (given)
Variable overhead What does this mean?
$16.00 (given)
Allocated fixed overhead $4.00 (given)

Relevant Cost to Manufacture (i.e., to "make"):

Direct materials $28.00 per unit
Direct labor $18.00 per unit
Variable overhead $16.00 per unit
Total relevant cost/unit $62.00 per unit
Relevant cost to buy $60.00 per unit

Key question: is the fixed overhead

avoidable? Qualitative Considerations:
a. How does the quality of product compare, insourcing vs. outsourcing?

b. Reliability (i.e., on-time delivery performance)?

c. Financial condition of the supplier? (With the supplier be in business?)

d. Are there alternative (i.e., better) uses of the available capacity?

e. Will outsourcing allow information leakage regarding your product (a

negative if eventually in the hands of your competitors)?

f. Will outsourcing cause an increase in unemployment? Attendant costs:

increased payroll taxes; negative goodwill.

Part b: Disposal of Assets

Data Input What does the term "NBV" mean?

Inventory of discontinued units 2,000 (given)

Net book value (NBV) of inventory $50,000 (given)
Additional (i.e., incremental) cost to remachine parts $25,000 (given)
Estimated sales value of remachined parts $30,000 (given)
Current disposal value of parts ("as is") $2,500 (given)

Note the use of a conditional IF statement

Incremental Revenues from Further Processing:

Estimated sales value of remachined parts $30,000
Current disposal value of parts $2,500
Incremental revenue from remachining $27,500
Incremental Costs (remachining) $25,000

Difference $2,500
in favor of remachining
Note the use of the ABS value

What qualitative/strategic factors might affect the decision?


1. Any other (better) use of the capacity that will be devoted to this task?
2. Perception in the marketwill consumers matter that remachined parts make their
way into the market?
3. Reliability/quality of the remachined parts (in the minds of the consumer)?

Part c: Asset Replacement

$90,000 (given)
Data Input $9,000 (given)
$92,000 (given)
$75,000 (given)

Original cost of asset (boat)

Current disposal (salvage) value of Note the use of a conditional IF statement

boat Cost of new boat

Refurbishing cost (old boat) $92,000
Solution $83,000
$8,000 in favor of refurbishing

Net cost of new boat:

Gross cost of new boat
Less: Current salvage value of old $92,000
boat Net cost of new boat $75,000
Refurbishing cost--old boat
Difference $9,000 $84,000

Alternative presentation format:

Cost to buy a replacement boat =

Total cost of refurbishing:

Out-of-pocket cost =
Plus: Opportunity cost =

Qualitative Considerations:
1. Personal preference (ultility function) for new vs. refurbished asset?
2. Safety/reliability of refurbished boat vs. new boat?

Other quantiative Considerations:

1. Disposal value of each option, at end of useful life?
2. Income tax consequences (e.g., casualty loss write-off), if any?

Part d: Sell or Process Further?

(please see diagram below)
Data Input
Joint production costs =
Item $240,000

A B C Total
Units produced

Sales values @ split-off point 12,000 8,000 4,000 24,000

Relative sales values @ split-off point $240,000 $100,000 $60,000 $400,000
Allocation of joint costs 60% 25% 15% 100%
Ultimate sales values (given) $144,000 $60,000 $36,000 $240,000
Separable processing costs (given) $280,000 $120,000 $70,000 $470,000
$28,000 $20,000 $12,000 $60,000
Final Sales
Costs--A Value--A

Final Sales

Costs--B Value--B

Split- off Separable

Final Sale s

Costs--C Value--C


1. Definitions:

a. joint production process: process in which more than output emerges from a common resource input
(e.g., barrel of crude oil)

b. joint costs: in a joint production process, these are costs incurred before the split-off point; that is,
these costs are joint or common to the outputs; since these costs are non-traceable, they must be
allocated to outputs

c. separable processing costs: in a joint production process these are the costs incurred after the split-off
point; as such, these costs are traceable to individual products and incremental to the decision to
process products beyond the split -off point

d. split-off point: point in a joint production process where products with individual identities emerge; cost
incurred prior to the split-off point are called joint costs, while those incurred after the split-off point are
called separable processing costs

2. Which products, if any, should be processed further and then sold?

Incremental Revenue: Ultimate sales values

(given) Sales value @ split-off (given) $280,000 $120,000 $70,000
Incremental revenue $240,000 $100,000 $60,000
Incremental Cost (given)
Increm. Revenue - Increm. Cost $40,000 $20,000 $10,000
$28,000 $20,000 $12,000
$12,000 $0 ($2,000)

Deaton Corp. is indifferent about the further processing for B since the net benefit
is zero. There would be a positive benefit for further processing of A ($12,000)
and a loss from further processing of C ($2,000). Note that the joint production
costs of $240,000 are sunk with respect to the decision whether individual
products should be sold at the split-off point or processed further and then sold.

3. For financial reporting and tax purposes, accountants need to value inventory on a "full cost" basis. Thus,
in the present case for income-statement preparation purposes and for purposes of preparing an end-of-
period balance sheet, a portion of the joint production cost of $240,000 must be assinged to each unit
sold during the period and each unit on hand at the end of the period. There are alternative ways to
allocate joint production costs to outputs. Regardless of how these costs are handled for financial
reporting and tax purposes, they are irrelevant to the sell-or-process further decision.

Part e: Make-or-Buy (sourcing decision)

Data Input
Volume of parts (units) required
Purchase price/unit from outisde supplier 20,000 per year
% of fixed overhead that is unavoidable $90.00
Full Manufacturing Cost per Unit Produced: 40%

Direct materials
Direct labor $35.00 ??
Variable overhead $16.00
Fixed overhead $24.00
Total $20.00


Relevant Cost to "Make" = "Avoidable Mfg. Costs":

Direct materials
Direct labor $35.00
Variable overhead $16.00
Avoidable fixed overhead $24.00 Note the
Avoidable manufacturing costs $12.00 use of a
External purchase price/unit IF

$3.00 in favor of producing internally

What qualitative factors might affect the decision here?

a. Are there alternative (better) uses for the available capacity?
b. Quality of the supplier's product: how does it compare to the quality of internal production?
c. Reliability--on-time delivery performance of the supplier?
d. Future price trends: is the supplier price likely to be lower (or greater) in the long run?
e. Outsourcing may allow information about the design of the product to leak out to competitors.
f. Employment-related considerations: if we outsource, what happens to our labor force and
costs such as unemployment insurance, goodwill, etc.?

Part f: Selection of Most Profitable Product

Data Input
Sales price per unit Flash Clash
Costs: $250 $140
Direct materials
Direct labor ($25/hr.) $50 $25
Variable overhead (based on DLHs) $100 $50
Fixed overhead (based on DLHs) $50 $25
Marketing costs (all fixed) $20 $10
Total cost per unit $10 $10
Operating profit per unit $230 $120
$20 $20

Direct labor cost/hr. (given) = $25.00

Direct labor hours/unit (given) 2.0 1.0


1. The comment "Flash and Clash are processed through the same production departments" can be
taken to mean that capacity-related (i.e., fixed manufacturing) costs in total are unrelated to short-term
fluctuations in product mix. For short-term product planning, therefore, the total fixed costs are not relevant.

2. Product Preference:
Flash Clash

Selling price per unit $250 $140

Variable costs per unit $200 $100
Contribution margin (cm) per unit $50 $40
DLHs (the scarce resource) per unit 2.00 1.00
Contribution margin per DLH $25.00 $40.00
Thus, based on the above, we should produce as much CLASH as possible
Note the use of a conditional IF statement

Clash returns the highest amount per DLH, the scare resource. Therefore, the optimum short-term product
mix would consist of producing Clash up to external demand. Any remaining DLHs would then be devoted to

the production of Flash.

Part g: Special-order pricing

Data Input
Luncheon Information:
Average # of patrons/day
Selling price per lunch 600
Estimated variable cost per lunch $5.00
Current capacity per day $2.00
Fixed costs per day 700 patrons
Tour-Bus Information: $1,200
Number of patrons
Incremental fixed costs 50
Offer price from the tour group $0
$3.50 per meal

Should the owner accept the special bid-price from the tour groups?

Minimum selling price per unit = incremental costs

Out-of-pocket costs:
(variable + fixed + opportunity):
Variable out-of-pocket costs per meal
Fixed out-of-pocket costs per meal $2.00
This is a general model
Opportunity costs $0 for structuring the
Incremental costs special-sales order
Bid price from tour group $2.00 decision.

Therefore, short-term profits increase by taking on the additional business.

What if the tour company were able to guarantee 200 patrons at least once per month, for

$3.00 per meal?

Number of patrons per month 200

Special-order price offered by tour company (given)

Incremental costs per tour-bus meal:

Variable out-of-pocket costs per meal $2.00
Fixed out-of-pocket costs per meal $0.00
Note the use of a conditional IF statement

Opportunity cost per meal:

Lost sales (customers) 100

Lost cm per customer $3.00
Total lost CM $300.00
Opportunity cost per tour-bus meal $1.50
Incremental costs per tour-bus meal $3.50

Therefore, the special 4-busload offer is NOT financially attractive

Note the use of a conditional IF statement

Problem 11-31: Special Order; Strategy, International
Williams Company, located in southern Wisconsin, manufactures a variety of
industrial valves and pipe fittings that are sold to customers in nearby states. Currently, the
company is operating at about 70 percent capacity and is earning a satisfactory return on
Glasgow Industries Ltd. of Scotland has approached management with an offer to buy
120,000 units of a pressure valve. Glasgow Industries manufactures a valve that is almost
identical to Williams pressure valve; however, a fire in Glasgow Industries valve plant has
shut down its manufacturing operations. Glasgow needs the 120,000 valves over the next
four months to meet commitments to its regular customers; the company is prepared to pay
$21 each for the valves.
Williams product cost for the pressure valve, based on current attainable standards,

Direct materials $6
Direct labor (0.5 hr per valve) $8
Manufacturing overhead (1/3 variable) $9
Total manufacturing cost $23

Additional costs incurred in connection with sales of the pressure valve are sales
commissions of 5 percent and freight expense of $1 per unit. However, the company does not
pay sales commissions on special orders that come directly to management. Freight expense
will be paid by Glasgow.
In determining selling prices, Williams adds a 40 percent markup to product costs. This
provides a $32 suggested selling price for the pressure valve. The marketing department,
however, has set the current selling price at $30 to maintain market share.
Product management believes that it can handle the Glasgow Industries order without
disrupting its scheduled production. The order would, however, require additional fixed
factory overhead of $12,000 per month in the form of supervision and clerical costs.
If management accepts the order, Williams will manufacture and ship 30,000 pressure
valves to Glasgow Industries each month for the next four months. Shipments will be made in
weekly consignments, FOB shipping point.

Current level of capacity ultilization (%) 70%

Special-order chacteristics:
# of units 120,000
offer price (per unit) $21.00
Cost data--pressure valve:
Direct materials (per unit) $6.00
Direct labor:
Hours per unit 0.5
DL cost per unit $8.00
Manufacturing overhead per unit $9.00
% of overhead that is variable 33.3333%
Additional fixed manufacturing costs:
Per-month charge $12,000
Duration (# of months) 4.00
Additional information:
normal mark-up % over manufacturing cost 40.00%
Suggested selling price per unit $32.00
Marketing department suggested price per unit $30.00
sales commission, sales to regular customers 5.00%
freight charge, per unit, sales to reg. customers $1.00
monthly production/shipment of product 30,000
lost sales per month (Part 5) 5,000


1. Determine how many additional direct labor hours (DLHs) will be required each month to fill the
Glasgow order.
2. Prepare an analysis showing the impact on operating income of accepting the Glasgow order.
3. Calculate the minimum unit price that Williams' management could accept for the Glasgow order
without reducing operating income.
4. Use the Goal Seek option in Excel to solve for the minimum unit price determined in 3 above.
5. Suppose now that if the Glasgow order were accepted sales of 5,000 units per month to regular customers
would be precluded (at a selling price of $30 per unit). All other facts are as given above. What is the
revised breakeven selling price per unit for the Glasgow special sales order?
6. Identify the strategic factors that Williams should consider before accepting the Glasgow order.
7. Identify the factors related to international business that Williams should consider before
accepting the Glasgow order.


1. Additional DLHs needed each month to fill the Glasgow order:

# of DLHs per unit produced = 0.5

# of units (valves) needed, per month = 30,000
additional DLHs needed, per month = $15,000

2. Analysis of the impact of the Glasgow order on operating income:

Total for
Per Unit 120,000 units
Incremental revenue $21.00 $2,520,000
Incremental costs
Variable costs
Direct materials $6.00 $720,000
Direct labor $8.00 $960,000
Variable overhead $3.00 $360,000
Total variable costs $17.00 $2,040,000
Fixed overhead
Supervisory and clerical costs
(4 mos. @ 12,000) $48,000
Total incremental costs $2,088,000
Incremental operating income $432,000

OR: 120,000 units ($21 $17)/unit $48,000 = $432,000 increased operating income

3. The minimum per-unit price that Williams Company could accept, without reducing operating
income = incremental cost (variable, fixed, plus oppportunity [if any]). The $30.00 suggested
selling price is irrelevant for evaluating the special sales order.

Incremental variable cost, per unit:

Direct materials $6.00
Direct labor $8.00
Variable overhead $3.00
Incremental fixed costs, per unit ($48,000 120,000 units) 0.40
Minimum selling price per unit $17.40

4. Using Goal Seek to Solve for the Minimum Selling Price Per Unit:

Four-month volume (in units) 120,000

Selling price per unit $17.40
Incremental revenue, special sales order $2,088,000
Incremental costs:
Variable, per unit $17.00
Variable, total $2,040,000
Fixed, total (4 mos. @ $12,000/month) $48,000
Opportunity cost $0
Total incremental cost, full order $2,088,000
Difference: Incr. Revenue Incremental Costs $0

5. Solving for a minimum selling price when there are opportunity costs:

Incremental variable cost, per unit:

Direct materials $6.00
Direct labor $8.00
Variable overhead $3.00 $17.00
Incremental fixed costs, per unit ($48,000 120,000 units) 0.40
Opportunity Cost:
Total lost sales (in units) (4 5,000 units) 20,000
Regular selling price per unit $30.00
Less: variable costs (per unit):
Direct materials $6.00
Direct labor $8.00
Variable manufacturing overhead $3.00
Sales commissions (5% of sales $) $1.50
Freight charge (per unit) $1.00
Total variable cost per unit $19.50
Contribution margin per unit, regular sales $10.50
Total lost contribution margin (20,000 units) $210,000
Lost CM per unit of special sales order (120,000 units) 1.75
Minimum selling price per unit $19.15

6. Williams Company should consider the following strategic factors before accepting
the Glasgow Industries order:

a. The effect of the special order on Williams' sales at regular prices? (That is, what is
the possibility of price erosion?)
b. The possibility of future sales to Glasgow Industries and the effects of participating in
the international marketplace.
c.The company's "relevant range" of activity, and whether or not the special order would
cause total output volume to exceed this range (thereby triggering the need for
additional capacity-related costs).
d. The impact of the transaction on local, state, and federal taxes.
e. The effect on machinery or the schedule maintenance of equipment used by Williams.
f. The strategic advantage of the long-term commitment from Glasgow in recognition
of help provided by the Williams Company.
g. Which firm would handle warranty, repair, service and the like?
h. The ethical and competitive issues of helping a competitor in distress.

7. The international issues that Williams Company should consider include:

a. What customs duties and import/export restrictions might affect the special order
any future business with Glasgow?
b. While this special order will be completed in the relatively short time of a few months,
foreign exchange rates might change significantly in this period. What does the special
order agreement say--if anything--regarding the sales price, in dollars or pounds/euro?
c.Might the Glasgow special order introduce Williams to new markets in Scotland or elsewhere in
Britain or in Europe? If Williams is not now significantly involved in global sales, how might the
company use this opportunity to increase its presence in foreign markets?
Prob. 11-32: Special Sales Order

Data Input

Current manufacturing capacity = 10,000 units per month (given)

Curent production output = 7,500 units per month (given)
Normal sales price per unit = $175.00 (given)
Current Product Costs:

Variable Costs:
Labor $375,000
Material $262,500
Marketing $187,500
Total Variable Costs $825,000
Fixed Costs:
Manufacturing $275,000
Marketing $175,000
Total Fixed Costs $450,000
Total (i.e., Full Manufacturing) Cost $1,275,000
Information regarding the special sales order:

Number of units 2,500

Offer price, per unit $100.00


1. Calculate both the old (i.e., prior to the special order) average cost per unit and the recalculated
average cost per unit, including the effect of the special sales order. Are either of these two
figures relevant for evaluating whether to accept or reject the special order? Explain.

Old (prior to special order) average cost per unit:

Total Cost/month $1,275,000
Total Output/month 7,500
Average cost/unit $170.00

Recalculated Average Cost, including Special Sales Order:

Old Total Cost/month $1,275,000
Special-Order Costs:
Direct manufacturing labor $125,000
Material $87,500
Total Costs $1,487,500
Total Output (units) 10,000
New average cost/unit $148.75

Neither of the above two cost figures are relevant to the decision at hand: both include sunk costs in the
form of fixed manufacturing overhead and fixed marketing costs, both of which are "sunk" with respect to
the decision at hand. That is, these costs will likely be the same (in total) regardless of whether or not we
accept the special sales order. As such, they are not relevant to this decision.

2. Short-term profit impact of accepting the special sales order:

Incremental cost for Special Order $212,500

Number of units in special order 2,500
Incremental cost/unit $85.00

Effect on short-term profit of accepting the special order:

Incremental Revenues $250,000
Incremental Costs $212,500
Incremental operating profit (loss) $37,500

3. Breakeven price on special sales order:

The breakeven selling price is the price that would leave the operating profit for the company
unchanged. Alternatively, the breakeven price can be defined as the sum of "relevant costs," that is,
incremental variable costs, incremental fixed costs (if any), and opportunity cost (if any).

In the present case, relevant cost includes only incremental variable costs, as follows:

Relevant Costs:
Incremental Direct manufacturing labor $125,000
Incremental Material $87,500
Total Incremental Cost $212,500
Number of Units 2,500
Breakeven selling price per unit $85.00

4. Discuss at least three other considerations that Cathy Senna should include in her
analysis of the special order.

a) is the order likely to lead to further regular business with this customer?
b) is the order in the strategic best interest of the firm, for example: will it
support or undermine the company's desired image in the market?
c) while Award Plus has just enough capacity to complete the special order, will
there be other costs in addition to the variable manufacturing costs in order to
complete the order (for example, special tooking or set-up costs, etc.)
d) see part 5 below
5. Explain how Cathy Senna should try to resolve the ethical conflict arising out of the controller's
insistence that the company avoid competitive bidding. Refer to the IMA's Statement of
Ethical Professional Practice, go to the following site:

Obviously, the controller (LePenn) has a conflict of interest in the sourcing of raw
materials for the company. Cathy has the ethical responsibility under the IMA
to bring this matter to the attention of the appropriate person in the company.
Since LaPenn is the controller, the appropriate person for Cathy to contact is
likely to be the Vice-President of Finance, the Chief Financial Officer (CFO), a
member of top management, or the audit committee if Award Plus has one.
Problem 11-33: Special Order


Green Glow Inc. (GGI) manufactures lawn fertilizer and because of its very high quality often receives special orders
from agricultural research groups. For each type of fertilizer sold, each bag is carefully filled to have the precise mix of
components advertised for that type of fertilizer. GGIs operating capacity is 22,000 one-hundred-pound bags per month, and
it currently is selling 20,000 bags manufactured in 20 batches of 1,000 bags each. The firm just received a request for a
special order of 5,000 one- hundred-pound bags of fertilizer for $125,000 from APAC, a research organization. The production
costs would be the same, although delivery and other packaging and distribution services would cause a one-time $2,000 cost
for GGI. The special order would be processed in two batches of 2,500 bags each. The following information is provided about
GGIs current operations:


Sales and production cost data for 20,000 bags, per bag:
Sales price $38.00
Variable manufacturing costs $15.00
Variable marketing costs $2.00
Fixed manufacturing costs $12.00
Fixed marketing $2.00

Additional information:
Operating capacity (per month) 22,000 bags (100 lbs. each)
Current monthly production/sales level 20,000 bags
Batch size 1,000 bags
Current number of batches per month 20 batches
Information regarding special order:
No. of bags (100 lbs. each) 5,000
Offering price (total sales revenue) $125,000
One-time charge for the order $2,000

Note: No marketing costs would be associated with the special order. Since the order would be used in
research and consistency is critical, APAC requires that GGI fill the entire order of 5,000 bags.


1. What is the total relevant cost of filling this special order?

2. What would be the change in operating income if the special order is accepted?
3. What is the breakeven selling price per unit (i.e., the selling price that would result in a zero effect on
operating income)?
4. Support your answer to 3 above by preparing comparative income statements, on a contribution basis, with
the special sales order (at the breakeven price) and without the special sales order.
5. Suppose that after GGI accepts the special order it finds that unexpected production delays will not allow it to
supply all 5,000 units from its own plants and meet the promised delivery date. It can provide the same material
purchasing the material in bulk from a competing firm. The materials would then be packaged in GGI bags to
complete the order. GGI knows the competitor's materials are very good quality, but it cannot be sure that the
quality meets its own exacting standards. There is not enough time to carefully test the competitor's product in an
effort to determine product quality. What should GGI do?


1. In general, relevant cost equals the sum of out-of-pocket costs (variable + fixed) plus opportunity costs (if any). In
this case, the total relevant cost is $140,000, as follows:

Out-of-Pocket Costs:
Variable costs:
Manufacturing cost ($15 per unit) $75,000
Fixed costs:
One-Time Packing & Delivery Cost $2,000
Opportunity Cost:
No. of lost unit sales (if any) 3,000
CM per unit, regular sales:
Selling price, per unit $38.00
Variable manufacturing cost $15.00
Variable selling cost $2.00 $21.00 $63,000
Total Relevant Cost $140,000

2. Effect on shortterm operating income of accepting the special sales order:

Offering price, special order $125,000

Less: relevant costs (see above) $140,000
Income effect of accepting special sales order ($15,000)

Since the relevant costs of $140,000 exceed the price of the special order ($125,000), there would
be a loss of $15,000 if the special order were accepted. Therefore, GGI should not accept the order.

Note that if GGI had available capacity, the only relevant cost would be the variable manufacturing and
the delivery costs, totaling $77,000; in this case, the special order should be accepted.

3. Breakeven selling price per unit:

The breakeven selling price per unit is defined as the selling price that just covers relevant costs, both
out-of-pocket and opportunity (if any). In the present case, we have:

Total relevant cost (answer to part 1 above) $140,000

Divided by # of units in the special sales order 5,000
Breakeven selling price per unit $28.00

Any price above $28.00 per unit would increase short-term operating income.

4. Comparative Income Statements, Contribution Basis:

Current Situation +
Current Situation Special Sales Order
Regular (@$38/unit) $760,000 $646,000
Special order (@ $28/unit) $0 $760,000 $140,000 $786,000
Less: Variable Costs:
Manufacturing (@$15/unit) $300,000 $330,000
Marketing (@ $2/unit) $40,000 $340,000 $34,000 $364,000
Contribution Margin $420,000 $422,000
Less: Fixed Costs:
Manufacturing $240,000 $240,000
Marketing $40,000 $40,000
One-Time Packing/Delivery $0 $280,000 $2,000 $282,000
Operating Income $140,000 $140,000

Thus, if the special sales units are sold at $28.00 per unit, the operating income for the company will be
unaffected. Any price above $28.00 per unit would increase operating income, will a price below $28.00
would have the opposite effect.

5. There are both ethical and strategic issues for GGI. From a strategic view, GGI would suffer severe
damage to its reputation if APAC were to have any problems with the purity of the special order. One of
the reasons APAC has requested the special order from GGI is because of its reputation for quality. It is
clear that GGI competes on differentiation, with quality being a critical success factor.

Also, there is an ethical issue. The use of a competitor's materials would deceive APAC, who is
expecting the hightest-quality product from GGI.

To take into account both strategic and ethical issues, GGI should make it clear to APAC that is will
need to fill a portion of the order from competitor's stock. GGI might request that the shipment be
delayed untilit can provide all of the product from its own stock. Alternativey, it might offer to reduce
the price, or to perform careful tests of its own on the competitor's materials.
Problem 11-34: Special Order; ABC Costing (Continuation of Problem 11-33)

Assume the same information as for Problem 11-33, except that the $12 fixed manufacturing overhead consists of
$8 per unit batch-related costs and $4 per unit facilities-level fixed costs. Also, assume that each new batch
causes increased costs of $5,000 per batch; the remainder of the batch-level costs consists of tools and
supervision labor that do not vary with the number of batches. The remaining fixed costs do not vary with the
number of units produced or the number of batches.


Sales and production cost data for 20,000 bags, per bag
Sales price $38.00
Variable manufacturing costs $15.00
Variable marketing costs $2.00
Fixed manufacturing costs $12.00
Fixed marketing $2.00
Additional information:
Operating capacity (per month) 22,000 bags (100 lbs. each)
Current monthly production level 20,000 bags
Batch size 1,000 bags
Current number of batches per month 20 batches
Information regarding special order:
No. of bags (100 lbs. each) 5,000
Offering price (total sales revenue) $125,000
One-time charge for the order $2,000
Breakdown of $12 per-unit fixed overhead cost:
Batch-related costs $8.00
Facilities-level fixed ovherhead costs $4.00
Incremental costs per batch $5,000


1. What is the total fixed manufacturing cost for the period? Breakdown this total into its components.
2. Calculate the relevant unit and total cost of the special order, including the new information about
batch-related costs.
3. If accepted, how would the special order affect GGI's operating income? (Show calculations.)

1. Total fixed manufacturing overhead, broken down into its components:

Total batch-related Costs ($8/unit 20,000 units) $160,000

Incremental costs ($5,000/batch 20 batches) = $100,000

Non-incremental batch-related costs (plug figure) $60,000
Facilities-related fixed overhead costs ($4/unit 20,000 units) = $80,000
Total fixed manufacturing overhead costs $240,000
2. Relevant cost of special sales order:

No. of incremental batches, special order = (22,000-20,000)/1,000 =

= [current capacity (in units) current usage (in units)] 1,000 units/batch 2
Relevant cost for the special order:

Variable manufacturing cost ($15/unit 5,000 units) = $75,000

Incremental batch-related ovh costs (2 batches $5,000/batch) = $10,000
One-time delivery cost = $2,000
CM on lost sales (opportunity cost):
Sales ($38/unit 3,000 units) = $114,000
Less: variable costs ($15 + $2) 3,000 units = $51,000
Less: cost for three batches (@$5,000 per batch) = $15,000 $48,000
Total relevant cost for the special order $135,000
3. Effect of the special sales order on operating income:

Sales revenue from special sales order = $125,000

Relevant cost of the special sales order (from 2 above) = $135,000

The short-term financial impact on operating profit = ($10,000)
Therefore, the company should reject the order

Uses IF Statement in Excel

1. Assuming Martens plans to meet the expected demand for 20,000 attic fans, how many should it manufacture and how many should it
purchase from Harris Products? Explain your reasoning with calculations.
2. Idenpendent of Part 1 above, assume that Beth Johnson, Marten's product manager, has suggested that the company could make better
use of its fan department capacity by manufacturing marine pumps instead of fans. Johnson believes that Martens could expect to use
the production capacity to produce and sell 25,000 pumps annually, at a price of $60 per pump. Johnson's estimate of the costs to
manufacture the pumps is presented below. If Johnson's suggestion is not accepted, Martens would sell 20,000 attic fans instead. Should
Martens manufacture pumps or attic fans? Information on the sales price, costs, and volume for the marine pumps follows.

Selling price per pump ##

Cost per unit:
Electric motor $5.50
Other parts $7.00
Direct labor ($15/hr) $7.50
Manufacturing overhead $9.00
Selling and administrative cost $20.00 ##
Profit per pump ##
No. of pumps (units) ###

3. What are some of the long-run considerations in Martens' decisions in Parts 1 and 2 above?


1. How many fans should be manufactured by Martens and how many should be purchased from Harris Products?

Total Relevant Costs Relevant Costs Relevant Costs

Cost to Manufacture to Purchase for Pumps
Selling price per unit $72.00 $72.00 $72.00 $60.00

Cost per unit: $46.00

Electric motor $6.00 $6.00 $5.50
Other parts $8.00 $8.00 $7.00
Direct labor ($15.00/hr.) $15.00 $15.00 $7.50
Manufacturing overhead $15.00 * $5.00 $5.00
Selling and adm. cost $20.00 $64.00 ** $14.00 $14.00 $14.00
Contribution per unit $24.00 $12.00 $21.00
* Of the total per unit manufacturing overhead of $15, $10 is fixed ($100,000/10,000
units) and the remaining $5 is variable.
* Of the total per unit selling and administrative cost, $6 is given as fixed, and the
remaining $14 is variable.

Since the per-unit contribution margin from selling manufactured fans ($24.00) > the per-unit contribution margin from selling purchased fans
($12.00), Martens should sell as many manufactured fans as possible, as follows:

Conribution margin from manufactured fans (15,000 units $24.00/unit) $360,000

Contribution margin from purchased fans (5,000 units $12.00/unit) $60,000
Total $420,000
No. of units, manufactured 15,000
No. of units, purchased fans 5,000
Total fans produced 20,000
2. Should Martens manufacture pumps or the attic fans?

Total contribution margin for the marine pumps:

Per-unit contribution margin = $21.00


1. GianAuto is in a high-growth, highly competitive industry. Automakers are increasingly outsourcing the of
parts and entire brake or seating systems to low-cost producers throughout the world. In North Ameri
these plants are located in Mexico and throughout Latin America. To be competitive in this business, Gi
continue to be cost-competitive, and also to rovide the customer service and reliability that is expected o
GianAuto can also look for additional ways to be competitive by assisting the automakers in improving t
parts, developing modular manufacturing systems, and improving the quality of the parts produced.

Continuing to obtain covers from its own Denver Cover Plant would allow GianAuto to maintain its curre
control over the quality of the covers and the timing of their delivery. Keeping the Denver Cover Plant o
allows GianAuto more flexibility than purchasing the coverings from outside suppliers. GianAuto could m
alter the coverings' design and change the quantities produced, especially if long-term contracts are req
outside suppliers. GianAuto should also consider the economic impact that closing Denver cover will ha
community and how this might affect GianAuto's other operations in the region.

Other items that should be considered by GianAuto before making a decision include:

a. The disposal value or alternate uses of the plant and associated equipment.
b. Any income tax implications, including tax rebates applicable to gain/loss on the sale of plant, dep
tax shields, depreciation and investment tax credit recapture, etc.
c. Projected supplier prices in the future.
d. Cost to manufacture coverings at the Denver Plant in future years.
e. Ethical issues involved in the termination of 400 employees.
f. Federal and state statutes regarding employee layoffs and terminations, as well as plant closings
g. Should GianAuto continue to manufacture the covers, but in a new, cost-efficent plant? The locati
be anywhere in the world.

2. The following are avoidable costs, and therefore are relevant to the plant-closing decision:

Materials $32,000
Direct $23,000
Supervision $3,000
Indirect--plant $4,000 $30,000
Differential pension expense $1,000
Term charges on cancelled DM purchases $4,800
Employment assistance $1,000
TOTAL $68,800

The following costs are not relevant to the decision (since they are unavoidable):
Depreciation--equipment $5,000
Depreciation--building $3,000
Continuing pension expense ($4,000 $1,000) $3,000
Plant manager and staff $2,000
Corporate allocation $6,000
purchase it from Marley Company for 2013.
2. Identify and briefly discuss the strategic factors that Midwest should consider in this decision.

3. By referring to the specific ethical standards for management accountants outlined in Chapter 1, assess the ethical
issues in John Porters request of Lynn Hardt.


1. The following relevant cost analysis (per unit, and total for 32,000 units) shows that the Midwest Division
should purchase the parts, for a saving of $15,440 ($575,040 $559,600).

Cost per
unit Total Cost
Cost to purchase MTR-2000 from Marley:
Bid price from Marley $17.3000 $553,600
Equipment lease penalty [($36,000 12) 2 1] $0.1875 6,000
Total cost to purchase $17.4875 $559,600
Cost for Midwest to Make MTR-2000:

Direct material ($195,000 30,000) 1.08 $7.02 $224,640

Direct labor ($120,000 30,000) 1.05 $4.20 134,400
Factory space rental ($84,000 32,000 units)* $2.63 84,000
Equipment leasing costs($36,000 32,000 units)* $1.13 36,000
Variable manufacturing overhead $3.00 96,000
Total cost to make $17.97 $575,040

Relevant Cost Differential $0.4825 $15,440

*Total production required in 2013 is 32,000 units; 30,000 units in 2012. Unit variable costs are
based on 2012 costs and units; fixed costs in total are the same in 2013 as in 2012.

2. Strategic factors that the Midwest Division and Paibec Corporation should consider before agreeing to purchase MTR-2000
from Marley Company include the following:
The quality of the Marley component should be equal to, or better than, the quality of the internally made component, or
else the quality of the final product might be compromised and Paibec's reputation affected.
Marley's reliability as an on-time supplier is important, since late deliveries could hamper Paibec's production schedule
and delivery dates for the final product.
Layoffs may result if the component Is outsourced to Marley, This could impact Midwest's and Paibec's other
employees and cause labor problems or affect the company's position in the community, In addition, there may be
termination costs which have not been factored into the analysis.
Giving up production capability risks dependence upon Marleys future pricing.

3. Referring to the specific standards for ethical practice by a management accountant (http://www.imanet.org/PDFs/Statement
%20of%20Ethics_web.pdf), Lynn Hardt should consider the ethical standards of competence, integrity, and objectivity:
Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information.
John has asked Lynn to adjust and falsify her report and leave out some manufacturing overhead costs.
Refrain from either actively or passively subverting the attainment of the organization's legitimate and ethical objectives,
Paibec has a legitimate objective of trying to obtain the component at the lowest cost possible, regardless of whether it is
manufactured by Midwest or outsourced to Marley.
Communicate unfavorable as well as favorable information and professional judgments. Hardt needs to communicate the
proper and accurate results of the analysis, regardless of whether or not it is favorable to Midwest.
Refrain from engaging in or supporting any activity that would discredit the profession. Falsifying the analysis would
discredit Hardt and the profession.


Communicate information fairly and objectively. Hardt needs to perform an objective make-or-buy analysis and
communicate the results objectively.
Disclose all relevant information that could reasonably be expected to influence an intended users understanding of the
reports, comments, and recommendations presented. Hardt needs to fully disclose the analysis and the expected cost
Problem 11-38: Outsourcing Call Centers


Merchants Bank (MB) is a large regional bank operating in 634 locations in the Southeast U.S. MB has grown steadily over the last 20 years, because
of the regions growth and the banks prudent and conservative business practices. The bank has been able to acquire less successful competitors in
recent years, further enhancing its growth. Until 2005, the bank operated a call center for customer inquiries out of a single location in Atlanta, GA. MB
understood the importance of the call center for overall customer satisfaction and made sure that the center was managed effectively. However, in
early 2004, it became clear that the cost of running the center was increasing very rapidly, along with the firms growth, and that some issues were
arising about the quality of the service. To improve the quality and dramatically reduce the cost of the service, MB moved its called center to
Bangalore, India, where it is now run by an experienced outsourcing firm, Naftel, which offers similar services to other banks like MB.

The Naftel contract was for five years, and in late 2008 it was time to consider whether to renew the contract, change to another call center
service provider (in India or elsewhere), or bring the call center back to Atlanta.

Some important factors to consider in the decision:

At the time of the decision in late 2008 the value of the dollar had been increasing relative to most other currencies.
The financial crisis of 2008 had been affecting the banking business, and the outlook for growth for MB was not as rosy as it had been for the last
few years. Top management and economic advisors for the bank have basically no idea what the right forecast for the coming five years was.
At the time of the decision, the employment rate in Atlanta had fallen to the point that there was a good supply of talented employees who could
have been recruited into the call center if the center were relocated back to Atlanta.
The bank had just completed a new headquarters building in Atlanta and had a good bit of space in the building that MB had yet to lease. The
outlook for the Atlanta economy was such that MB did not expect to lease much of this space for at least three years. If the call center were
returned to Atlanta, it would occupy a space that would be rented for $100,000 per month, if there were a company that wanted to lease the
If renewed, the Naftel contract would cost $4,200,000 per year for the next five years.
The cost of salaries to staff the call center in Atlanta were expected to be $2,300,000 per year, the equipment would be leased for $850,000 per
year, telecommunication services were expected to cost $500,000 per year, administrative costs for the call center were expected to be
$600,000 per year, and the call centers share of corporate overhead was expected to be $400,000 per year.


Annual Cost of Naftel contract 4,200,000

Call Center (Atlanta) Costs:
Cost of salaries 2,300,000
Cost of equipment 850,000
Cost of telecom. Service 500,000
Administrative Costs 600,000
Share of corporate overhead 400,000
Lease opportunity cost 100,000


1. Should MB return the call center to Atlanta or renew the contract with Naftel? Develop your answer for both a one-year and a five-year time
horizon. Consider the strategic context of the decision as an integral part of your answer. (Hint: using discounted cash flow is not required
but would improve your answer; MB uses a discount rate of 6%.)
2. What are the global issues that should be considered in the decision?
3. What ethical issues, if any, should be considered in the decision?


1. The corporate overhead cost is irrelevant since in total it will not change whether or not the call center is returned to Atlanta.
That is, this is considered an unavoidable cost.

Naftel Atlanta Present Value Present Value

Annual Costs First 3 Yrs Yrs 4-5 Factor (6%) Naftel Atlanta
Naftel Contract $4,200,000 - - 4.21200 $17,690,400
Lease Opportunity cost, Yr 4 - - $100,000 0.79209 - $79,209
Lease Opportunity cost, Yr 5 - 100,000 0.74726 - 74,726
Salaries - $2,300,000 2,300,000 4.21236 - 9,688,437
Equipment (leased) - $850,000 850,000 4.21236 - 3,580,509
Telecommunications - $500,000 500,000 4.21236 - 2,106,182
Administrative - $600,000 600,000 4.21236 - 2,527,418
Naftel, per-year amount $4,200,000 $17,690,400
Atlanta, per-year amounts $4,250,000 $4,450,000 $18,056,481
Cost Difference:
Raw (Undiscounted) Basis $650,000
Present-Value Basis $366,081
Discount factors, at 6%:

Year 4 0.7920936632
Year 5 0.7472581729
Five-Year Annuity 4.2123637856

The analysis above calculates the annual cost for each year for Naftel, and for each of the first three years and for years 4 and 5 for the Atlanta option. The
present value factor for an annuity for 5 years at 6% is used to discount the amounts applicable to all five years, while single-sum discount factors are used
for the lease opportunity cost in years 4 and 5. (See the spreadsheet for calculation of the present value factors and the present value annuity factor.)

The analysis shows that the Naftel contract would save MB $50,000 per year in each of the first three years, and $150,000 in years 4 and 5. When
analyzed on a present-value basis, the comparison is a total for all five years for the Naftel contract of $17,690,000 versus $ 18,056,481 for the Atlanta
location, a difference of $366,081 in favor of the Naftel option.

Whether you consider the unadjusted or the present-value analysis, it is clear that the Naftel contract has the lower cost. But the difference is not great
relative to total cost, so that strategic issues are important in making the final decision. Some of these strategic issues are discussed in parts 2 and 3
below. In addition:

Since customer service is very important for MBs success, would the location of the call center in Atlanta or at Naftel provide better quality customer
service? This is the dominant strategic question, especially since the cost difference is not significant relative to total cost.

Since the banking business was, at the time, forecast to be in troubled times for the next several months, would it not have been important to retain
the admittedly small cost advantage of the Naftel contract?
Given the difficult times ahead for the banking industry, is it not especially important now to differentiate your company from others, and customer
service is one important way to do that. If customer service in Atlanta can be carefully managed so that it provides the very high quality service, this
could be an important competitive advantage.
2. At the time of the decision (late 2008), the value of the dollar had been increasing relative to most other currencies. This means that the cost to MB of the
service by Neftal would be less in currency-adjusted terms if the contract is in Indias currency, the Rupee. Other global issues include the importance to
MB of maintaining strong business relationships with firms like Neftal that can provide valuable services as MB grows.

3. The ethical issues in the decision here include the consideration of a community obligation that MB had for providing jobs, when possible, in a local
economy that is suffering from high unemployment.
Pr. 10-58/Pr. 11-39: Sustainability
Electricity Budgeted
Product Selling Price Materials Cost (per Labor (per five- (per five-
Batches per
pound of laundry) pound batch) pound
Commercial $25.00 $1.00 $4.00 $1.50 7,500
Individual $21.00 $0.50 $4.00 $1.00 3,000
Batch size = 5 pounds of laundry

Cost of New Cleaning Compound = $2.25 per pound of laundry

Estimated (possible) fine (e.g., EPA) = $60,000
Assumed level of cost decrease per month = 1.000% (applied to labor and electricity)
Requirement #1: Short-Term Financial Analysis

Estimated fine (e.g., EPA) $60,000

Exta processing cost based on new compound:

Estimated batches per year--Commercial 7,500
# of pounds of laundry per batch 5
Total estimated laundry, in pounds 37,500
Increased Cleaning compound cost/pound* $1.25 $46,875
Estimated batches per year--Individual 3,000
# of pounds of laundry per batch 5
Estimated laundry, per year (in pounds) 15,000
Increased cost of cleaning compound/pound* $1.75 $26,250 $73,125
One-Year Cost differential $13,125
*$2.25 less original cleaning compound cost

Therefore, based on the above short-term financial analysis,

it does not make sense to switch to the new cleaning compound

Requirement #2: Assume the Switch to the New Compound and the Introduction of Continuous-
Improvement (Kaizen) Budgeting

Estimated increase in processing cost, per year with new compound (from above) = $73,125
Estimated annual cost savings, per Kaizen budget:

Original Monthly Processing Costs (other than materials):

Labor ($4.00/batch x 7,500 batches/year 12 months/year) $2,500.00
Electricity ($1.50/batch x 7,500 batches/year 12 months/year) $937.50
Labor ($4.00/batch x 3,000 batches/year 12 months/year) $1,000.00
Electricity ($1.00/batch x 3,000 batches/year 12 months/year) $250.00
Total Monthly Processing Costs (Other than Materia $4,687.50
Original Annual Processing Costs (other than materials) $56,250.00
Revised Level of Monthly Processing Costs (other than materials):
Month Labor Electricity
1 $3,465.00 $1,175.63
2 $3,430.35 $1,163.87
3 $3,396.05 $1,152.23
4 $3,362.09 $1,140.71
5 $3,328.47 $1,129.30
6 $3,295.18 $1,118.01
7 $3,262.23 $1,106.83
8 $3,229.61 $1,095.76
9 $3,197.31 $1,084.80
10 $3,165.34 $1,073.95
11 $3,133.68 $1,063.21
12 $3,102.35 $1,052.58
Total--Yr. 1 $39,367.64 $13,356.88 $52,724.52
\ Year 1 Kaizen-based cost savings (processing costs other than material) $3,525.48
Net Increase in Year-One Processing Costs (materials + labor + electricity) = $69,599.52
Difference between fine and net increase in year-one processing costs $9,599.52

Thus, strictly speaking, it is better to incur the fine rather than change to the new cleaning
compound, even after implementing Kaizen budgeting.

Requirement 3

a. Determine the Monthly Cost-Reduction Rate that would Equate the net increase in year-one total
processing costs (materials + labor + electricity) with the anticipated fine

Step One: Define the Breakeven Cost Equation

Difference between the fine and net increase in year-one processing costs $9,599.52

Step Two: Run Goal Seek

Step Three: Solution

In other words, in order to be indifferent between incurring the fine ($60,000) and incurring extra
processing costs per year, after implementing Kaizen budgeting, the monthly rate of cost decrease
must be 4.164%. At this level, the year-one Kaizen-based cost savings would be $13,125, while the net
year-one processing cost increase would be $60,000 ($73,125 - $13,125)--an amount exactly equal to
the estimated fine. Note, however, that such a dramatic increase in productivity is highly questionable.

b. The cost per pound for the new compound that would equate the anticipated fine with the net year-one
costs, assuming no Kaizen budgeting plan (i.e., no reduction per month in processing costs other than

Step One: Set Up Cost Equation

Cost differential: anticipated fine and net one-year processing costs, with no Kaizen budgeting
plan = $13,125
Step Two: Run Goal Seek

Step Three: Results

In other words, if the price of the new compound were to be reduced from $2.25 per pound of
laundry to $2.00 per pound of laundry, with no other changes, then the owner would be indifferent
between incurring the estimated fine and using the new (higher-priced) compound. Of course, other
considerations may affect the ultimate decision.

4. Operational Changes Needed to Ensure Kaizen Cost Savings

The reduction in labor time might be realized by improving the efficiency of operations, including a
decrease in machine downtime. It is probably the case that line employees (i.e., operating personnel) may
have suggestions for ways to improve operational efficiency (e.g., changes that would reduce idle time as
well as processing time.

In order to achieve aggressive cost reductions in labor, it may be necessary to institute some type of
employee incentive program.

Savings in electricity consumption may be more difficult to achieve. Some reduction would likely accompany the
planned-for reduction in labor cost. However, ultimately to improve electicity consumption it may be necessary
to invest in more modern technology, particularly given recent (and anticipated) increases in utility rates.

Finally, as the present example shows, effective Kaizen budgeting may require collaborative work with
individuals/companies across the value chain. David Duncan is more likely to achieve his cost-reduction goals
through working with his suppliers. As indicated above, if the cost of the new compound could be
decreased by only $0.25 per pound of laundry processed, David would be indifferent (solely on an expected
cost basis) between incurring the fine ($60,000) and the increased processing cost associated with the
the use of the new cleaning compound ($60,000 as well).

5. Other (qualitative) Considerations that Might Affect the Ultimate Decision:

*What impact, perhaps negative, will the Kaizen budgeting approach have on employee morale?
*Will the quest to achieve aggressive levels of cost reduction have a negative effect on service quality?
* Will the use of the new, environmentally friendly cleaning compound have a beneficial effect on the
image of the business and therefore on sales?
* Would the use of the new cleaning compound have a beneficial impact on employee health/working
conditions? Alternatively, would continued use of the existing compound require special handling costs or
preventative measures (e.g., to guard employee health and safety)?
* Would incurring a fine (rather than incurring increased operating costs) negatively affect the image of the
business, and therefore future service demand? (Would negative media coverage reduce demand?)
* Does the exisiting cleaning compound create a hazardous work environment for employees (the
problem is silent on this issue)?
* If the existing cleaning compound is considered hazardous to employee well-being, is there an
effect on employee absenteeism?
* Duncan's business essentially consists of two service lines/segments: commercial and individual. Is there a
differential effect on marketing activity for these two groups? (That is, do these groups differ in their response
to either positive or negative media coverage?)
* Would it make more sense for Duncan to invest in new technology, which might bring the company
into full compliance with current emission requirements?

1. Using Excel or an equivalent spreadsheet, develop an analysis that can help Hal decide about the future of the Weldon l Should the Weldon
line be dropped? Why or why not?
2. Using the spreadsheet you developed in Part 1, determine whether your answer would change if sales of Weldon expected to fall by 80
3. Again using the spreadsheet in Part 1, determine whether the Weldon line should be discontinued if the resources devote Weldon could be
used to increase sales by 10 percent in each of the other two lines.
4. Again using the spreadsheet in Part 1 and using Goal Seek in Excel or an equivalent, determine the sales increase decrease) in the sales
of the Parker line that would be necessary if the Weldon line were discontinued to maintain the fir overall profit in Part 1. For an illustration
of Goal Seek, seek Exhibit 9.5 in Chapter 9.
5. Given your answers to Parts (1) through (4) above, consider the overall competitive environment facing HPF and make y recommendations
regarding the firms strategic position and direction at this time.


1. The first step in the solution is to construct a contribution income statement.

Parker Virginian Weldon Total

Per Unit Total Per Unit Total Per Unit Total
Sales units 150,000 335,000 165,000
Sales dollars $459.00 $68,850,000 365.00 $122,275,000 248.00 $40,920,000 $232,045,000
Variable Costs
Labor 125.00 18,750,000 118.00 39,530,000 62.00 10,230,000 68,510,000
Raw Materials 88.50 13,275,000 66.00 22,110,000 78.00 12,870,000 48,255,000
Power 23.50 3,525,000 15.60 5,226,000 13.80 2,277,000 11,028,000
Variable Costs $237.00 35,550,000 $199.60 66,866,000 $153.80 $25,377,000 $127,793,000
Contribution Margin $222.00 $33,300,000 $165.40 $55,409,000 $94.20 $15,543,000 $104,252,000
Fixed Costs
Repairs 7,962,500
Factory Equipment 21,775,000
Other Factory Costs 8,473,750
Selling Expense 22,935,000
Office Expense 10,920,000
Administrative Expense 17,875,000
Other S&A Expenses 4,225,000
Total Fixed Costs $94,166,250
Operating Profit (Loss) $10,085,750

The analysis shows that all three lines have a positive contribution margin, including the Weldon line. The short-term financial
effect of dropping the Weldon line would be a loss of contribution margin of $15,543,000. For a longer-term perspective, Hal
should expecte the Weldon line to cover its full operating costs, including fixed costs (subject to strategic considerations, as
discussed below in Part 5). Thus, there should be a consideration of sales trends and alternative uses of the plant's capacity.
For example, if sales in the Weldon line are expected to fall, and there are attractive alternative uses of the plant's capacity,
then the Weldon line might be discontinued now, suffering a short-term loss (as noted above), for the purpose of securing a
longer-term gain.

2. Since the Weldon line has a positive contribution margin of $94.20 per unit, the total contribution margin will be positive regardless
of the level of sales (beyond zero, of course), and the analysis in Part 1 above will continue to favor keeping the line (at least in the
short run). However, Hal and Joan might want to consider alternative uses of the plant facilty if Weldon sales continue to fall.

3. The 10% sales increase has total sales of 165,000 units for the Parker line and 368,500 units for the Virginian line. The analysis for
dropping Weldon shows a decrease in operating profit of $6,672,100 ($10,085,750 - $3,413,650). So, in the short run it would be
better to retain Weldon (as long as other more attractive uses of Weldon's line do not exist).

Parker Virginian Weldon Total

Per Unit Total Per Unit Total Per Unit Total
Sales units 165,000 368,500 0
Sales dollars $459.00 75,735,000 $365.00 134,502,500 $248.00 - $210,237,500
Variable Costs
Labor 125.00 20,625,000 118.00 43,483,000 62.00 - 64,108,000
Raw Materials 88.50 14,602,500 66.00 24,321,000 78.00 - 38,923,500
Power 23.50 3,877,500 15.60 5,748,600 13.80 - 9,626,100
Total Variable Costs $237.00 $39,105,000 $199.60 $73,552,600 $153.80 - $112,657,600
Contribution Margin $222.00 $36,630,000 $165.40 $60,949,900 $94.20 - $97,579,900
Fixed Costs
Repairs 7,962,500
Factory Equipment 21,775,000
Other Factory Costs 8,473,750
Selling Expense 22,935,000
Office Expense 10,920,000
Administrative Expense 17,875,000
Other S&A Expense 4,225,000
Total Fixed Costs $94,166,250
Operating Profit (Loss) $3,413,650

4. Required change in sales for the Parker line to compensate for the loss of the Weldon line (using Goal Seek):

Step #1: Refer to the Contribution Income Statement in Part 3 above (cells B103:I122).
Enter a zero into cell D105; enter 335,000 into cell F105. Afterwards, you should see the following:
1. Calculate the contribution margin for each type of paint and total firm-contribution under each of the
following scenarios:
Scenario A Current production, including the Virginia contract
Scenario B Without either the Virginia contract or the promotion to expand sales of commercial paint
Scenario C Without the Virginia contract but with the promotion to expand sales of the commercial paint
2. Determine whether scenario B or C (per Part 1 above) should be chosen by Meyer and explain why,
including a consideration of the strategic context.


1. First, calculate the contribution margin for traffic paint and for commercial paint. The first step here is to
determine the unit cost of latex, as follows:

For Traffic Paint = (450 $32) 1,000 = $14.4000

For Commercial Paint = (325 $32) 1,000 = $10.4000
The contribution margin per unit of output for each product is determined as follows:

Traffic Commercial

Selling price/gallon $20.00 $24.00

Direct materials costs:
Latex $14.40 $10.40
Camelcarb $0.76 $1.08
Silica $0.74 $1.04
Pigment $0.24 $0.76
Other ingredients $0.12 $0.06
Direct labor cost $0.92 $1.70
Freight $1.56 $0.86
Total variable cost $18.74 $15.90
Contribution margin $1.26 $8.10

Using the above contribution margin per unit figures, the total contribution margin for each scenario can be determined as
follows, where total traffic paint = 342,000 gallons (i.e., 380,000 gallons 0.90), and total commercial paint = 38,000
gallons (i.e., 380,000 gallons - 342,000 gallons). The loss of the Virginia contract would reduce the traffic paint to 254,000
gallons (i.e., 342,000 gallons - 88,000 gallons). A doubling of commercial paint (using the promotion) would result in 76,000
gallons (i.e., 38,000 gallons 2).

Gallons of Ouput Scenario A Scenario B Scenario C

Traffic Paint 342,000 254,000 254,000
Commercial Paint 38,000 38,000 76,000
Totals 380,000 292,000 330,000
Scenario A Scenario B Scenario C

Original Original Units w/o CM w/o Units with CM with

units CM/unit CM Virginia Virginia promotion promotion
Traffic 342,000 $1.26 $430,920 254,000 $320,040 254,000 $320,040
Commercial 38,000 $8.10 $307,800 38,000 307,800 76,000 615,600
CM 380,000 $738,720 292,000 $627,840 330,000 $935,640
Savings on materials handling costs $80,000 $80,000
Less cost of promotional campaign $120,000
Total $707,840 $895,640

Note: The $50,000 fixed costs traceable to the Virginia contract are ignored in the above formulation since these costs
cannot be eliminated within a year.

2. The proposed promotional campaign without the Virginia contract, scenario C, has the greatest contribution margin, as shown in
the calculations above. Strategic issues for the decision between scenario B and scenario C include the reliability of the
projected sales-volume increase in commercial paint and the assumption that the volume of commercial paint can be doubled
without increasing fixed costs, other than the cost of the promotion. A strategic opportunity, on the other hand, is that the
company (Meyer Paint) can move from a relatively low contribution margin product line (traffic paint) to a relatively high
contribution product line (commercial paint). Suppose, for example, that the sales of commercial paint increase by only 30%
rather than 100% (an increase to 49,400 rather than 76,000 gallons). Note that scenario C would now be the least profitable
1. Explain whether either contest is desirable or not. Supplement your analysis by determining the total co
Gliders and for Table-and-Chair sets under each of the following assumptions: actual sales volume at a
usage, and actual costs; and, actual sales volume at budgeted selling prices, budgeted resource usage
2. Explain the strategic issues guiding your choice about these contests.

Solution Second contest:

First contest: Gliders Chair and Stool

Per Unit Total Per Unit Total
Budgeted Sales 4,000 8,000
Actual Sales 2,600 6,900
Sales Shortfall 1,400 1,100
Sales Value of Shortfall $80.00 $112,000 $61.00 $67,100
Direct material $16.00 $22,400 $11.00 $12,100
Direct labor rate per hr $11.00 $9.50
Direct labor hrs per unit 2.50 3.25
Direct labor cost $27.50 $38,500 $30.88 $33,963
Sales commission $15.00 $21,000 $10.00 $11,000
Contribution margin $21.50 $30,100 $9.13 $10,038
Cost of Prize $16,500 $12,500
Excess of CM over cost $13,600 $(2,463)

The Glider contest has a $13,600 positive contribution margin net of the estimated cost of the and-Stool
contest has a negative contribution of $2,463. Note that the above solution used act cost information.

The analysis below compares the contribution margin for each product based on actual sales a usage
to the product contribution margins based on actual sales at budgeted cost and budg
shows that if Hillside had controlled usage and cost of materials and labor, it would have improv amount
far exceeds the $13,600 potential improvement from increasing the sales of Gliders usin

Thus, strategically, it is important for Hillside to focus on cost management as well as improving s

Based on Actual Sales Volume, Actual Resource Usage, and Actual Cost Data
Gliders Chair and Stool
Per Unit Total Per Unit Total Total
Budgeted Sales 4,000 8,000
Actual Sales 2,600 6,900
Sales Shortfall 1,400 1,100
Actual Sales $80.00 $208,000 $61.00 $420,900

Direct material $16.00 $41,600 $11.00 $75,900

constraints in determining your answer.
3. Without regard to your answer to Part 2, assume that Donna decides to sell 40,000 units at $200 per unit a
24,000 units at $180 per unit. Prepare a budgeted income statement for DimLok showing whether her deci
will achieve DimLok's profit objectives.
4. Assess DimLok's competitive strategy.
5. Indentify strategic success factors that are associated with DimLok strategy.


1. The dollar value of the present level of DimLok's fixed costs per year is calculated as follows:

Profit target based on 20% of annual fixed costs = $800,000

\ Total fixed costs = $800,000 0.20 = $4,000,000

2. DimLok must sell 64,000 units in order to achieve both profit objectives, viz., a 20% return on fixed assets
$20 per unit sold.

Supporting Calculations:

First, the solution must consider the following constraints:

40,000 unit capacity for the current facility
$1,000,000 additional fixed charge for production up to 80,000 units
a sales discount of $20 per unit for sales beyond 40,000 units
a variable cost decrease of $20 per unit after the prodution of 60,000 units

Second, the calculation of profit with the current facility at the capacity level of 40,000 units will not me
objectives, as demonstrated by the following calcuations:

Contribution margin per unit below the 40,001 unit level = $200 selling price - ($80 vc per unit + $
= $100 contribution per unit, up to 40,000 units sold $100.00

Calculation of the number of units to achieve the desired profit objectives

= (Fixed charges + Desired profit) Contribution margin per unit
= ($4,000,000 + $800,000) $100 per unit = 48,000

\ required number of units exceeds current capacity by 8,000

Third: Thus, in order to achieve the profit targets, DimLok must increase plant capacity, thereby incurri
additional $1,000,000 in fixed costs. This, in turn, increases the profit target based on fixed costs
total of $1,000,000 (i.e., 0.20 [$4,000,000 + $1,000,000]), as follows:

Capacity expansion requires increase in FC per year = $1,000,000

New profit target based on new FC per year (@20%) = $1,000,000
Increase in profit target based on FCs = $200,000

The per-unit contribution margin for production in the range of 40,001 to 60,000 units, with the se
reduced $20 (to $180 per unit) is as follows:

The per-unit contribution margin for production in the 40,001 to 60,000 units range, with a r
selling price ($180) per unit is $80, as follows:

= $180 selling price - ($80 vc per unit + $20 profit per unit) = $80.00

Rcalculation of the number of units to achieve overall profit objectives:

operting income = CM - FC
$1,000,000 = [($100/unit 40,000 units) + ($80(X - 40,000 units))] - $5,000,000
X= 65,000 units

65,000 units exceeds the 60,000-unit critical level (supplier's contract); therefore,
variable costs are reduced by $20 per unit for production in excess of 60,000 units

Fourth: The contribution margin for production in the range of 60,000 units - 80,000 units, with the vari
per unit reduced to $60 per unit (from $80 per unit) is determined as follows:

= $180 selling price per unit - ($60 vc per unit + $20 profit per unit) $100.00

Finally, calculation of the number of units (X) needed to achieve overall profit objectives:

operating income = CM - FC
$1,000,000 = [($100 40,000) + ($80 20,000) + $100(X - 60,000)] - $5,000,000

X = ($6,000,000 + $6,000,000 - $4,000,000 -$1,600,000) $100 per unit = 64,000

3. DimLok Division

Pro Forma Income Statement


40,000 units $200/unit = $8,000,000

24,000 units $180/unit = $4,320,000 $12,320,000
Variable Costs:
60,000 units $80/unit = $4,800,000
4,000 units ($80 - $20)/unit = $240,000 $5,040,000
Contribution Margin (CM) $7,280,000
Fixed Costs $5,000,000
Operating Income $2,280,000

The dual profit objectives [(20% of FC) + ($20 per unit sold)] are met, as shown below:

= (0.20 $5,000,000) + ($20 64,000 units)) $2,280,000

= $1,000,000 + $1,280,000 =
Problem 11-44: Product Profitability Analysis, Scarce Resources

Santana Company produces a variety of consumer electronic products. Unit selling prices and costs for three models
in one of its product lines are given below. Variable overhead cost is charged to products on the basis of direct labor
hours (DLHs); fixed overhead is allocated on the basis of machine hours.

No Frills Standard Super
Selling price/unit Model Options Model
$35 $60 $80
DM cost/unit $9 $11 $14
DL cost/unit $10 $20 $30
Variable overhead cost/unit $3 $6 $9
Fixed overhead cost/unit $3 $6 $6
DL rate/hour $20.00


1. What is fundamentally different about the fixed versus variable overhead assigned to products? (Answer the
question within the context of the relevance of this difference to the determination of short-term product mix.)
2. Calculate for each product both the gross profit per unit and the contribution margin per unit. Are either of these
profitability measures useful for planning the optimum short-term product mix? Why or why not?
3. If the company has excess machine capacity but a limited amount of labor time, how should the optimum short-
term product mix be determined?
4. Assume now that machine hours, not DLHs, is the limiting resource. How, if at all, would this affect the product-
mix decision?
5. How can the optimum product mix be determined when there are only two products, and one or more constraints?
6. How can the optimum product mix be determined when there are more than two products, and one or more
7. What is the primary role of the management accountant in terms of planning the optimum short-term product mix?


1. Fixed manufacturing overhead costs, in total are by definition capacity-related costs and as such are not expected to
change in the short run. Thus, in total, short-term fixed costs should be independent of production volume and
production mix. On the other hand, variable overhead costs, by definition, are somehow related to volume and/or mix
of products produced. Thus, these costs will normally be relevant to the short-term product-mix decision.

2. Gross profit per unit and contribution margin per unit, by product:

No Frills Standard Super

Model Options Model
Selling price/unit $35 $60 $80
Less: CGS
DM cost/unit $9 $11 $14
DL cost/unit $10 $20 $30
Variable overhead cost/unit $3 $6 $9
Fixed overhead cost/unit $3 $6 $6
Gross Profit/unit $10 $17 $21
Plus: Fixed overhead/unit $3 $6 $6
Contribution margin/unit $13 $23 $27

Neither of the above profit figures is useful in terms of determining the optimum short-term product mix. In the absence
of production constraints, and assuming all per-unit contribution margins are positive, we should produce each product
up to its level of demand. In the presence of resource constraints (or limitations), logic dictates that we allocate available
resources "to their most profitable use." In this case, this means on the basis of the contribution margin per unit of the
scarce resource(s). These amounts are provided in Parts 3 and 4 below.

3. In the presence of a single resource constraint, we should focus on those products that provide the greatest
contribution margin per unit of the scare resource, in this situation, labor time. The calculations follow.

No Frills Standard Super

CM per unit Model Model Model
$13.00 $23.00 $27.00
DLHs/unit of output* 0.50 1.00 1.50
CM per DLH $26.00 $23.00 $18.00
Product Profitability Rankings = (1) (2) (3)

*Direct labor cost per unit = $10, $20, and $30, respectively. The above amounts are derived from the fact that the
labor cost per hour is $20.00 (given).

4. If machine hours represent the scarce resouce, then the allocation of machine hours to products should be based on
the contribution margin per machine hour. As seen from the calculations below, the product profitability rankings
differ from those determined in Part 3 above.

No Frills Standard Super

CM per unit Model Model Model
$13.00 $23.00 $27.00
Relative machine hours/unit 1.00 2.00 2.00 Note how these are calculated.
CM per relative hour $13.00 $11.50 $13.50
Product Rankings = (2) (3) (1)

Note that while we do not know the number of machine hours per unit, we do know the relative number of machine
hours across the three products: this information comes from the allocated fixed manufacturing cost data.

5. If there are only two products (and one or more constraints), we could solve the product-mix problem using the
graphical approach presented in the chapter (see Exhibits 11.19 and 11.21). One alternative is to evaluate the total
profitability at each of the corner points associated with the feasible region and to choose the product mix (corner
point) that maximizes short-term profit. Another alternative is to us a set of iso-profit lines (combination of the two
products that results in a given level of profit). Extend the iso-profit line up to the right until it just touches a point in
the feasible set (region): this point (mix of the two products) defines the optimum product mix.

6. In the case where there are more than two products (and one or more constraints), the graphical approach is not
practical. In this case, the use of dedicated software ("constrained optimization") such as the Solver routine in
Excel should be used for short-term production planning.

7. The primary role of the management accountant in terms of short-term profit planning is to generate accurate
estimates of the contribution margins for each product (or service). Whether a simple or a complex decision
context, the general solution to the product-mix problem is to allocate scare resources on the basis of the
contribution margin of each product/service per unit of scarce resource. If these estimates are in error, then
resolution of the short-term optimum product mix may be compromised.
Problem 11-45: Profitability Analysis; Linear Programming (Appendix)


Home Service Company offers monthly service plans to provide prepared meals that are delivered to customers homes and need only
be heated in a microwave or conventional oven. Home Service offers two monthly plans, premier cuisine and haute cuisine. The
premier cuisine plan provides frozen meals that are delivered twice each month; the premier generates a contribution of $150 for each
monthly service plan sold. The haute cuisine plan provides freshly prepared meals delivered on a daily basis and generates a
contribution of $100 for each monthly plan sold. Home Services strong reputation enables it to sell all meals that it can prepare.
Each meal goes through food preparation and cooking steps in the companys kitchens. After these steps, the premier cuisine
meals are flash frozen. The time requirements per monthly meal plan and hours available per month follow:

Preparation Cooking Freezing

Hours required:
Premier cuisine 3 2 1
Haute cuisine 1 3 0
Hours available/month 80 120 45

For planning purposes, Home Service Company uses linear programming to determine the most favorable mix of Premier
and Haute Cuisine meals to produce.


1. Using the Solver function in Excel, determine the most profitable product mix for Home Service Company given the existing
constraints and product contribution margins.
2. Generate and interpret the information contained in the "Sensitivity Report" associated with the solution associated with Part
1 above.
3. Using the Solver function in Excel, determine the most profitable product mix for Homer Service Company given the existing
contribution margins and all constraints except the preparation time constraint.


1. Solve for all three constraints: the solution is 17 units of Premier and 29 units of Haute, as shown in
Exhibit 11-45C, cells B5 and B6. The Solver set up for this solution is shown in Exhibit 11-45A. The completed dialog box
("Solver Parameters") is presented in Exhibit 11-45B.

Exhibit 11-45A: Problem Set Up

Note: Formulas for total contribution margin must be entered into cells G5 and G6 (cell G7 contains the sum of the individual
product contribution margins). As well, formulas for capacity usage must be entered into cells H5:J6. A separate
formula for the use of each resource is entered in cells H7:H9.

Exhibit 11-45B: Solver dialog window ("Solver Parameters")

Exhibit 11-45C: Optimum Solution

2. Sensitivity Report

Notes--Sensitivity Report:
1. Reduced costs: these pertain to the two decision variables (Premier and Haute). If all such variables are in the optimum
solution (as in the present case), then these values will be zero. Technically, the "reduced cost" for a variable not in the
optimum solultion represents the amount by which the per-unit contribution margin would have to change in order for
the variable to enter the optimal solution.
2. For each decision variable, the "Allowable Increase" and "Allowable Decrease" provide a range over the objective
function coefficents (here, per-unit contribution margins) over which the optimum solution holds. For example, the
current optimum solution holds as long as the contribution margin per unit is within the range $66.26 - $300.00.
3. For each constraint (Prep, Cook, and Freeze) the Final Value represents the amount of the resource used under the
optimum solution. If you look at cell H7 and I7 you see that the entire time allotment for Prep and Cook are used up
under the optimum solution. As such, each of these two constraints has a "shadow price," which represents the
maximum amount Home Service Company would be willing to pay for one additional unit (here, hour) of each
constraint. You will note that under the optimum solution the entire amount of Freeze hours is not used up. Thus, by
definition the "shadow price" for this constraint must be zero.
4. Finally, for each constraint there is an "Allowable Increase" and an "Allowable Decrease" show the range, around the
value of each constraint, over which the indicated "shadow prices" hold.

3. Results after removing the preparation time constraint: the constraint to remove from the "Solver Parameters" dialog box is

Exhibit 11-45D: Optimal Solution after removal of Preparation Time Constraint

Problem 11-46 (Also 9-50): CVP Analysis; Sustainability; Uncertainty; Decision Tables

With gasoline prices increasing rapidly in recent years, consumers have moved to high miles-per-gallon (mpg) vehicles,
in particular hybrid vehicles that rely on a battery as well as a gasoline engine for even greater mpg. The new vehicles
save money on gas, but also reduce the motorist's "carbon footprint" in an environment of global warming. To encourage
the purchase of fuel-efficient vehicles such as hybrids, the government may provide incentives, include income tax
credits, which represent dollar-for-dollar reductions in the tax liability of the individual in the year of purchase.
As both a cost-conscious and an environmentally conscious consumer, you are currently evaluating whether to
purchase a hybrid vehicle. Assume that you have narrowed your decision down to two choices, a gasoline-powered vehicle
or its equivalent hybrid (e.g., Ford Escape versus Escape hybrid). Relevant information regarding each of these two
vehicles, as well as additional information pertinent to your decision is given below.

Data Cost Tax Credit mpg

Gasoline model $17,000 $0 23.0

Hybrid model $19,000 $500 27.0

Estimated usage (in years), both models = 4

Estimated miles driven per year = 15,000


1. Generate a cost function for each decision alternative, where the dependent variable, Y, is "lifetime cost" and the independent
variable, Q, is "lifetime miles driven."
2. Calculate the breakeven price for gas (per gallon) between the gasoline-powered model and the hybrid model. (Ignore the
time value of money in your calculation.)
3. Prepare a graph for lifetime cost (Y) for each of the two autos as a function of price per gallon of gas (X), based on
60,000 lifetime miles for each auto. Use the following value of X (price per gallon of gas) to generate each cost function:
4. This decision problem is similar to the choice-of-cost-structure (variable vs. fixed) discussed in the chapter. Here, the
issue is whether to pay an up-front primium (exta fixed cost) for the hybrid model, in exchange for lower variable costs over
the life of the vehicle. In a typical CVP model, we were able, at any output level (X) to calculate a measure of profit sensitivity,
which we called the degree of operating leverage (DOL). In the present contexxt, which involves only costs for each vehicle
over a four-year period, we cannot calculate DOL, but we might calculate an analogous measure: the ratio of % change in
lifetime cost to % change in miles. Refer to this as a pseudo-DOL. Calculate the pseudo DOL measure for each decision
alternative, from a base of 60,000 lifetime miles. To calculate the percentage change figures, use 62,000 miles. What
information is conveyed in the two measures you calculated?

5. You are wondering whether, in the present context (i.e., decision choice) the price of gas (per gallon) has much of
an impact on the financial consequence regarding choice of automobile. To explore this issue further, you decide to construct a
decision table. As pointed out in the text, a decision table discloses combinations of actions (here, choice of automobile), and
events (here, lifetime miles driven, and mpg performance of each auto). Prepare a decision table that discloses the breakeven
point is gas price (per gallon) for 50,000 miles, 60,000 miles, and 70,000 miles for each of five situations regarding the difference
in initial cost (after rebate) between the gasoline-powered model and the hybrid model. Construct your table based on the
following initial cost differences between the two: $2,500; $2,000; $1,500 (the base case, based on original data); $1,000; and,
$500. (Hint: with five different initial cost differences and three alternatives for lifetime miles driven, your decision table should
disclose 15 (i.e., 5 x 3) breakeven points in terms of price per gallon of gas.) Interpret a couple of points from the decision table
you constructed.

Initial Cost Lifetime Miles

Difference Driven
$2,500 70,000
$2,000 60,000
$1,500 50,000

Note: Initial cost difference = Cost of Hybrid (net of rebate) Cost of gasoline-powered model

6. The following probabilities (p) apply to the set of possible events (price of gas, per gallon) listed above in (3): 0.05; 0.05; 0.05;
0.05; 0.15; 0.25; 0.15; 0.10; 0.10; and 0.05. Your decision consists of choosing one of two actions: buy the hybrid model or
buy the gasoline-powered model. Given this set of probabilities and events, calcuate the expected value of the lifetime cost
associated with each action (decision choice) under the assumption that lifetime miles driven = 60,000. For each action, the
expected value of lifetime cost, E(a), is the weighted average of outcomes (lifetime costs), where the weights for each outcome

is the outcome's probability. i Event p

1 $2.75 0.01
2 $3.00 0.05
3 $3.25 0.05
4 $3.50 0.05
5 $3.75 0.15
6 $3.88 0.15
7 $4.00 0.15
8 $4.25 0.20
9 $4.50 0.10
10 $4.75 0.09

7. As noted in the preceding analyses, in some plausible scenarios the lifetime cost of each of the two decision alternatives is very
close--in some cases they are practically indistinguishable. What non-financial (qualitative) factors and other quantitative factors
(beyond those considered above) might be relevant to your decision? Explain.


1. Lifetime cost functions: let Y = lifetime cost, and v = cost per gallon of gas

Regular model:
Lifetime Cost (Y) = Fixed Cost + Variable Cost
Lifetime Cost (Y) = $17,000 + (v [60,000 miles 23.0 mpg])
Lifetime Cost (Y) = $17,000 + (2,608.7 gals. v)
Hybrid model:
Lifetime Cost (Y) = Fixed Cost + Variable Cost
Lifetime Cost (Y) = ($19,000 - $500) + (v [60,000 miles 27.0 mpg])
Lifetime Cost (Y) = $18,500 + (2,222.2 gals. v)

2. Breakeven gas price (point of cost indifference): let "v" = breakeven price per gallon

Lifetime Cost--Gas Model = Lifetime Cost--Hybrid Model

$17,000 + (2,608.7 gals. v ) = $18,500 + (2,222.2 gals. x v)

v = [$18,500 - $17,000] [2,608.7 gals. - 2,222.2 gals.]

= $1,500 386.5 gals. =

$3.88 per gallon

3. Lifetime cost graph: Gasoline-Powered Model versus Hybrid Model

X (price Lifetime Cost

per gal.) Gas Model Hybrid
$2.750 $24,174 $24,611
$3.000 $24,826 $25,167
$3.250 $25,478 $25,722
$3.500 $26,130 $26,278
$3.750 $26,783 $26,833
$4.000 $27,435 $27,389
$4.250 $28,087 $27,944
$4.500 $28,739 $28,500
$4.750 $29,391 $29,056
$5.000 $30,043 $29,611

Lifetime Costs: Gas-Powered vs. Hybrid Model

$ 30,000

$ 29,500

$ 29,000

$ 28,500

$ 28,000

$ 27,500

$ 27,000

$ 26,500

$ 26,000

$ 25,500

$ 25,000

$ 24,500
Column E
$ 24,000

$ 3.000 $ 3.250 Column F $ 4.250 $ 4.500 $ 4.750 $ 5.000

$ 2.750 $ 3.500 $3.750 $ 4.000

Based on the above analysis and graph, we see that for these two alternatives (gas-powered vs. hybrid model), and
60,000 miles total usage over a four-year period, the lifetime costs are close, that is, they are insensitive to the predicted
cost of gas per gallon.

4. Pseudo DOL measure (sensitivity of change in total cost to change in activity, miles driven)

Alternative Lifetime Mileage Assumption = 62,000

Original Assumption--Lifetime Mileage = 60,000
Assumed price-per-gallon of gas = $4.00
Lifetime Cost Lifetime Cost % Change % Change Pseudo

Option @ 62,000 miles @ 60,000 miles Cost Mileage DOL

Gas Powered Car $27,783 $27,435 1.2678% 3.333% 0.380
Hybrid Model $27,685 $27,389 1.0818% 3.333% 0.325

The above pseudo DOL measure for the gas-powered car indicate that from a baseline of
60,000 lifetime miles, for each 1% change in lifetime miles driven, lifetime cost changes by 0.38%.
The relevant measure for the hybrid, from this base, is 0.325%. What this tells us is that for this
particular example, the lifetime cost for BOTH alternatives is approximately equally sensitive to change in miles driven.

5. Decision Table: breakeven gas price (per gallon) for different combinations of intial cost differential (hybrid - gas model)
and lifetime miles driven.

Initial Cost Lifetime Miles Gas Price
Differential Driven (per gallon)
$2,500 70,000 $5.545
$2,500 60,000 $6.469
$2,500 50,000 $7.763
$2,000 70,000 $4.436
$2,000 60,000 $5.175
$2,000 50,000 $6.210
$1,500 70,000 $3.327
Base Case $1,500 60,000 $3.881
$1,500 50,000 $4.658
$1,000 70,000 $2.218
$1,000 60,000 $2.588
$1,000 50,000 $3.105
$500 70,000 $1.109
$500 60,000 $1.294
$500 50,000 $1.553

For example, for the base case ($1,5000 intial cost differencen and 60,000 lifetime miles driven) the breakeven cost per
gallon of gas is $3.881 (as found earlier in part 2). As this price, and all other things equal, you would be indifferent between
the hybrid model and the gasoline-powered model. Notice from the above table that the higher the initial cost differential for the
hybrid versus the gasoline-powered model, the greater the breakeven point in terms of cost per gallon of fuel. You also notice
that the breakeven gas price is inversely related to lifetime miles driven. While both conclusions seem intuitively appealing, the
advantage of the decision table is the structured way in which it allows you to deal quantitatively with uncertainty surrounding
the financial consequence of your decision choice.

6. Expected value analysis

Number of lifetime miles assumed = 60,000

i p Action (Decision)
Event Hybrid Gas Model
1 $2.75 0.01 $246 $242
2 $3.00 0.05 $1,258 $1,241
3 $3.25 0.05 $1,286 $1,274
4 $3.50 0.05 $1,314 $1,307
5 $3.75 0.15 $4,025 $4,017
6 $3.88 0.15 $4,069 $4,069
7 $4.00 0.15 $4,108 $4,115
8 $4.25 0.20 $5,589 $5,617
9 $4.50 0.10 $2,850 $2,874
10 $4.75 0.09 $2,615 $2,645
Sum = $27,360 $27,401

To minimize the expected lifetime cost, we should choose the hybrid model. However, these expected values are so
close that they are effectively equal, given uncertainty in the price of gas. Thus, if total miles driven over the lifetime of
each vehicle (4 years) is 60,000, then the expected lifetime cost of both actions (given the assumed probability
distribution) is approximately equal.

Finally, note that basing the decision solely on expected value (in this case, lifetime cost) ignores the risk preferences of
the decision-maker. The decision table presented above in part 5 can be used to facilitate this discussion.

7. Qualitative and other quantiative considerations: student answers will likely differ. Below are representative considerations.

Qualitative Considerations

a. safety record--does this differ between the two models?

b. reliability--does this differ between the two models? (in some cases, the reliability of new models is considerably less than the
reliability of older, more established models)
c. as noted in conjunction with the discussion of decision tables (above), we have not given explicity consideration to the decision-
maker's attitude toward risk associated with the inputs to the decision model
d."carbon footprint" issue--it is true that from an operating standpoint, the carbon footprint of the hybrid would be less than it is
for the related gasoline-powered model. However, what this comparison ignores is the total carbon footprint--from
manufacture, through operation (use), through disposal. It is possible, for example, that when one considers the relatively
energy consumption needed to build the hybrid model, depending on total miles driven, its carbon footprint might be larger
than it is for the related gasoline-powered model.
e. relationship between mpg and lifetime miles driven: ignored thus far in the analysis is the fact that the latter might be a
function of the former. Our analysis has, in fact, assumed that these two variables are unrelated (i.e., we assumed in the
base case that for both decision alernatives lifetime miles driven = 60,000). However, it is entirely possible that people who
purchase the more fuel-efficient hybrid model drive more.

Additional Quantitative Considerations

a. useful life--what is the estimated useful life for each vehicle? (this would be important if the buyer intended to use the vehicle
beyond the four-year planning horizon)
b. estimated salvage/disposal value at the end of the four-year planning horizon--does this amount differ between the
two models?
c. related to point b above, what is the estimated salvage value at the end of each of years 1 through 3? (important as a
potential "bail-out" consideration)
d. other operating expenses (e.g., insurance, repairs/maintenance)--how do these compare for the two vehicles?
What is the estimated battery life for the hybrid? What is the likelihood that the battery would have to be replaced during
the four-year ownership period?
e. time value of money (discount rate)--the underlying decision here is long-term in nature. As such, the decision-maker should
consider the present (i.e., discounted) value of costs associated with each decision alternative (similar to the approach
taken in capital budgeting decisions)
f. the given mpg figures are based on some type of average driving (or mix between city and highway miles driven). Is the
anticipated driving behavior of the purchaser different from this assumed mix so that the use of average mpg data would not
be appropriate? If most of the driving will be done in the city, this is a greater advantage for the hybrid, since electric propulsion
would be used more frequently in this context. On the other hand, if most of the driving will be highway driving, the fuel
efficiency gap between the hybrid and the gasoline-powered model closes.Once the hybrid gets to highway speed it is being
propelled mostly by the gasoline engine.
Problem 11-47: Decision-Making (Cognitive) Biases


Obtain from your library a copy of the following article: D. Kahneman,

D. Lovallo, and O. Sibony, Before You Make That Big Decision,
Harvard Business Review, June 2011, pp. 51-60. Even highly
experienced, superbly competent, and well-intentioned managers are
fallible (p. 60). This article discusses a variety of cognitive biases
associated with the decision-making process. Such biases can
diminish the quality of decisions. The authors maintainP that
understanding these biases may decrease their effect and offer a
check-list designed to facilitate decision quality control.

1. What is meant by the term cognitive bias?
2. What is the specific decision-making context addressed by the
authors of this article?
3. What are the three major categories of the decision quality-control
check-list recommended by the authors?
4. What are the specific cognitive biases discussed by the authors of
this article?


1. The term "cognitive bias" refers to factors that distort reasoning in business, that is, that
diminish the quality of decisions. Such biases, it is maintained, result from the fact that in
the real world managers often rely on heuristics (rules of thumb) to make decisions.
We can define heuristics as "mental shortcuts" that are used in judgment, estimation,
and decision-making. Evidence from cognitive psychology over a number of years
suggests that the use of such heuristics can lead to predictable, systematic errors and
biases, of the sort discussed in this article.

2. The decision-making context used as the basis of discussion in this article is a manager/
executive who must make a decision based on recommendations to him/her from a decision-
making team. The article offers a systematic framework that, according to the authors, can be
used to vet the quality of proposals submitted for evaluation. This framework consists of a
checklist of 12 items divided into three categories. Use of the checklist is designed to allow the
manager/executive to detect 12 different cognitive biases.

3. The three major categories comprising the checklist are:

* Questions managers/executives should ask themselves
* Questions that should be addressed to the decision-making team
* Questions focused on evaluating the proposal under consideration

4. Specific questions within each of the three major categories on the

checklist: Questions Managers/Executives Should Ask Themselves

a. Is there reason to suspect bias driven by self-interest of the recommending team

(i.e., is the proposal motivated by self-interest--as measured in financial terms,
reputational effect, organizational power, or career options)? Does the proposal
include only a single realistic option--the one that the recommending team prefers?

b. Has the team "fallen in love with" its own proposal? Check for what is called an
"affect hueristic" (that is, the tendency of the decision team to minimize the risks and
costs of a proposed course of action that it favors, and to do the opposite for a
proposal it does not favor). Essentially, this bias is rooted in emotional effects.

c. Check for "groupthink," that is, the tendency of a team to minimize conflict by converging on
a decision/recommendation because it appears to be gathering support. Thus, it is
appropriate to ask: "Were there dissenting opinions within the team?"

Questions to be asked of the team making the recommendation

a. Is the proposal/recommendation subject to "saliency bias" (i.e., undue reliance on an

analogy to a memorable success--a salient analogy)? As the authors note (p. 55), the
use of a single or just a few analogies almost always leads to faulty inferences!

b. Confirmation bias (did the team seek out only evidence that helped support its
recommendation and/or ignore or underweight evidence that contradicted the
recommendation?) Does the proposal include more than one recommended option?

c. Availability bias (i.e., the tendency of individuals/teams to base judgments only on

readily available information). The key here is to think critically about the data that are
needed to make an informed decision and not simply to rely on information that is

d. Anchoring bias (achoring refers to the tendency to make judgments consistent with
some prior cue or anchor, regardless of the relevance of that anchor). A strategy to
deal with this possible bias is to re-anchor with figures generated by other models or
benchmarks--a kind of sensitivity analysis.

e. Halo effect ("guilt by association" or false inferences based on reputational effects).

f. Sunk-Cost Fallacy/Endowment Effect (people have a tendency to become committed to

a previously selected course of action or project beyond the point prescribed by a
rational/optimal model). This is particularly true when these individuals have made
large investments via prior decisions (i.e.,"sunk costs") or when they feel the need to
justify past decisions that have had bad outcomes (i.e., "escalation of commitment").

Evaluating the Proposal Itself

a. Is the base-case scenario overly optimistic? Does the proposal include potential
competitor reactions?

b. The "disaster effect": is the worst-case scenario overly optimistic (i.e., not "bad
enough")? (The authors' discussion of a "pre-mortem" is an interesting way to deal
with this potential problem.)

c. Loss aversion: is the recommending team being overly cautious? Put another way, is
the proposed paln creative or ambitious enough?
Problem 11-48: Sell-or-Process-Further Decision


Humbolt Electric manufactures electronic subcomponents that be sold at the end of Process #1 or
processed further, in Process #2, and then sold. Currently, the entire output of Process #1 can be sold at
a price of $2 per unit. The output of Process #2 has in the past sold for $5.50 per unit; however, the price
of this output has recently dropped to $5.10 (on average).

On the basis of an analysis of the above cost and selling price information, as well as an analysis of
market trend-data, the VP of Marketing has suggested that output from Process #2 should be curtailed
whenever the price of its output falls below $4.50 per unit. The VP of Manufacturing has indicated that
the total available capacity is interchangeable between the two processes. (That is, fixed manufacturing
costs are largely independent of decisions regarding short-term product mix.) He recommends that,
based on current prices, all sales should be from Process #2 output. His analysis follows:

Data Process 1 Process 2

Selling price, after deducting
selling-related costs $2.00 $5.10
Direct Materials (DM) $1.00 $1.50
Direct Labor (DL) $0.20 $0.40
Manufacturing overhead $0.60 $1.20
Transferred-in variable costs from
Process #1 (DM + DL) $0 $1.20
Operating income $0.20 $0.80

Direct materials and direct labor are variable costs. All manufacturing overhead costs are fixed and
are allocated to units produced based on hours of capacity used.
Total hours of capacity available are 600,000. The products are produced in batches of 60 units.
Each batch of output from Process #1 requires 1 hour of processing, and two additional hours of
processing per batch produced in Process #2.

Total hours of capacity available = 600,000

Batch size = 60.00 units
Hours per Batch, Process 1 = 1.00 hour
Add'l. processing time/batch, Process 2 = 2.00 hours
% variable overhead (Part 4) = 50%
Alternative selling price per unit, Proces 2 = $5.50
1. Develop a schematic diagram of the two-stage process. Include in your diagram relevant revenue (selling price
per unit) as well as relevant costs (per unit of output).
2. If the price of the output from Process #2 for the coming year is expected to be $5.10, should all sales be only
from Process #2, as asserted by the VP of Manufacturing?
3. What is the lowest acceptable price for the output from Process #2 to make it as profitable as the output from
Process #1?
4. Suppose that 50% of the manufacturing overhead costs are variable. Do you answers to parts 1 and 2 above
change? If so, why?
5. Sensitivity analysis: Calculate the contribution margin per machine hour for both Process #1 output and
Process #2 output under each of the following assumptions regarding the percentage of variable overhead
cost: 0%, 25%, 50%, and 100%. Do these calculations both for a selling price of $5.10 per unit for Process #2
output and a selling price of $5.50 per unit. What general conclusion can you draw on the basis of this
sensitivity analysis?


1. Schematic Diagram: Two-Stage Process

Process #2
Variable cost = $1.90/unit

Process #1 1 Batch = 60 units Selling

price/unit =
1 Batch = 2 hour $5.10
Variable cost = $1.20/unit

1 Batch = 60 units

1 Batch = 1 hour

price/unit =

Note: The problem states that manufacturing overhead is entirely fixed; as such,it
is considered a sunk cost with respect to the sell-or-process further decision.
Incremental costs and revenues are reflected in the above diagram.

2. Should all sales be from Process 2 if the selling price per unit = $5.10?

Since the number of processing hours is limited (i.e., is a scarce resource), the short-term
objective would be to maximize the contribution margin per hour of processing time. Data in
this regard for each of the two products are as follows:

Process 1 Process 2
Net selling price per unit $2.00 $5.10
Less: Variable costs:
DM $1.00 $1.50
DL $0.20 $0.40
Transferred-in costs from Process. 1 $0 $1.20
Total variable cost per unit $1.20 $3.10
Contribution margin per unit $0.80 $2.00
No. of hours per unit 0.0167 0.0500
Contribution margin per hour $48.00 $40.00

Note: 0.0167 = 1 60; 0.050 = (1 + 2) 60; $48.00 = $0.80 0.0167;

$40.00 = $2.00 0.050

Thus, on a contribution margin per processing hour basis, Process #1 output is

more profitable than output from Process #2. Short-run operating income would
be maximized if all available hours were used to produce Process #1 output.

3. The selling price from Process #2 output must increase to $5.50 (from $5.10),
as follows:
a. The required increase in profitability per processing hour
= $48.00 $40.00 = $8.00per hour
b. To make one unit of output from Process #2 requires 0.05 hours
c. Therefore, the increase in selling price per unit
= $8.00 per hour 0.05 hours/unit = $0.40per unit
d. Minimum selling price, output from Process #2 =
= current price/unit + required price increase
= $5.10/unit + $0.40/unit = $5.50per unit

4. Assume that 50% of the total overhead costs are variable. To determine whether the answer to Part 2 or
Part 3 changes, we need to recalculate the contribution margin per hour for each product, as follows:

Process 1 Process 2
Net selling price per unit $2.00 $5.10
Less: Variable costs:
DM $1.00 $1.50
DL $0.20 $0.40
Variable overhead (50%) $0.30 $0.60
Transferred-in costs from Process. 1 $0 $1.50
Total variable cost per unit $1.50 $4.00
Contribution margin per unit $0.50 $1.10
No. of hours per unit 0.0167 0.050
Contribution margin per hour $30.00 $22.00

Note: the variable overhead cost per unit of output from Process #1 =
50% $0.60; the variable overhead cost per unit of output from
Process #2 = 50% $1.20. Total transferred-in costs from Process #1
= DM + DL + Var. Ovh. = $1.00 + $0.20 + $0.30 = $1.50/unit.

Given the above results, the conclusion reached in Part 2 still holds.

5. Sensitivity analysis: look at the difference in contribution margins per hour under different selling prices per
unit of Process #2 output and for different variable overhead cost percentages.

@$5.10/Unit @$5.50/unit
CM/hour CM/hour
% VOH P1 P2 P1 P2
0% $48.00 $40.00 $8.00 $48.00 $48.00 $0.00
25% $39.00 $31.00 $8.00 $39.00 $39.00 $0.00
50% $30.00 $22.00 $8.00 $30.00 $30.00 $0.00
100% $12.00 $4.00 $8.00 $12.00 $12.00 $0.00

This sensitivity analysis helps explain the result obtained in Part 4. Compared to Process #1,
Process #2 output uses three times as much processing time per unit. This is independent of
selling prices and the composition of variable overhead.

Further, the amount of variable overhead charged per unit of Process #2 output is always
three times as much variable overhead charged per unit of output from Process #1. For
example, if variable overhead % = 10, then the variable overhead per unit of Process #1 output
= $0.06 (i.e., 10% $0.60). The amount of variable overhead charged per unit of output from
Process #2 = $0.18 ($0.06 transferred from Process #1, plus $0.12 additional variable
overhead from Process #2 [= 10% $1.20]).

Because these ratios are constant across selling prices per unit for Product #2 and also
constant across levels of variable overhead, the difference in contribution margin per hour
between Process #1 and Process #2 output, at each assumed selling price per unit for
Process #2 output, will be constant and independent of the proportion of total overhead
that is variable.