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INDIAN INSTITUTE OF MANAGEMENT INDORE

MANAGERIAL ACCOUNTING & CONTROL - II


Mid Term Examination
November, 18 2008
Time: 2 hrs

9.30 a.m. to 11.30 a.m.

This is open book examination


Examinees are allowed to carry:
Cost Accounting, A Managerial Emphasis
(By Charles T. Horngren et al)
Class Note Book
Ordinary Calculator

Case
Assignment
Essential

Hospital Supply, Inc.


Given at the end of case
Neatness, systematic presentation,
working notes

Hospital Supply, Inc.

Hospital Supply, Inc. produced hydraulic hoists that were used by hospitals to move
bedridden patients. The costs of manufacturing and marketing hydraulic hoists at the
companys normal volume of 3000 units per month are shown in Exhibit 1.
EXHIBIT 1

Costs per Unit of hydraulic hoists

Unit manufacturing costs:


Variable materials
Variable labour
Variable overhead
Fixed overhead
Total manufacturing costs
Unit marketing costs:
Variable
Fixed
Total marketing costs
TOTAL UNIT COSTS

$ 550
825
420
660
$ 2455
275
770
1045
_______
$ 3500
======

The following questions refer only to the data given in Exhibit 1. Unless otherwise stated,
assume there is no connection between the situations described in the questions; treat
them independently. Unless otherwise stated, assume a regular selling price of $ 4350 per
unit. Ignore income tax and any other costs not mentioned in Exhibit 1 or in a question
itself.
Questions:
1.
2.

What is break-even volume in units? In sales dollars?


Market research estimates that monthly volume could increase to 3500 units,
which is well within hoist production capacity limitations, if the price were cut
from $ 4350 to $ 3850 per unit. Assuming costs behavior patterns implied by the
data in Exhibit 1 are correct, would you recommend this action? What would be
the impact on monthly sales, costs, and income?

3.

On March 1, a contract offer is made to Hospital Supply, Inc. by the federal


government to supply 500 units to Veteran Administration hospitals for delivery by
March 31. Because of an unusually large number of rush orders from its regular

4.

customers, Hospital Supply plans to produce 4000 units during March, which will
use all available capacity. If the government order is accepted, 500 units normally
supplied to regular customers would be lost to a competitor. The contract given by
the government would reimburse the governments share of March production
costs, plus a fixed fee (profit) of $ 275,000. (There would be no marketing costs
incurred on the governments units) What impact would accepting the government
contract have on March income?
An inventory of 200 units of an obsolete model of the hoist remains in the
stockroom. These must be sold through regular channels at reduced prices or the
inventory will soon be valueless. What is the minimum price that should be
acceptable in selling these units?

THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 80 THROUGH 84.


Tiger Pride produces two product lines: T-shirts and Sweatshirts. Product profitability is analyzed
as follows:
T-SHIRTS
SWEATSHIRTS
Production and sales volume
60,000 units
35,000 units
Selling price
$16.00
$29.00
Direct material
Direct labor
Manufacturing overhead
Gross profit
Selling and administrative
Operating profit

$
$
$
$
$
$

2.00
4.50
2.00
7.50
4.00
3.50

$ 5.00
$ 7.20
$ 3.00
$13.80
$ 7.00
$ 6.80

Tiger Prides managers have decided to revise their current assignment of overhead costs to
reflect the following ABC cost information:
Activity
Supervision
Inspection

Activity cost
$100,920
$124,000

Activity-cost driver
Direct labor hours (DLH)
Inspections

Activities demanded
T-SHIRTS
SWEATSHIRTS
0.75 DLH/unit
1.2 DLH/unit
45,000 DLHs
42,000 DLHs

60,000 inspections
80.

17,500 inspections

Under the revised ABC system, the activity-cost driver rate for the supervision activity is
a.
$2.58
b.
$2.40
c.
$2.24
d.
$1.16
Answer: d
Difficulty:
$100,920 / 87,000 dlh = $1.16 per dlh

Objective:

81.

Under the revised ABC system, supervision costs allocated to Sweatshirts will be
a.
$48,720.
b.
$100,800.
c.
$100,920.
d.
none of the above.
Answer: a
Difficulty: 1
Objective:
$100,920 / 87,000 dlh = $1.16 per dlh x 42,000 dlh = $48,720

82.

Under the revised ABC system, total overhead costs allocated to Sweatshirts will be
a.
$ 48,720.
b.
$ 76,720.
c.
$224,920.
d.
none of the above.
Answer: b
Difficulty: 2
Objective:
$124,000 / 77,500 inspections = $1.60 per inspection x 17,500 = $28,000
$48,720 + $28,000 = $76,720

83.

Under the revised ABC system, overhead costs per unit for the Sweatshirts will be
a.
$1.39 per unit.
b.
$1.60 per unit.
c.
$2.19 per unit.
d.
$2.47 per unit.
Answer: c
Difficulty:
$76,720 / 35,000 sweatshirts = $2.19

84.

Objective:

Using an ABC system, next years estimates show manufacturing overhead costs will total
$228,300 for 52,000 T-shirts. If all other T-shirt costs and sales prices remain the same, the
profitability that can be expected is
a.
$5.41 per t-shirt.
b.
$4.39 per t-shirt.
c.
$1.11 per t-shirt.
d.
($0.81) per t-shirt.
Answer: c
Difficulty: 3
Objective: 5
(52,000 ($16 - $2.00 - $4.50 - $4.00) ) - $228,300 = $57,700 / 52,000 = $1.11

Total fixed costs (TFC) = fixed costs per unit times normal volume =($660 + $770)*3,000 = $4,290,000.
Contribution margin per unit = unit price minus unit variable costs = $4,350 - $2,070 = $2,280.
Break even volume

$4,290,000
1,882 units
$2,280

$4,350 - 2,070
$8,185,461
$4,350

Break even sales $4,290,000/

(actually, 1,882 *$4,350 = $8,186,700)


Question 2
Recommendation: Lowering prices reduces income. Other factors, such as the reduction of available
capacity and the capacity and the impact on market share, could also affect the decision.

Before Price
After Price
Impact:
Reduction
Reduction
Difference
Price...................................................................................................................................................................................
$
4,350
$
3,850
$
(500)
Quantity.............................................................................................................................................................................
3,000
3,500
500
Revenue.............................................................................................................................................................................
$13,050,000
$13,475,000
$ 425,000
Variable mfg. costs.............................................................................................................................................................
( 5,385,000)
(6,282,500)
(897,500)
Variable mktg. costs...........................................................................................................................................................
(825,000)
(962,500)
(137,500)
Contribution margin........................................................................................................................................................
6,840,000
6,230,000
(610,000)
Fixed mfg. costs.................................................................................................................................................................
(1,980,000)
(1,980,000)
-Fixed mktg. costs...............................................................................................................................................................
(2,310,000)
(2,310,000)
-Income.........................................................................................................................................................................
$ 2,550,000
$ 1,940,000
$(610,000)

Note that the differential contribution margin and differential income are the same.
Question 3
Recommendation: Don't accept contract

Without
With Government Contract
Govt.
Impact:
Contract
Regular
Government
Total
Difference
Revenue.............................................................................................................................................................................
$17,400,000 $15,225,000
$1,420,000 $16,645,000
$(755,000)
Variable mfg.......................................................................................................................................................................
(7,180,000)
(6,282,500)
(897,500)
(7,180,000)
-Variable mktg. costs...........................................................................................................................................................
(1,100,000)
(962,500)
-(962,500)
137,500
Contribution margin........................................................................................................................................................
9,120,000
7,980,000
522,500
8,502,500
(617,500)
Fixed mfg. costs.................................................................................................................................................................
(1,980,000)
(1,980,000)
-Fixed mktg. costs...............................................................................................................................................................
(2,310,000)
(2,310,000)
-Income.........................................................................................................................................................................
$ 4,830,000
$ 4,212,500
$(617,500)
Government revenue = (500 * $1,795) +.125 ($1,980,000) + $275,000 = $1,420,000, assuming the government's "share" of
March fixed manufacturing costs is .125 (500/4,000).

A shorter approach to question 3 (but harder for some students to understand) is this:

Forgone contribution (equals forgone income, as was illustrated by question


2) on regular sales if government contract is accepted.......................................................................................................
500 * $2,280 = $1,140,000
Income from government contract:
Fixed fee................................................................................................................................................................
275,000
Share of fixed mfg. costs (1/8 * $1,980,000).........................................................................................................
247,500
522,500
Differential income if contract accepted................................................................................................................
$(617,500)
Question 4
Minimum price = variable mfg costs + shipping costs + order costs
= $1,795 + $410 + $22,000/1,000 = $2,227
At this price per unit, the $2,227,000 of differential costs caused by the 1,000-unit order will just be
uncovered. Some students solve for this price using the break-even formula (UR = unit revenue):
TCF
UR UVC Q
22,000
UR 2,205 1,000 units

$22,000 = 1,000UR - $2,205,000


$2,227,000 = 1,000UR
$2,227 = UR
Question 5
The manufacturing costs are sunk; therefore, any price in excess of the differential costs of selling the
hoists will add to income. In this case, those differential costs are apparently the $275 per unit variable
marketing costs, since the hoists are to be sold through regular channels; thus the minimum price is $275.
(If the instructor wishes to reinforce the concept of opportunity cost, the most general answer to this
question is that the price should exceed the sum of (1) the differential marketing costs and (2) the
potential scrap proceeds, which are an opportunity cost of selling the hoists rather than scrapping them.)
This assumes, however, that sale of these "obsolete" hoists will not cut into sales of the current model. If
this assumption is not valid, then the contribution margin on any "cannibalized" sales must be taken into
account.

Question 6
What price is equivalent to in-house cost of production?

All Production
1,000 Units
In-house
Contracted
Total revenue......................................................................................................................................................................
$13,050,000
$13,050,000
Total variable manufacturing costs.....................................................................................................................................
(5,385,000)
(3,590,000)
Total variable marketing costs............................................................................................................................................
(825,000)
(770,000)
Total contribution margin...................................................................................................................................................
6,840,000
8,690,000
Total fixed manufacturing costs.........................................................................................................................................
(1,980,000)
(1,386,000)
Total fixed marketing costs................................................................................................................................................
2,310,000
(2,310,000)
Payment to contractor.....................................................................................................................................................
-_________X
Income......................................................................................................................................................................
$ 2,550,000
$ 4,994,000 - X
$4,994,000 - X = $2,550,000
X = $2,444,000 or $2,444 per unit maximum purchase price
Therefore, a $2,475 purchase price is not acceptable; it would decrease income by $31,000 [($2,475 $2,444) * 1,000].
A shorter (but more difficult) approach uses the concept of opportunity costs:

Variable manufacturing cost........................................................................................................................................


$1,795
Variable marketing opportunity cost ($275 - $220).....................................................................................................
55
Fixed manufacturing opportunity cost.........................................................................................................................
594*
Equivalent in-house cost..............................................................................................................................................
$2,444
*($1,980,000 - $1,386,000)/1,000 units

Question 7

Contract 1,000 Regular Hoists and


3,000 Regular
Produce 800 Modified Hoists
Hoists
Produced
Regular
In-house
Regular (In)
(Out)
Modified
Total
Revenue.............................................................................................................................................................................
$13,050,000
$8,700,000
$4,350,000
$3,960,000 $17,010,000
Variable mfg. costs.............................................................................................................................................................
(5,385,000) (3,590,000)
-- (2,420,000) (6,010,000)
Variable mktg. costs...........................................................................................................................................................
(825,000)
(550,000)
(220,000)
(440,000) (1,210,000)
Contribution margin...........................................................................................................................................................
6,840,000
4,560,000
4,130,000
1,100,000
9,790,000
Fixed mfg. costs.................................................................................................................................................................
(1,980,000)
(1,980,000)
Fixed mktg. costs...............................................................................................................................................................
(2,310,000)
(2,310,000)
Payment to contractor.........................................................................................................................................................
--(X)
-(X)
Income.........................................................................................................................................................................
$ 2,550,000
$5,500,000 - X
Maximum payment = $2,950,000. Now the proposal should be accepted as a price of $2,475.