Exercise 12-11:

Identification of Relevant Costs

Given:
Samantha Ringer purchased a used automobile for $10,000 at the beginning of last year and incurred the
following operating costs:
Depreciation ($10,000 / 5 years)
Insurance
Garage rent
Automobile tax and license
Variable operating costs

$2,000
960
480
60
$0.08 per mile

The variable operating cost consist of gasoline, oil, tires, maintenance, and repairs. Samantha estimates
that at her current rate of usage the car will have zero resale value in five years, so the annual straightline depreciation is $2,000. The car is kept in a garage for a monthly fee.
Required:
1. Samantha drove the car 10,000 miles last year. Compute the average cost per mile of owning and
operating the car.
Fixed costs
Depreciation ($10,000 / 5 years)
Insurance
Garage rent
Automobile tax and license
Variable costs
Variable operating costs per mile
Miles
Total cost of operating the car
Miles
Average total cost per mile to operate car

$2,000
960
480
60
$0.08
10,000

$3,500

800
$4,300
10,000
$0.43

2. Samantha is unsure about whether she should use her own car or rent a car to go on an extended
cross-country trip for two weeks during spring break. What costs above are relevant in this decision?
Explain.
Variable operating costs:
These are future costs which will only be incurred if Samantha uses her own car.
Fixed costs:
These are sunk cost that will be incurred regardless of her decision.
These costs are not future costs and they do not differ between alternatives.
3. Samantha is thinking about buying an expensive sports car to replace the car she bought last year.
She would drive the same number of miles regardless of which car she owns and would rent the same
parking space. The sports car's variable operating costs would be roughly the same as the variable
operating costs of her old car. However, her insurance and automobile tax and license costs would go
up. What costs are relevant in estimating the incremental cost of owning the more expensive car?
Explain.
Cost Item:

Relevant

Reason

Cost of new sports car

Sales value of older car
Residual value of new sports car
Insurance on new sports car
Automobile tax & license on new car
Cost of older car
Insurance on older car
Automobile tax & license on older car
Variable operating costs: same
Garage rent: same

Yes
Yes
Yes
Yes
Yes
No
No
No
No
No

Future cost which differs between alternatives

Future revenue which differs between alternatives
Future cost which differs between alternatives
Future cost which differs between alternatives
Future cost which differs between alternatives
Past Cost -- Sunk Cost
Past Cost -- Sunk Cost
Past Cost -- Sunk Cost
Future cost which does not differ between alternatives
Future cost which does not differ between alternatives

nd incurred the

ntha estimates
nual straight-

n extended
n this decision?

ght last year.

d rent the same
s the variable
costs would go
ensive car?

een alternatives
etween alternatives
een alternatives
een alternatives
een alternatives

fer between alternatives

fer between alternatives

Exercise 12-15
Dropping or Retaining a Segment
Given:
Boyle's Home Center, a retailing company, has two departments, Bath and Kitchen. The company's
most recent monthly contribution format income statement follows:

Sales
Variable expenses
Contribution margin
Fixed expenses
Net operating income (loss)

Bath
$1,000,000
300,000
$700,000
900,000
($200,000)

Kitchen
$4,000,000
1,600,000
$2,400,000
1,800,000
$600,000

Total
$5,000,000
1,900,000
$3,100,000
2,700,000
$400,000

A study indicates that $370,000 of the fixed expenses being charged to the Bath Department are
sunk costs or allocated costs that will continue even if the Bath Department is dropped. In addition,
the elimination of the Bath Department would result in a 10% decrease in the sales of the Kitchen
Department.
Required:
If the Bath Department is dropped, what will be the effect on the net operating income
of the company as a whole?
Bath
Kitchen
Total
Sales
$0
$3,600,000
$3,600,000
Variable expenses
0
1,440,000
1,440,000
Contribution margin
$0
$2,160,000
$2,160,000
Fixed expenses
370,000
1,800,000
2,170,000
Net operating income (loss)
($370,000)
$360,000
($10,000)
Disadvantage of closing Bath Department

$410,000

Alternate Solution:
Bath Department contribution margin lost (100%)
Kitchen Department contribution margin lost (10%)
Avoidable fixed cost saved by closing Bath Department
Decrease in net operating income if Bath Department is closed

($700,000)
(240,000)
530,000
($410,000)

Exercise 12-3
Make or Buy A Component
Given:
Climate-Control, Inc., manufactures a variety of heating and air conditioning units. The
company is currently manufacturing all of its own component parts. An outside supplier
has offered to sell a theromostat to Climate-Control for $20 per unit. To evaluate this
offer, Climate-Control, Inc., has gathered the following information relating to its own
cost of producing the thermostat internally:
15,000
Per
Units Per
Unit
Year
Direct materials
$6
$90,000
Direct labor
8
120,000
Variable manufacturing overhead
1
15,000
Fixed manufacturing overhead, traceable ***
5
75,000
Fixed mfg. overhead, common, and allocated
10
150,000
Total cost
$30 $450,000
300000
*** 40% supervisory salaries; 60% depreciation of special equipment (no resale value).
Required:
1. Assuming that the company has no alternative use for the facilities now being used to
produce the thermostst, should the outside supplier's offer be accepted?
15,000
Per
Units Per
Cost savings by not producing component internally
Unit
Year
Direct materials
$6
$90,000
Direct labor
8
120,000
Variable manufacturing overhead
1
15,000
Fixed manufacturing overhead, traceable and avoidable
2
30,000
Fixed mfg. overhead, common, and allocated
0
0
Total cost
$17 $255,000
Cost of purchasing component from outside supplier
(20) (300,000)
Disadvantage of buying component from outside supplier
($3) ($45,000)
Disadvantage of buying component from outside supplier
($45,000)
Alternate Solution:
Total costs if units are produced internally
Total costs if units are purchased from external supplier:
Cost paid to external supplier
Unavoidable fixed costs
Traceable but unavoidable
Allocated and unavoidable
Disadvantage of buying component from outside supplier

$450,000
$300,000
45,000
150,000

495,000
($45,000)

2. Suppose that if the thermostats were purchased, Climate-Control, Inc., could use the
freed capacity to launch a new product. The segment margin of the new product
would be $65,000 per year. Should Climate-Control, Inc., accept the offer to buy the
thermostats from the outside supplier for $20 each?
Segment margin generated by using freed capacity to launch a new product

$65,000

Disadvantage of buying component from outside supplier with idle freed capacity
Advantage of using freed capacity to launch a new product and outsource
Thus, the company should accept the offer and purchase the parts from the outside supplier.

(45,000)
$20,000

$150,000

Exercise 12-14:
Special Order
Given:
Glade Company produces a single product. The costs of producing and selling a single unit of this
product at the company's current activity level of 8,000 units per month are:

Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Variable selling & administrative expenses
Fixed selling & administrative expenses

Per Part
$2.50
3.00
0.50
4.25
1.50
2.00
$13.75

The normal selling price is $15 per unit. The company's capacity is 10,000 units per month. An
order has been received from a potential customer overseas for 2,000 units at a price of $12.00
per unit. This order would not affect regular sales.
Required:
1. If the order is accepted, by how much will monthly profits increase or decrease? (The order
would not change the company's total fixed costs.)
Total for
Per Part
2,000 Units
Increase in revenue from special order
$12.00
$24,000
Increase in cost related to special order
Direct materials
$2.50
$5,000
Direct labor
3.00
6,000
Variable manufacturing overhead
0.50
1,000
Variable selling & administrative expenses
1.50
3,000
Incremental cost
$7.50
$15,000
Increased contribution margin from special order
$4.50
$9,000
$9,000
2. Assume the company has 500 units of this product left over from last year that are inferior to
the current model. The units must be sold through regular channels at reduced prices. What
unit cost is relevant for establishing a minimum selling price for these units? Explain.
The only unit cost that is relevant is the variable selling & administrative expense of $1.50.
All of the other costs are past unit costs and not future costs. All of these other costs are
sunk and will not increase or decrease because of distressed sales.

gle unit of this

per month. An
rice of $12.00

e inferior to
rices. What

Exercise 12-13
Utilization of a Constrained Resource
Given:
Banner Company produces three products: A, B, and C. The selling price, variable costs
and contribution margin for one unit of each product follow:
A
Selling price
Variable costs:
Direct materials
Direct labor
Variable manufacturing overhead
Total variable cost
Contribution margin per unit
Contribution margin ratio

$60

$90

$80

$27
12
3
$42
$18
30%

$14
32
8
$54
$36
40%

$40
16
4
$60
$20
25%

Due to a strike in the plant of one of its competitors, demand for the company's products
far exceeds its capacity to produce. Management is trying to determine which product(s)
to concentrate on next week in filling its backlog of orders. The direct labor rate is $8 per
hour, and only 3,000 hours of labor time are available each week.
Required:
1. Compute the amount of contribution margin that will be obtained per hour of labor time
spent on each product.
A
B
C
Contribution margin per unit
$18
$36
$20
Direct labor
$12
$32
$16
Direct labor rate per hour
8
8
8
Direct labor hours required per unit
1.50
4.00
2.00
CM per unit of limiting resource (DLH)
$12.00
$9.00
$10.00
2. Which orders would you recommend that the company work on next week -- the orders
for product A, product B, or product C?
Banner Company should work on meeting the demand for Product A first, then Product C,
and finally Product B. This work order is based on contribution margin generated per unit
of limiting resource which at this time is direct labor hours available.
3. By paying overtime wages, more than 3,000 hours of direct labor time can be made available
next week. Up to how much should the company be willing to pay per hour in overtime
wages as long as there is unfilled demand for the three products?
The amount Banner Company should be willing to pay in overtime wages for additional
direct labor hours depends on how the time would be used:

Normal direct labor rate per hour

CM per direct labor hour
Maximum overtime hourly rate

A
$8.00
12.00
$20.00

B
$8.00
9.00
$17.00

C
$8.00
10.00
$18.00

Acceptable overtime pay range:

Management would prefer to pay as
close to the $8.00 rate as possible.

$8 to $20

$8 to $17

$8 to $18

Note: Fill back orders in the following order A, C, then B provided additional hours can be
acquired within the product DL pay range.
Proof:
Selling price
Variable costs:
Direct materials
DL (based on maximum overtime rate)****
Variable manufacturing overhead
Total variable cost
Contribution margin per unit
Contribution margin ratio
****

$60

$90

$80

$27
30
3
$60
$0
0%

$14
68
8
$90
$0
0%

$40
36
4
$80
$0
0%

If pay was any higher CM would become negative.

per unit

Exercise 12-19

Sell or Process Further

Given:
Abilene Meat Processing Corporation is a major processor of beef and other meat products.
The company has a large amount of T-bone steak on hand, and it is trying to decide whether
to sell the T-bone steaks "as is" or to process them further into filet mignon and New York cut
steaks.
Management believes that a 1-pound T-bone steak would yield the following profit:
Wholesale selling price per pound
Less joint costs incurred up to the split-off point where T-bone steaks can be
identified as a separate product
Profit per pound

$2.25
1.70
$0.55

As mentioned above, instead of being sold as is, the T-bone steaks could be further processed
into filet mignon and New York cut steaks. Cutting one side of a T-bone steak provides the filet
mignon, and cutting the other side provides the New York cut. One 16-ounce T-bone steak cut
in this way will yield one 6-ounce filet mignon and one 8-ounce New York cut; the remaining
ounces are waste. The cost of processing the T-bone steaks into these cuts is $.20 per pound.
The filet mignon can be sold for $3.60 per pound, and the New York cut can be sold wholesale
$2.90 per pound.
Required:
1. Determine the profit per pound from processing the T-bone steaks further into filet mignon
and New York cut steaks.
Incremental Revenue
Revenue from processing further a one-pound T-bone steak
6-ounce filet mignon @ $3.60 per pound
8-ounce New York cut @ $2.90 per pound
Wholesale selling price of a one-pound T-bone steak "as is"
Increase in revenue from processing further
Incremental Cost
Per pound cost of processing a one-pound T-bone steak into
a 6-ounce filet mignon and a 8-ounce New York cut
Incremental benefit of further processing per a one-pound T-bone steak

$1.35
1.45

2. Would you recommend that the t-bone steaks be sold as is or processed further? Why?
Process further. There is a $.35 benefit per one-pound T-bone steak processed.
Note: The allocated joint cost of $1.70 is irrelevant. The cost will be incurred regardless of
whether the T-bone steaks are processed further or not.
To be relevant a cost or revenue must:
1. be a future cost or revenue, not a past cost or past revenue, and
2. the future cost or revenue must differ between alternatives.

$2.80
2.25
$0.55

0.20
$0.35