CHAPTER 14

Decision Making: Relevant Costs and

Benefits

EXERCISE 14-30 (20 MINUTES)

FLIGHT ROUTE DECISION

Revenues and Costs
Under Two Alternatives
(a) (b) (c)
With Stop
Nonstop In San Differenti
Route* Francisc al
o* Amount
Passenger revenue ................................. $240,000 $258,000 $(18,000)
Landing fee in San Francisco ................ -0- (5,000) 5,000
Use of airport gate facilities ................... -0- (3,000) 3,000
Flight crew cost ....................................... (2,000) (2,500) 500
Fuel ........................................................... (21,000) (24,000) 3,000
Meals and services ................................. (4,000) (4,600) 600
Total revenue less costs ........................ $213,000 $218,900 $ (5,900)

*In columns (a) and (b), parentheses denote costs, and numbers
without parentheses are revenues.

In column (c), parentheses denote differential items favoring
option (b).

EXERCISE 14-31 (15 MINUTES)

The owners analysis incorrectly includes the following allocated costs

that will be incurred regardless of whether the ice cream counter is
operated:
Utilities ............................................................................................... $ 4,350
Depreciation of building ................................................................... 6,000
Deli managers salary ....................................................................... 4,500
Total .................................................................................................... $14,850
It is possible that closing the ice cream counter might save a
portion of the utility cost, but that is doubtful.
A better analysis follows:
Sales ................................................................................. $67,500
Less: Cost of food ........................................................... 30,000
Gross profit ...................................................................... 37,500
Less: Operating expenses
Wages of counter personnel .............................. $18,000
Paper products ..................................................... 6,000
Depreciation of counter equipment and 3,750
furnishings* ......................................................................
Total ....................................................................... 27,750
Profit on ice cream counter $ 9,750

*Depreciation on the counter equipment and furnishings is included

because it is traceable to the ice cream operation and is an expense in the
determination of income. If a cash-flow analysis is desired, this noncash
expense should be excluded.

EXERCISE 14-36 (15 MINUTES)

1. Relevant data:
Current sales value for unmodified parts .......................................$7,000
Sales value for modified parts ......................................................... 20,300
Modification costs ............................................................................. 10,000

Irrelevant data:
Current book value of inventory ...................................................... 19,500

This is a sunk cost. It will not affect any future course of

action.

2. There are two alternatives for disposing of the obsolete

parts: (a) sell in unmodified condition or (b) modify and then
sell.
(a)Benefit if parts are sold without modification ...........................$7,000

(b)Sales value for modified parts ....................................................$20,300

Less: Cost of modification .........................................................10,000
Net benefit if parts are sold after being modified ......................$10,300

Conclusion: Modify the parts and then sell them.

PROBLEM 14-44 (25 MINUTES)

1. Contemporary Trends will be worse off by $6,400 if it

discontinues wallpaper sales.

Paint and
Supplies Carpeting Wallpaper

Sales $1,900,000 $2,300,000 $ 700,000

Less: Variable 1,140,000 1,610,000 560,000
costs.
Contribution $ 760,000 $ 690,000 $ 140,000
margin.

If wallpaper is closed, then:

Loss of wallpaper contribution margin $(140,000)

Remodeling (62,000)
Added profitability from carpet 325,000
sales*.
Fixed cost savings ($225,000 x 40%) 90,000
Decreased contribution margin from paint
and supplies ($760,000 x 20%). (152,000)
Increased advertising (125,000)
Income (loss) from closure $ (64,000)

* The current contribution margin ratio for carpeting is

30% ($690,000 $2,300,000). This ratio will increase
to 35%, producing a new contribution for the line of
$1,015,000 [($2,300,000 + $600,000) x 35%]. The end
result is that carpetings contribution margin will rise
by $325,000 ($1,015,000 - $690,000), boosting firm
profitability by the same amount.

2. This cost should be ignored. The inventory cost is sunk (i.e.,

a past cost that is not relevant to the decision). Regardless
of whether the department is closed, Contemporary Trends
will have a wallpaper inventory of $118,500.

3. The Internet- and magazine-based firms likely have several

advantages:

These companies probably carry little or no inventory.

When a customer places an order, the firm simply calls its
supplier and acquires the goods. The result may be lower
expenditures for storage and warehousing.
 These firms do not need retail space for walk-in
customers.
Internet- and magazine-based firms can conduct business
globally. Contemporary Trends, on the other hand, is
confined to a single store in Baltimore.
4. In the electronic version of the solutions manual, press the
CTRL key and click on the following link: 10E - BUILD A
SPREADSHEET 14-44.XLS

PROBLEM 14-46 (25 MINUTES)

1.
Food
Process
Blender or
Unit cost if purchased from an outside supplier ................. $60 $114
Incremental unit cost if manufactured:
Direct material ...................................................................... $18 $ 33
Direct labor ...........................................................................
12 27
Variable overhead
$48 $30 per hour fixed ................................................... 18
$96 (2)($30 per hour fixed) ............................................ 36
Total ....................................................................................
$48 $ 96
Unit cost savings if manufactured ......................................... $12 $ 18
Machine hours required per unit ........................................... 1 2
Cost savings per machine hour if manufactured
$12 1 hour ..........................................................................$12
$18 2 hours ........................................................................ $ 9

Therefore, each machine hour devoted to the production of

blenders saves the company more than a machine hour
devoted to food processor production.

Machine hours available ............................................................... 50,000

Machine hours needed to manufacture 20,000 blenders .......... 20,000
Remaining machine hours ........................................................... 30,000
Number of food processors to be produced (30,000 2) .......... 15,000

Conclusion:Manufacture....................................20,000 blenders
Manufacture........................15,000 food processors
Purchase 13,000 food processors
2. If the companys management team is able to reduce the
direct material cost per food processor to $18 ($15 less than
previously assumed), then the cost savings from
manufacturing a food processor are $33 per unit ($18
 savings computed in requirement (1) plus $15 reduction in
material cost):
Food
Process
Blender or
New unit cost savings if manufactured ...................... $12.00 $33.00
Machine hours required per unit ................................. 1 MH 2 MH
Cost savings per machine hour if manufactured
$12 1 hour ................................................................ $12.00
$33 2 hours .............................................................. $16.50

Therefore, devote all 50,000 hours to the production of

25,000 food processors.
Conclusion: Manufacture: 25,000 food processors
Purchase: 3,000 food processors and 20,000
blenders
3. In the electronic version of the solutions manual, press the
CTRL key and click on the following link: 10E - BUILD A
SPREADSHEET 14-46.XLS

PROBLEM 14-47 (25 MINUTES)

1. Incremental unit cost if purchased:

Purchase price ..................................................................... $ 90,000
Material handling .................................................................. 18,000
Total ....................................................................................... $ 108,000
Incremental unit cost if manufactured:
Direct material ...................................................................... $ 6,000
Material handling .................................................................. 1,200
Direct labor ........................................................................... 48,000
Variable manufacturing overhead ($72,000 1/3) ............. 24,000
Total ....................................................................................... $ 79,200
Increase in unit cost if purchased ($108,000 $79,200) ...... $ 28,800
2. Increase in monthly cost of acquiring part RM67 if
purchased
(10 $28,800, as computed above) ...................................... $288,000
Less: rental revenue from idle space .................................... 150,000
Increase in monthly cost ........................................................ $ 138,000
3. Contribution forgone by not manufacturing alternative
product ..................................................................................... $312,000
Less: Savings in the cost of acquiring RM67
(10 $28,800 as computed in requirement 1) ..................... 288,000
Net cost of using limited capacity to produce part RM67 ... $ 24,000
PROBLEM 14-49 (25 MINUTES)

1. Per-unit contribution margins:

Standard Enhanced

Selling price $750.00 $990.00

Less: Variable costs:
Direct $84.00 $135.00
material
Direct 45.00 60.00
labor..
Variable manufacturing 72.00 96.00
overhead
Sales commission
$750 x 10%; $990 x 75.00 99.00
10% 276.00 390.00
Total unit variable
cost
Unit contribution margin $474.00 $600.00

2. The following costs are not relevant to the decision:

Development costssunk
Fixed manufacturing overheadwill be incurred
regardless of which product is selected
Sales salariesidentical for both products
Market studysunk

3. Martinez, Inc. expects to sell 1,000 Standard units (4,000

units x 25%) or 800 Enhanced units (4,000 units x 20%). On
the basis of this sales forecast, the company would be
advised to select the Standard model.

Standard Enhanced
Total contribution margin:
1,000 units x $474; 800 units x $474,000 $480,000
$600.
Less: Marketing and 20,000 30,000
advertising..
Income $454,000 $450,000

4. The quantitative difference between the profitability of

Standard and Enhanced is relatively small, which may
prompt the firm to look at other factors before a final
decision is made. These factors include:
- Competitive products in the marketplace
- Data validity
 - Growth potential of the Standard and Enhanced models
- Production feasibility
- Effects, if any, on existing product sales
- Break-even points

PROBLEM 14-52 (40 MINUTES)

1. The costs that will be relevant in Peters analysis of the special order
being considered by Treasure Island Beach Equipment, Inc. are those
expected future costs that are applicable to a particular decision (the
costs that will differ between the alternatives of accepting or rejecting the
offer). Only the variable costs of labor and material are relevant. Since the
order was received directly by Treasure Island Beach Equipment, Inc.,
variable marketing is not relevant, because additional marketing costs will
not be incurred under this order. Also, the fixed costs are not relevant,
because no additional capital investments are needed to meet the order.
The firm is operating below full capacity and will be able to absorb this
order.
2. Management should accept the offer. Although the combined average unit
cost of $446.25 is higher than the price offered ($300), the incremental
average unit cost is only $255 for the units in the special order. Accepting
the special order will result in a contribution per unit of $45 ($300 less
$255) and a total additional contribution margin of $28,125 (625 units
$45). The calculations follow.
Current Monthly Special Combined
Production Order Production
1,875
Units produced .................................................................... 2,500
625
a
Sales .....................................................................................
$ 984,375 $187,500b $1,171,875
Variable costs: .....................................................................
Direct labor .......................................................................
$ 281,250 $93,750c $ 375,000
Direct material ..................................................................
196,875 65,625d 262,500
Marketing ..........................................................................
140,625 140,625
Total variable costs ......................................................
$ 618,750 $159,375 $ 778,125
Fixed costs:
Manufacturing ..................................................................
$ 206,250 $ 206,250
Marketing ..........................................................................
131,250 131,250
Total fixed costs ...........................................................
$ 337,500 $ 337,500
Total costs ............................................................................
$ 956,250 $159,375 $1,115,625
Income before tax ................................................................
$ 28,125 $ 28,125 $ 56,250
Cost per unit
Variablee............................................ $330.00 $255.00 $311.25
f
Fixed ................................................ 180.00 135.00
g
Average unit cost ........................... $510.00 $255.00 $446.25
a
$525 1,875 units = $984,375
b
$300 625 units = $187,500
c
($281,250/1,875 units) 625 units = $93,750
d
($196,875/1,875 units) 625 units = $65,625
e
Total variable cost/units produced = variable incremental cost per unit
f
Total fixed cost/units produced = fixed cost per unit
g
Total cost/units produced = average cost per unit

3. Other considerations that Samantha Peters should include in her analysis

of the special order include the following:
Possible problems with other customers who pressure the company
for similar treatment.
The future customer potential of the buyer of the special order,
generating additional revenues.
Samantha Peters could try to resolve the ethical conflict arising out of the
controllers insistence that the company avoid competitive bidding by
taking the following steps:
She should follow the companys established policies on such matters.
If such policies do not exist, or if they do not resolve the conflict, she
should discuss the situation with her manager unless, as in this case,
the manager is involved in the conflict. Then, she should discuss the
situation with the managers supervisor.
If this approach does not help her resolve the matter, then she should
continue going to the next-higher managerial level, including the audit
committee of the board of directors, if necessary.
She should clarify relevant concepts by confidential discussions with
an objective advisor to obtain an understanding of possible courses of
action.
If the ethical conflict still exists after exhausting all of these avenues of
internal review, she may have to resign from the company and submit
an informative memorandum to the board of directors.
5. In the electronic version of the solutions manual, press the CTRL key and
click on the following link: 10E - BUILD A SPREADSHEET 14-52.XLS

PROBLEM 14-53 (40 MINUTES)

1. a. An analysis of the relevant costs that shows whether the

Midwest Division of Palisades Corporation should make
JY-65 or purchase it from Marley Company is as follows:
Total for
Amount 32,000
Per Unit Units
Cost to purchase JY-65 from Marley:
Bid price from Marley ............................................ $8.65 276,800
Equipment lease penalty ($18,000/12) 2 ........... 3,000
Total cost to purchase ........................................... $279,800
Cost for Midwest to make JY-65:
Direct material ($97,500/30,000) 1.08 ................ $3.51 $112,320
Direct labor ($60,000/30,000) 1.05...................... 2.10 67,200
Variable manufacturing overhead
($112,500 .4)/30,000 ........................................... 1.50 48,000
Factory space rental .............................................. 42,000
Equipment leasing costs ....................................... 18,000
Total cost to make .................................................. $287,520
Cost savings if purchased from Marley .................. $ (7,720)
b. Based solely on the financial results, the 32,000 units of
JY-65 should be purchased from Marley. The total cost
from Marley would be $279,800, or $7,720 less than if the
units were made by the Midwest Division.
2. The qualitative factors that the Midwest Division and
Palisades Corporation should consider before agreeing to
purchase JY-65 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 Palisades reputation adversely
affected.
Marleys reliability as an on-time supplier is important,
since late deliveries could hamper Palisades production
schedule and delivery dates for the final product.
 Layoffs may result if the component is outsourced to
Marley. This could impact Midwests and Palisades other
employees and cause labor problems or affect the
companys position in the community. In addition, there
may be termination costs that have not been factored into
the analysis.
3. Lynn Hardt would consider the request of John Porter to be
unethical for the following reasons, which are based on the
Standards of Ethical Conduct for Management Accountants.
Competence
Prepare complete and clear reports and recommendations
after appropriate analysis of relevant and reliable
information. He has asked her to adjust and falsify her
report and leave out some manufacturing overhead costs.
Integrity
Refrain from either actively or passively subverting the
attainment of the organizations legitimate and ethical
objectives. Palisades 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 or opinions.
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.
Credibility
Communicate information fairly and objectively. Hardt
needs to perform an objective make-versus-buy analysis
and communicate the results fairly.
Disclose fully 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 increases.