What is the cost incurred in the past that Cannot be changed by any future action?

The five steps in the decision process outlined in Exhibit 11-1 of the text are

Relevant costs are expected future costs that differ among the alternative courses of action being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternative future courses of action.

No. Relevant costs are defined as those expected future costs that differ among alternative courses of action being considered. Thus, future costs that do not differ among the alternatives are irrelevant to deciding which alternative to choose.

Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial––that is, they can be easily expressed in monetary terms. Direct materials are an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as on-time flight arrivals, cannot be easily expressed in monetary terms. Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. An example is employee morale.

No. Some variable costs may not differ among the alternatives under consideration and, hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be relevant.

No. Some of the total manufacturing cost per unit of a product may be fixed and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy decision. The key comparison is between purchase costs and the costs that will be saved if the company purchases the component parts from outside plus the additional benefits of using the resources freed up in the next best alternative use (opportunity cost). Furthermore, managers should consider nonfinancial factors such as quality and timely delivery when making outsourcing decisions.

11-8 Define opportunity cost.

Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.

No. When deciding on the quantity of inventory to buy, managers must consider both the purchase cost per unit and the opportunity cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quantity of inventory purchased is large, but the benefit of the lower cost may be more than offset by the high opportunity cost of the funds invested in acquiring and holding inventory.

No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availability of machine-hours).

11-11 “A branch office or business segment that shows negative operating income should be shut down.” Do you agree? Explain briefly.

No. For example, if the revenues that will be lost exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision.

11-12 “Cost written off as depreciation on equipment already purchased is always irrelevant.” Do you agree? Why?

Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be written off as depreciation is often relevant.

No. Managers often favor the alternative that makes their performance look best so they focus on the measures used in the performance-evaluation model. If the performance-evaluation model does not emphasize maximizing operating income or minimizing costs, managers will most likely not choose the alternative that maximizes operating income or minimizes costs.

(ii) Graphic approach

Most LP applications in practice use standard software packages that rely on the simplex method to compute the optimal solution.

SOLUTION

Choice "d" is correct. Calculating the costs of production of the part versus buying the part from an outside source is a quantitative factor used by a company to determine the lowest cost alternative. Choice "a" is incorrect. Whether the outsourced part can be manufactured to the required level of quality is a qualitative factor that Atlas would consider in their decision. Choice "b" is incorrect. Loss of confidentiality and trade secrets is a qualitative factor to consider when buying outside of the organization. Choice "c" is incorrect. An outside supplier may not be able to meet specific deadlines or have the same priorities as the purchaser and is a qualitative factor that needs to be considered.

SOLUTION

Choice "d" is correct. At excess capacity, Chade will accept the special order as long as the sales price is greater than the variable cost per unit. At $9 per unit for variable cost, Chade will accept the special order at a sales price greater than $9 per unit. Choice "a" is incorrect. At full capacity, Chade will accept the special order as long as the sales price is greater than both the variable cost per unit and the opportunity cost (contribution margin) of the next best alternative per unit. The company will not be profitable in this scenario unless the sales price is greater than $14 per unit ($9 variable cost + $5 contribution margin). Choice "b" is incorrect. At excess capacity, the company must receive a selling price greater than $9 per unit in order to be profitable. Choice "c" is incorrect. At full capacity, the selling price must be greater than $14 per unit in order for the special order to be profitable.

11-18 Special order, opportunity cost. In order to determine whether a special order should be accepted at full capacity, the sales price of the special order must be compared to the per unit:

SOLUTION

Choice "d" is correct. If the selling price is greater than the variable cost per unit of the special order (at full capacity) plus the contribution margin per unit of the next best alternative (the opportunity cost), then the company will accept the special order. Choice "a" is incorrect. Variable costs have to be taken into account, in addition to the contribution margin of the next best alternative. Choice "b" is incorrect. The contribution margin of the next best alternative (rather than the special order) must be taken into account in order to determine whether to accept the special order. Choice "c" is incorrect. The variable costs of the special order (not the next best alternative) must be accounted for in this determination.

11-19 Keep or drop a business segment. Lees Corp. is deciding whether to keep or drop a small segment of its business. Key information regarding the segment includes:

Contribution margin: 35,000 Avoidable fixed costs: 30,000 Unavoidable fixed costs: 25,000

Given the information above, Lees should:

SOLUTION

Choice "c" is correct. Whether to keep or drop a segment will depend on whether the contribution margin of the segment in question exceeds avoidable fixed costs (relevant costs that wouldn’t exist if the segment did not exist). Unavoidable fixed costs will be incurred regardless of whether or not the segment is kept, so they are not factored into the decision. Choice "a" is incorrect. Fixed costs need to be broken out between avoidable and unavoidable in order to make the determination as to whether to keep or drop a segment. Lees Corp. would only drop the segment if the contribution margin of the segment is less than the avoidable fixed (relevant) cost. Choice "b" is incorrect. The contribution margin needs to be compared to avoidable fixed costs in order to determine whether to keep or drop a segment. Choice "d" is incorrect. Unavoidable fixed costs will be incurred regardless, so contribution margin of the segment needs to be compared to the avoidable fixed costs as the key elements to determine whether to keep or drop a segment.

SOLUTION

Choice "a" is correct. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision. Opportunity cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant since the company has alternative courses of action. Choice "b" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Choice "c" is incorrect. Opportunity cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant since the company has alternative courses of action. Choice "d" is incorrect. Sunk costs are not relevant since they were incurred in the past and cannot be recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision.

SOLUTION

(20 min.) Disposal of assets.

1. This is an unfortunate situation, yet the $76,000 costs are irrelevant regarding the decision to remachine or scrap. The only relevant factors are the future revenues and future costs. By ignoring the accumulated costs and deciding on the basis of expected future costs, operating income will be maximized (or losses minimized). The difference in favor of remachining is $4,500:

	(a) Remachine		(b) Scrap
Future revenues	$33,500		$2,500
Deduct future costs	26,500		–
Operating income	$ 7,000		$2,500
Difference in favor of remachining		$4,500

2. This, too, is an unfortunate situation. But the $100,500 original cost is irrelevant to this decision. The difference in relevant costs in favor of replacing is $3,500 as follows:

	(a) Replace	(b) Rebuild
New truck	$103,000	–
Deduct current disposal price of existing truck	18,000	–
Rebuild existing truck	–	$88,500
$ 85,000	$88,500
Difference in favor of replacing	$3,500

Note, here, that the current disposal price of $18,000 is relevant, but the original cost (or book value, if the truck were not brand new) is irrelevant.

Relevant and irrelevant costs. Answer the following questions. 1. DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of $280 each. Variable cost per unit is $190 and fixed cost per unit is $90. Peach Electronics offers to supply 5,200 units of CB76 for $260. If DeCesare buys from Peach it will be able to save $10 per unit in fixed costs but continue to incur the remaining $80 per unit. Should DeCesare accept Peach’s offer? Explain. 2. LN Manufacturing is deciding whether to keep or replace an old machine. It obtains the following information: Old Machine New Machine Original cost $10,700 $9,000 Useful life 10 years 3 years Current age 7 years 0 years Remaining useful life 3 years 3 years Accumulated depreciation $7,490 Not acquired yet Book value $3,210 Not acquired yet Current disposal value (in cash) $2,200 Not acquired yet Terminal disposal value (3 years from now) $0 $0 Annual cash operating costs $17,500 $15,500 11-22

LN Manufacturing uses straight-line depreciation. Ignore the time value of money and income taxes. Should LN Manufacturing replace the old machine? Explain.

SOLUTION

(20 min.) Relevant and irrelevant costs. 1.

DeCesare Computers should reject Peach’s offer. The $80 of fixed costs is irrelevant because it will be incurred regardless of this decision. When comparing relevant costs between the choices, Peach’s offer price is higher than the cost to continue to produce.

2.

LN Manufacturing should keep the old machine. The cost savings are less than the cost to purchase the new machine.

11-23 Multiple choice. (CPA) Choose the best answer.

The Counter Company has offered to sell 30,000 units of Part No. 498 to Sacramento for $47 per unit. Sacramento will make the decision to buy the part from Counter if there is an overall savings of at least $30,000 for Sacramento. If Sacramento accepts Counter’s offer, $8 per unit of the fixed overhead allocated would be eliminated. Furthermore, Sacramento has determined that the released facilities could be used to save relevant costs in the manufacture of Part No. 575. For Sacramento to achieve an overall savings of $30,000, the amount of relevant costs that would have to be saved by using the released facilities in the manufacture of Part No. 575 would be which of the following: (a) $90,000, (b) $150,000, (c) $180,000, or (d) $210,000? Show your calculations. What other factors might Sacramento consider before outsourcing to Counter?

SOLUTION

(15 min.) Multiple choice.

Before outsourcing to Counter, Sacramento must consider the consequence of increasing its dependence on Counter. Sacramento would want to be sure about the quality of Counter’s product and the reliability of its delivery schedules over a long-run period. Sacramento would also want Counter to continuously reduce costs. To achieve all these goals, Sacramento may want to build close partnerships and alliances with Counter.

Gold Plus has just received a special one-time-only order for 1,000 medals at $100 per medal. Accepting the special order would not affect the company’s regular business. Gold Plus makes medals for its existing customers in batch sizes of 50 medals (200 batches × 50 medals per batch = 10,000 medals). The special order requires Gold Plus to make the medals in 25 batches of 40 medals.

Required:

SOLUTION

(30 min.) Special order, activity-based costing.

Gold Plus’ operating income under the alternatives of accepting/rejecting the special order are:

Alternatively, we could calculate the incremental revenue and the incremental costs of the additional 1,000 units as follows:

Gold Plus should accept the one-time-only special order if it has no long-term implications because accepting the order increases Gold Plus’ operating income by $15,000.

If, however, accepting the special order would cause the regular customers to be dissatisfied or to demand lower prices, then Gold Plus will have to trade off the $15,000 gain from accepting the special order against the operating income it might lose from regular customers.

Gold Plus’ operating income from selling 9,500 medals to regular customers and 1,000 medals under one-time special order follow:

Accepting the special order will result in a decrease in operating income of $18,750 ($100,000 – $81,250). The special order should, therefore, be rejected.

A more direct approach would be to focus on the incremental effects––the benefits of accepting the special order of 1,000 units versus the costs of selling 500 fewer units to regular customers. Increase in operating income from the 1,000-unit special order equals $15,000 (requirement 1). The loss in operating income from selling 500 fewer units to regular customers equals:

Accepting the special order will result in a decrease in operating income of $18,750 ($15,000 – $33,750). The special order should, therefore, be rejected.

NOTE: Even if operating income had increased by accepting the special order, Gold Plus should consider the effect on its regular customers of accepting the special order. For example, would selling 1,000 fewer medals to its regular customers cause these customers to find new suppliers that might adversely impact Gold Plus’s business in the long run.

The special order should, therefore, be rejected.

11-25 Make versus buy, activity-based costing. The Svenson Corporation manufactures cellular modems. It manufactures its own cellular modem circuit boards (CMCB), an important part of the cellular modem. It reports the following cost information about the costs of making CMCBs in 2017 and the expected costs in 2018:

Svenson manufactured 8,000 CMCBs in 2017 in 40 batches of 200 each. In 2018, Svenson

anticipates needing 10,000 CMCBs. The CMCBs would be produced in 80 batches of 125 each.

The Minton Corporation has approached Svenson about supplying CMCBs to Svenson in 2018 at $300 per CMCB on whatever delivery schedule Svenson wants.

Required:

On the basis of financial considerations alone, should Svenson make CMCBs or buy them from Minton? Show your calculations.

SOLUTION

(30 min.) Make versus buy, activity-based costing.

Cost of purchasing CMCBs from Minton $3,000,000	$300
Direct materials	$1,700,000	$170
Direct manufacturing labor	450,000	45
Variable batch manufacturing costs	120,000	12
Avoidable fixed manufacturing costs	320,000	32
Total incremental costs	$2,590,000 $3,000,000	$259	$300
Difference in favor of making	$410,000	$41

Note that the opportunity cost of using capacity to make CMCBs is zero because Svenson would keep this capacity idle if it purchases CMCBs from Minton.

Svenson should continue to manufacture the CMCBs internally because the incremental costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either the make or the buy alternative and, hence, are irrelevant.

An important point to note is that, because Svenson forgoes no contribution by not being able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero. It is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle.

A longer and more detailed approach is to use the total alternatives or opportunity cost analyses shown in Exhibit 11-7 of the chapter.

Svenson will minimize manufacturing costs and maximize operating income by making CMCBs.

OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS

11-26 Inventory decision, opportunity costs. Best Trim, a manufacturer of lawn mowers, predicts that it will purchase 204,000 spark plugs next year. Best Trim estimates that 17,000 spark plugs will be required each month. A supplier quotes a price of $9 per spark plug. The supplier also offers a special discount option: If all 204,000 spark plugs are purchased at the start of the year, a discount of 2% off the $9 price will be given. Best Trim can invest its cash at 10% per year. It costs Best Trim $260 to place each purchase order.

Required:

SOLUTION

(10 min.) Inventory decision, opportunity costs.

Opportunity cost of interest forgone from 204,000-unit purchase at start of year

Column (3) indicates that purchasing 17,000 spark plugs at the beginning of each month is preferred relative to purchasing 204,000 spark plugs at the beginning of the year because the opportunity cost of holding larger inventory exceeds the lower purchasing and ordering costs.

11-27 Relevant costs, contribution margin, product emphasis. The Beach Comber is a takeout food store at a popular beach resort. Sara Miller, owner of the Beach Comber, is deciding how much refrigerator space to devote to four different drinks. Pertinent data on these four drinks are as follows:

Miller has a maximum front shelf space of 12 feet to devote to the four drinks. She wants a minimum of 1 foot and a maximum of 6 feet of front shelf space for each drink.

Required:

SOLUTION

(20–25 min.) Relevant costs, contribution margin, product emphasis.

The maximum of six feet of front shelf space will be devoted to Natural Orange Juice because it has the highest contribution margin per unit of the constraining factor. Four feet of front shelf space will be devoted to Punch, which has the second highest contribution margin per unit of the constraining factor. No more shelf space can be devoted to Punch because each of the remaining two products, Lemonade and Cola (that have the second lowest and lowest contribution margins per unit of the constraining factor), must each be given at least one foot of front shelf space.

11-28 Selection of most profitable product. Isochlorine is produced in a chemical process that isvery threatening to the environment. As a result of this, the government has limited the yearly production. Company Soleil uses isochlorine to produce four cosmetic products A, B, C, and D. Soleil has a inventory of 2,000 kg of isochlorine at a value of $20,000:

As a result of production restrictions imposed on their supplier, Soleil will not be able to purchase additional isochlorine during the coming period.

Although Soleil, by means of its commercial campaign, suggests that its main goal is to let people experience the sanitary effects of its cosmetic products, the management is only interested in profit maximization.

The management of Soleil must decide how to use the scarce material. The following information is available concerning the next period:

The labor tariff per hour is $30. Labor costs are linear variable. Sales provision is 10% of the selling price. Which product(s) must Soleil produce during the next period? What is the contribution margin for thenext period? Show your calculations.

SOLUTION

(10 min.) Selection of most profitable product.

Each cabinet sells for $70 and has direct material costs of $30 incurred at the start of the machining operation. Pierce has no other variable costs. Pierce can sell whatever output it produces. The following requirements refer only to the preceding data. There is no connection between the requirements.

Required:

SOLUTION

(25 min.) Theory of constraints, throughput contribution, relevant costs.

Pierce should invest in the modern jigs and tools because the benefit of higher contribution (throughput) margin of $46,000 exceeds the cost of $35,000.

Pierce should contract with an outside contractor to do 9,500 units of finishing at $9 per unit because the benefit of higher throughput margin of $380,000 exceeds the cost of $85,500. The fact that the cost of $9 per unit is three times Pierce's finishing cost of $3 per unit is irrelevant.

6.

The cost of 1,700 defective units in the Finishing Operation is: Cost of direct materials used in the defective units $30 per unit  1,700 units $ 51,000 Opportunity cost, lost contribution (throughput) margin $40 per unit  1,700 units 68,000 Total cost of defective unit in the Finishing Operation Alternatively, the cost of 1,700 defective units in the Finishing Operation equals the revenues lost by selling 1,700 fewer units = $70 per unit The cost of the defective unit at a bottleneck operation is much higher than at a non-bottleneck operation because of the opportunity cost of lost contribution margin at the bottleneck operation.

$119,000

11-30 Closing and opening stores. Sanchez Corporation runs two convenience stores, one in Connecticut and one in Rhode Island. Operating income for each store in 2017 is as follows:

The equipment has a zero disposal value. In a senior management meeting, Maria Lopez, the management accountant at Sanchez Corporation, makes the following comment, “Sanchez can increase its profitability by closing down the Rhode Island store or by adding another store like it.”

Required:

SOLUTION

(2530 min.) Closing and opening stores.

The key reason that Sanchez’s operating income increases either if it closes down the Rhode Island store or if it opens another store like it is the behavior of corporate overhead costs. By closing down the Rhode Island store, Sanchez can significantly reduce corporate overhead costs presumably by reducing the corporate staff that oversees the Rhode Island operation. On the other hand, adding another store like Rhode Island does not increase actual corporate costs by much, presumably because the existing corporate staff will be able to oversee the new store as well.

SOLUTION EXHIBIT 11-30

Relevant-Revenue and Relevant-Cost Analysis of Closing Rhode Island Store and Opening Another Store Like It.

Julie Corporation indicates that it wants Rodeo to do an additional $140,000 worth of printing jobs during February. These jobs are identical to the existing business Rodeo did for Julie in January in terms of variable costs and machine-hours required. Rodeo anticipates that the business from Trent Corporation in February will be the same as that in January. Rodeo can choose to accept as much of the Trent and Julie business for February as its capacity allows. Assume that total machine-hours and fixed costs for February will be the same as in January.

Required:

What action should Rodeo take to maximize its operating income? Show your calculations. What other factors should Rodeo consider before making a decision?

SOLUTION

(20 min.) Choosing customers.

If Rodeo accepts the additional business from Julie, it would take an additional 1,000 machine-hours. If Rodeo accepts all of Julie’s and Trent’s business for February, it would require 5,000 machine-hours (3,000 hours for Trent and 2,000 hours for Julie). Rodeo has only 4,000 hours of machine capacity. It must, therefore, choose how much of the Trent or Julie business to accept.

To maximize operating income, Rodeo should maximize contribution margin per unit of the constrained resource. (Fixed costs will remain unchanged at $170,000 regardless of the business Rodeo chooses to accept in February and are, therefore, irrelevant.) The contribution margin per unit of the constrained resource for each customer in January is:

Because the $140,000 of additional Julie business in February is identical to jobs done in January, it will also have a contribution margin of $55 per machine-hour, which is greater than the contribution margin of $42 per machine-hour from Trent. To maximize operating income, Rodeo should first allocate all the capacity needed to take the Julie Corporation business (2,000 machine-hours) and then allocate the remaining 2,000 (4,000 – 2,000) machine-hours to Trent.

An alternative approach is to use the opportunity cost approach. The opportunity cost of giving up 1,000 machine-hours for the Trent Corporation jobs is the contribution margin forgone of $42 per machine-hour  1,000 machine-hours equal to $42,000. The contribution margin gained from using the 1,000 machine-hours for the Julie Corporation business is the contribution margin per machine-hour of $55  1,000 machine-hours equal to $55,000.

Although taking the Julie Corporation business over the Trent Corporation business will maximize Rodeo’s profits in the short run, Rodeo’s managers must also consider the long-run effects of this decision. Will Julie Corporation continue to demand the same level of business going forward? Will turning down the Trent business affect customer satisfaction? If Rodeo turns down the Trent business, will Trent continue to place orders with Rodeo or seek alternative suppliers? Rodeo’s managers need to consider these long-run effects and then decide whether it should accept Julie’s business at the cost of Trent’s. In other words, choosing customers is a strategic decision. If it sees long-run benefit in working with Trent, Rodeo’s managers must also look for ways to increase the profitability of the business it does with Trent by increasing prices or reducing costs.

The old oven had been purchased a year ago. Papa’s Pizza estimates that either oven has a remaining useful life of five years. At the end of five years, either oven would have a zero salvage value. Ignore the effect of income taxes and the time value of money.

Required:

SOLUTION

(20 min.) Relevance of equipment costs.

The cost of replacing the old oven is $65,000, while the cost of continuing to operate the old oven is $70,000.

11-33 Equipment upgrade versus replacement. (A. Spero, adapted) The TechGuide Company produces and sells 7,500 modular computer desks per year at a selling price of $750 each. Its current production equipment, purchased for $1,800,000 and with a five-year useful life, is only two years old. It has a terminal disposal value of $0 and is depreciated on a straight-line basis. The equipment has a current disposal price of $450,000. However, the emergence of a new molding technology has led TechGuide to consider either upgrading or replacing the production equipment. The following table presents data for the two alternatives:

All equipment costs will continue to be depreciated on a straight-line basis. For simplicity, ignore income taxes and the time value of money.

Required:

SOLUTION

(30 min.) Equipment upgrade versus replacement.

1. Based on the analysis in the table below, TechGuide will be better off by $337,500 over three years if it replaces the current equipment.

Comparing Relevant Costs of Upgrade and	Over 3 years	Difference in favor of Replace
Upgrade	Replace
Replace Alternatives	(1)	(2)	(3) = (1) – (2)
Cash operating costs $150; $75 per desk 7,500 desks per 3 yrs.	$3,375,000	$1,687,500	$1,687,5000
Current disposal price		(450,000)	450,000
One time capital costs, written off periodically as
depreciation	3,000,000	4,800,000	(1,800,000)
Total relevant costs	$6,375,000	$6,037,500	$ 337,500

2. Suppose the capital expenditure to replace the equipment is $X. From requirement 1, column (2), substituting for the one-time capital cost of replacement, the relevant cost of replacing is $1,687,500 – $450,000 + $X. From column (1), the relevant cost of upgrading is $6,375,000. We want to find X such that

Solving the above inequality gives us X < $6,375,000 – $1,237,500 = $5,137,500.

TechGuide would prefer to replace, rather than upgrade, if the replacement cost of the new equipment does not exceed $5,137,500. Note that this result can also be obtained by taking the original replacement cost of $4,800,000 and adding to it the $337,500 difference in favor of replacement calculated in requirement 1.

3. Suppose the units produced and sold over 3 years equal y. Using data from requirement 1, column (1), the relevant cost of upgrade would be $150y + $3,000,000, and from column (2), the relevant cost of replacing the equipment would be $75y – $450,000 + $4,800,000. TechGuide would want to upgrade when

That is, upgrade when y < 18,000 units (or 6,000 per year for 3 years) and replace when y > 18,000 units over 3 years.

When production and sales volume is low (less than 6,000 per year), the higher operating costs under the upgrade option are more than offset by the savings in capital costs from upgrading. When production and sales volume is high, the higher capital costs of replacement are more than offset by the savings in operating costs in the replace option.

4. Operating income for the first year under the upgrade and replace alternatives are shown below:

	Year 1
Upgrade (1)	Replace (2)
Revenues (7,500	$5,625,000	$5,625,000
Cash operating costs
$150; $75 per desk desks per year	1,125,000	562,500
	1,360,000	1,600,000
Loss on disposal of old equipment (0; $1,080,000 – $450,000)	0	630,000
Total costs	2,485,000	2,792,500
Operating Income	$3,140,000	$2,832,500

First-year operating income is higher by $307,500 ($3,140,000 – $2,832,500) under the upgrade alternative, and Dan Doria, with his one-year horizon and operating income-based bonus, will choose the upgrade alternative, even though, as seen in requirement 1, the replace alternative is better in the long run for TechGuide. This exercise illustrates the possible conflict between the decision model and the performance evaluation model.

(20 min.) Special order, short-run pricing

1.
Revenues from special order ($23 10,000 bats)	$230,000
Variable manufacturing costs	(200,000)
Increase in operating income if Bench order accepted	$ 30,000

GamesAhoy should accept FieldTactics’ special order because it increases operating income by $30,000. Because no variable selling costs will be incurred on this order, this cost is irrelevant. Similarly, fixed costs are irrelevant because they will be incurred regardless of the decision.

	$230,000
2a. Revenues from special order ($23 10,000 bats)
Variable manufacturing costs ($20 10,000 bats)	(200,000)
Contribution margin foregone	(130,000)
Decrease in operating income if Bench order accepted	$(100,000)

Based strictly on financial considerations, GamesAhoy should reject FieldTactics’ special order because it results in a $100,000 reduction in operating income.

An alternative approach is to recognize that GamesAhoy needs to earn $100,000 more than the revenues of $230,000 in requirement 2a, so that the decrease in operating income of $100,000 becomes $0. GamesAhoy will be indifferent between the special order and continuing to sell to regular customers if revenues from the special order = $230,000 + $100,000 = $330,000 or $33 per bat ($330,000  10,000 bats)

Looked at a different way, GamesAhoy needs to earn the full price of $36 less the $3 saved on variable selling costs.

Required:

SOLUTION

(15-20 min.) Short-run pricing, capacity constraints.

If Fashion Fabrics can get all the fabric it needs and has sufficient production capacity, then the minimum price it should charge per pair of shorts is the variable cost per pair of shorts = $36 + $10 + $4 = $50 per pair of shorts.

We calculate the contribution margin per pair of pants = Selling price – Variable costs = $142 − $100a = $42

aDirect materials, $72 + Variable direct manufacturing labor, $20 + Variable manufacturing overhead, $8

Pants require 6 yards of fabric so the contribution margin per unit of the constrained resource is $42 ÷ 6 yards = $7 per yard

The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per pair of shorts plus the contribution margin from 3 yards of fabric, or,

That is, if fabric is in short supply, Fashion Fabrics should not agree to produce any shorts unless the buyer is willing to pay at least $71 per pair of shorts.

Another way to calculate the opportunity cost of producing a pair of shorts is to recognize that every time Fashion Fabrics uses fabric to produce a pair of shorts, it gives up the opportunity to produce 0.5 pants. So,

Opportunity cost of a pair of shorts = 0.5 × Contribution margin from producing a pair of pants = 0.5 × $42 = $21.

The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per pair of shorts plus the opportunity cost of not producing 0.5 pants = $50 + $21 = $71.

SOLUTION

(20 min.) International outsourcing.

Cost of purchasing 400,000 figurines from Indonesian supplier = $3 400,000 figurines = $1,200,000.

Costs of

= Variable  Quantity of + Incremental fixed

Variable and fixed selling and distribution costs are irrelevant because they do not differ between the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing the figurines in Queensland.

Cuddly Critters should purchase the figurines from the Indonesian supplier because the cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in Cleveland.

As in requirement 1, selling and distribution costs are irrelevant.

Cuddly Critters should manufacture the figurines in Queensland because the relevant cost of $1,340,000 to manufacture the figurines in Queensland is less than the cost of $1,360,000 to enter into the forward contract and purchase the figurines from the Indonesian supplier.

The major problem is that Oregano has overstocked the previous version of its spreadsheet package, Easyspread 1.0. Martin knows that once Easyspread 2.0 is introduced, Oregano will not be able to sell any more units of Easyspread 1.0. Rather than just throwing away the inventory of Easyspread 1.0, Martin is wondering if it might be better to continue to sell Easyspread 1.0 for the next three months and introduce Easyspread 2.0 on October 1, 2017, when the inventory of Easyspread 1.0 will be sold out.

The following information is available:

Development cost per unit for each product equals the total costs of developing the software product divided by the anticipated unit sales over the life of the product. Marketing and administrative costs are fixed costs in 2017, incurred to support all marketing and administrative activities of Oregano Software. Marketing and administrative costs are allocated to products on the basis of the budgeted revenues of each product. The preceding unit costs assume Easyspread 2.0 will be introduced on October 1, 2017.

Required:

SOLUTION

(30 min.) Relevant costs, opportunity costs.

Reasons for other cost items being irrelevant are

Easyspread 1.0

Easyspread 2.0

Note that total marketing and administration costs will not change whether Easyspread 2.0 is introduced on July 1, 2017, or on October 1, 2017.

11-38 Opportunity costs and relevant costs. Jason Wu operates Exclusive Limousines, a fleet of 10 limousines used for weddings, proms, and business events in Washington, D.C. Wu charges customers a flat fee of $250 per car taken on contract plus an hourly fee of $80. His income statement for May follows:

All expenses are fixed, with the exception of driver wages and benefits and fuel costs, which are both variable per hour. During May, the company’s limousines were fully booked. In June, Wu expects that Exclusive Limousines will be operating near capacity. Shelly Worthington, a prominent Washington socialite, has asked Wu to bid on a large charity event she is hosting in late June. The limousine company she had hired has canceled at the last minute, and she needs the service of five limousines for four hours each. She will only hire Exclusive Limousines if they take the entire job. Wu checks his schedule and finds that he only has three limousines available that day.

Required:

SOLUTION

(30 min.) Opportunity costs and relevant costs

If Wu cancels the business event contract, the opportunity cost would be $943.20, as follows:

Wu should cancel the prom contracts because the opportunity cost would be lower by $56.80 ($943.20 – $886.40).

11-39 Opportunity costs. (H. Schaefer, adapted) The Wild Orchid Corporation is working at full production capacity producing 13,000 units of a unique product, Everlast. Manufacturing cost per unit for Everlast is:

Manufacturing overhead cost per unit is based on variable cost per unit of $8 and fixed costs of $78,000 (at full capacity of 13,000 units). Marketing cost per unit, all variable, is $4, and the selling price is $52.

A customer, the Apex Company, has asked Wild Orchid to produce 3,500 units of Stronglast, a modification of Everlast. Stronglast would require the same manufacturing processes as Everlast. Apex has offered to pay Wild Orchid $40 for a unit of Stronglast and share half of the marketing cost per unit.

Required:

SOLUTION

(20 min.) Opportunity costs.

The opportunity cost is $98,000. Opportunity cost is the maximum contribution to operating income that is forgone (rejected) by not using a limited resource in its next-best alternative use.

As calculated in requirement 1, Wild Orchid’s contribution margin from continuing to manufacture 3,500 units of Everlast is $98,000. Accepting the Apex Company and Chesapeake offer will benefit Wild Orchid by $7,000 ($105,000 – $98,000). Hence, Wild Orchid should accept the Apex Company and Chesapeake Corporation’s offers.

The starter assemblies are currently manufactured in Division 3 of Denver Engineering. The costs relating to the starter assemblies for the past 12 months were as follows:

Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for each starter assembly is $10 ($1,500,000  150,000).

Further analysis of manufacturing overhead revealed the following information. Of the total manufacturing overhead, only 25% is considered variable. Of the fixed portion, $300,000 is an allocation of general overhead that will remain unchanged for the company as a whole if production of the starter assemblies is discontinued. A further $200,000 of the fixed overhead is avoidable if production of the starter assemblies is discontinued. The balance of the current fixed overhead, $100,000, is the division manager’s salary. If Denver Engineering discontinues production of the starter assemblies, the manager of Division 3 will be transferred to Division 2 at the same salary. This move will allow the company to save the $80,000 salary that would otherwise be paid to attract an outsider to this position.

Required:

SOLUTION

(30–40 min.) Make or buy, unknown level of volume.

The variable costs per unit are $900,000 ÷ 150,000 = $6.00 per unit.

Let X = number of starter assemblies required in the next 12 months.

The data can be presented in both “all data” and “relevant data” formats:

The number of units at which the costs of make and buy are equivalent is

Assuming cost minimization is the objective, then

Alternatively stated, we would add the following line to the table shown in requirement 1 causing the total costs line to change as follows:

The number of units at which the costs of make and buy are equivalent is

If production is expected to be less than 190,000, it is preferable to buy units from Tutwiler. If production is expected to exceed 190,000, it is preferable to manufacture the units internally.

11-41 Make versus buy, activity-based costing, opportunity costs. The Lexington Company produces gas grills. This year’s expected production is 20,000 units. Currently, Lexington makes the side burners for its grills. Each grill includes two side burners. Lexington’s management accountant reports the following costs for making the 40,000 burners:

Lexington has received an offer from an outside vendor to supply any number of burners Lexington requires at $14.80 per burner. The following additional information is available:

Required:

SOLUTION

(30 min.) Make versus buy, activity-based costing, opportunity costs.

The allocated fixed plant administration, taxes, and insurance will not change if Lexington makes or buys the burners. Hence, these costs are irrelevant to the make-or-buy decision. The analysis indicates that it is less costly for Lexington to make rather than buy the burners from the outside supplier.

Lexington should buy the side burners from an outside vendor and use its own capacity to upgrade its grills.

In this case, Lexington should make the burners.

11-42 Product mix, constrained resource. Wechsler Company produces three products: A130, B324, and C587. All three products use the same direct material, Brac. Unit data for the three products are:

The demand for the products far exceeds the direct materials available to produce the products. Brac costs $9 per pound, and a maximum of 5,000 pounds is available each month. Wechsler must produce a minimum of 200 units of each product.

Required:

SOLUTION

(25 min.) Product mix, constrained resource.

1.

First, satisfy minimum requirements.

The remaining 1,800 pounds (5,000 – 3,200) should be devoted to C587 because it has the highest contribution margin per pound of direct material. Because each unit of C587 requires 3 pounds of Brac, the remaining 1,800 pounds can be used to produce another 600 units of C587. The following combination yields the highest contribution margin given the 5,000 pounds constraint on availability of Brac.

A130: 200 units B324: 200 units C587: 800 units (200 minimum + 600 extra)

1An alternative calculation focuses on column 3 for C587 of the table in requirement 1.

Additional information includes the following:

Required:

SOLUTION

(30–40 min.) Product mix, relevant costs.

1.

Even though EX4 has the higher contribution margin per unit of the constrained resource, the fact that Gormley must incur additional costs of $600,000 to achieve this higher contribution margin means that Gormley is better off using its entire 50,000-hour capacity on the regular machine to produce and sell 50,000 units (50,000 hours  1 hour per unit) of A6. The additional contribution from selling EX4 rather than A6 is $500,000 ($3,000,000  $2,500,000), which is not enough to cover the additional costs of leasing the high-precision machine. Note that, because all other overhead costs are fixed and cannot be changed, they are irrelevant for the decision. Gormley produces 50,000 units of A6, which increases operating income by $2,500,000.

2. If capacity of the regular machines is increased by 15,000 machine-hours to 65,000 machine-hours (50,000 originally + 15,000 new), the net relevant benefit from producing A6 and EX4 is as follows:

Adding 15,000 machine-hours of capacity for regular machines and using all the capacity to produce EX4 increases operating income by $3,000,000.

Investing in the additional capacity increases Gormley’s operating income by $500,000 ($3,000,000 calculated in requirement 2 minus $2,500,000 calculated in requirement 1), so Gormley should add 15,000 hours to the regular machine. With the extra capacity available to it, Gormley should use its entire capacity to produce EX4. Using all 65,000 hours of capacity to produce EX4 rather than to produce A6 generates additional contribution margin of $650,000 ($3,900,000  $3,250,000), which is more than the additional cost of $600,000 to lease the high-precision machine. Gormley should therefore produce and sell 130,000 units of EX4 (65,000 hours  0.5 hours per unit of EX4) and zero units of A6.

3.

The first step is to compare the operating profits that Gormley could earn if it accepted the Clark Corporation offer for 20,000 units with the operating profits Gormley is currently earning. V2 has the highest contribution margin per hour on the regular machine and requires no additional investment such as leasing a high-precision machine. To produce the 20,000 units of V2 requested by Clark Corporation, Gormley would require 20,000 hours on the regular machine resulting in contribution margin of $70 20,000 = $1,400,000.

Gormley now has 45,000 hours available on the regular machine to produce A6 or EX4.

Gormley should use all the 45,000 hours of available capacity to produce 45,000 units of A6. Thus, the product mix that maximizes operating income is 20,000 units of V2, 45,000 units of A6, and zero units of EX4. This optimal mix results in a contribution margin of $3,650,000 ($1,400,000 from V2 and $2,250,000 from A6). Relative to requirement 2, operating income increases by $650,000 ($3,650,000 minus $3,000,000 calculated in requirement 2). Hence, Gormley should accept the Clark Corporation business and supply 20,000 units of V2.

Rush manufactures only 275 units per year because the installation department has only enough capacity to install 275 units. The equipment sells for $45,000 per unit (installed) and has direct material costs of $20,000. All costs other than direct material costs are fixed. The following requirements refer only to the preceding data. There is no connection between the requirements.

Required:

SOLUTION

(20 min.) Theory of constraints, throughput contribution, relevant costs.

The throughput margin resulting from the proposed change in direct materials is greater than the current throughput margin. Therefore, Nebraska Industries should implement the new design.

The additional throughput margin exceeds incremental costs by $120,000, so Rush Industries should implement the new installation technique.

11-45 Theory of constraints, contribution margin, sensitivity analysis. Talking Toys (TT) produces dollsin two processes: molding and assembly. TT is currently producing two models: Chatty Chelsey and Talking Tanya. Production in the molding department is limited by the amount of materials available. Production in the assembly department is limited by the amount of trained labor available. The only variable costs are materials in the molding department and labor in the assembly department. Following are the requirements and limitations by doll model and department:

The following requirements refer only to the preceding data. There is no connection between the

requirements.

Required:

SOLUTION

11-45 (30-35 min.) Theory of constraints, contribution margin, sensitivity analysis.

For both types of dolls, the constraining resource is the availability of material because this constraint causes the lowest maximum production.

If only Chatty Chelsey is produced, TT can produce 18,000 dolls with a contribution margin of 18,000 ×$20 = $360,000

If only Talking Tanya is produced, TTcan produce 12,000 dolls with a contribution margin of 12,000 ×$22 = $264,000.

TT should produce Chatty Chelseys.

If TT sells three Chatty Chelseys for each Talking Tanya, then the maximum number of Talking Tanya dolls the Molding Departmentcan produce (where the number of Talking Tanya dolls is denoted as T) is:

The Molding Department can produce 4,000 Talking Tanya dolls, and 3 ×4,000 (or 12,000) Chatty Chelsey dolls.

Because TT can only produce 4,000 Talking Tanyas and 12,000 Chatty Chelseys before it runs out of ingredients, the maximum contribution margin (CM) is:

3. With 900 more pounds of materials, TT would produce more dolls. Using the same technique as in Requirement 2, the increase in production is:

TT would produce 100 extra Talking Tanya dolls and 300 extra Chatty Chelsey dolls.

Contribution margin would increase by

11-46 Closing down divisions. Ainsley Corporation has four operating divisions. The budgeted revenues and expenses for each division for 2017 follows:

Closing down any division would result in savings of 40% of the fixed costs of that division. Top management is very concerned about the unprofitable divisions (A and B) and is considering closing them for the year.

Required:

SOLUTION

(25 min.) Closing down divisions.

1. and 2.

Division A Division B

Sales	$504,000	$948,000
Variable costs of goods sold 0.80)	396,000	744,000
Variable S,G & A		101,25
0.50)	48,000	0
Total variable costs	444,000	845,250
Contribution margin	$ 60,000	$102,750

Division A’s contribution margin of $60,000 more than covers its avoidable fixed costs of $36,800. The difference of $23,200 helps cover the company’s unavoidable fixed costs. Because $36,800 of Division A’s fixed costs are avoidable, the remaining $55,200 is unavoidable and will be incurred regardless of whether Division A continues to operate. Division A’s $32,000 loss is the rest of the unavoidable fixed costs ($55,200 – $23,200). If Division A is closed, the remaining divisions will need to generate sufficient profits to cover the entire $55,200 unavoidable fixed cost. Consequently, Division A should not be closed because it helps defray $23,200 of this cost.

Division B earns a positive contribution margin of $102,750. Division B also generates $114,900 of avoidable fixed costs. Based strictly on financial considerations, Division B should be closed because the company will save $12,150 ($114,900 –$102,750). Division B is currently incurring $114,900 in fixed costs that it could have avoided while earning only $102,750 in contribution margin.

An alternative set of calculations is as follows:

Division A should not be shut down because loss of revenues if Division A is shut down exceeds cost savings by $23,200. Division B should be shut down because cost savings from shutting down Division B exceeds loss of revenues by $12,150.

The equipment has a zero disposal value. Guide wages, supplies, and vehicle fuel are variable costs with respect to the number of tours. Administrative salaries are fixed costs with respect to the number of tours. Brad Barrett, Mechum River Anglers’ president, is concerned about the losses incurred on the deluxe tours. He is considering dropping the deluxe tour and offering only the basic tour.

Required:

SOLUTION

(30 min.) Dropping a product line, selling more tours

1. Barrett should not drop the deluxe tours, as follows:

Note: Equipment depreciation, allocated corporate costs, and unavoidable administrative salaries are irrelevant to the decision.

2. Barrett should drop the deluxe tours, as follows:

Michael Shirra, vice president for sales, believes that at the current price, Della Simpson can sell all of its daily production of Della’s Delight and Bonny’s Bourbon. Both cookies are made in batches of 3,000. In each department, the time required per batch and the total time available each day are as follows:

Revenue and cost data for each type of cookie are as follows:

Required:

SOLUTION

(30–40 min.)

Optimal product mix.

1. Let D represent the batches of Della’s Delight made and sold.

Let B represent the batches of Bonny’s Bourbon made and sold. The contribution margin per batch of Della’s Delight is $300. The contribution margin per batch of Bonny’s Bourbon is $250.

The LP formulation for the decision is:

Maximize $300D + $250 B

SOLUTION EXHIBIT 11-48

Graphic Solution to Find Optimal Mix, Della Simpson, Inc.

Della Simpson Production Model

We next calculate the optimal production mix using the trial-and-error method.

The corner point where the Mixing Dept. and Baking Dept. constraints intersect can be calculated as (18, 8) by solving:

30D + 15B = 660 (1) Mixing Dept. constraint 10D + 15B = 300 (2) Baking Dept. constraint

Subtracting (2) from (1), we have

The corner point where the Filling and Baking Department constraints intersect can be calculated as (3,18) by substituting B = 18 (Filling Department constraint) into the Baking Department constraint:

The feasible region, defined by five corner points, is shaded in Solution Exhibit 11-43. We next use the trial-and-error method to check the contribution margins at each of the five corner points of the area of feasible solutions.

The optimal solution that maximizes contribution margin and operating income is 18 batches of Della’s Delights and 8 batches of Bonny’s Bourbons.

11-49 Dropping a customer, activity-based costing, ethics. Justin Anders is the management accountant for Carey Restaurant Supply (CRS). Sara Brinkley, the CRS sales manager, and Justin are meeting to discuss the profitability of one of the customers, Donnelly’s Pizza. Justin hands Sara the following analysis of Donnelly’s activity during the last quarter, taken from CRS’s activity-based costing system:

Sara looks at the report and remarks, “I’m glad to see all my hard work is paying off with Donnelly’s. Sales have gone up 10% over the previous quarter!”

Justin replies, “Increased sales are great, but I’m worried about Donnelly’s margin, Sara. We were showing a profit with Donnelly’s at the lower sales level, but now we’re showing a loss. Gross margin percentage this quarter was 40%, down five percentage points from the prior quarter. I’m afraid that corporate will push hard to drop them as a customer if things don’t turn around.”

“That’s crazy,” Sara responds. “A lot of that overhead for things like order processing, deliveries, and sales calls would just be allocated to other customers if we dropped Donnelly’s. This report makes it look like we’re losing money on Donnelly’s when we’re not. In any case, I am sure you can do something to make its profitability look closer to what we think it is. No one doubts that Donnelly’s is a very good customer.”

Required:

SOLUTION

(25 min.) Dropping a customer, activity-based costing, ethics.

Justin should not rework the numbers. Referring to “Standards of Ethical Conduct for Management Accountants,” in Exhibit 1-7, Justin Anders should consider the request of Sara Brinkley to be unethical for the following reasons.

Competence

Integrity

Credibility

Confidentiality

Justin should indicate to Sara that the costs he has derived are correct. If Sara still insists on making the changes to lower the costs to serve Donnelly’s Pizza, Justin should raise the matter with Sara’s superior, after informing Sara of his plans. If, after taking all these steps, there is a continued pressure to understate costs, Justin should consider resigning from the company rather than engage in unethical conduct.

Sanchez uses straight-line depreciation on all equipment. Annual depreciation expense for the old machine is $180,000 and will be $270,000 on the new machine if it is acquired. For simplicity, ignore income taxes and the time value of money.

Required:

SOLUTION

(30 min.) Equipment replacement decisions and performance evaluation.

First-year costs are lower by $39,000 under the keep machine alternative, and Susan Smith, with her one-year horizon and operating income-based bonus, will choose to keep the machine.

Note that the book value of the current machine ($360,000) would either be written off as depreciation over two years under the keep option, or, all at once in the current year under the replace option. Its net effect would be the same in both alternatives: to increase costs by $360,000 over two years; hence, it is irrelevant in this analysis.

This problem illustrates the conflict between the decision model and the performance evaluation model. From the perspective of Sanchez Manufacturing, the old machine should be replaced. Over the longer two-year horizon, replacing the old machine with the new equipment saves Sanchez Manufacturing $66,000. From a performance evaluation perspective, Susan Smith prefers to keep the old machine because operating income in the first year will be $39,000 higher if she keeps rather than replaces the old machine. Chapter 23 describes methods that companies use to reduce the conflict between the decision model and the performance evaluation model.

From requirement 1, the cost difference in the first year from replacing the old machine needs to be reduced by $39,000. This means that depreciation on the new equipment must be $39,000 less than it is, so $270,000 – $39,000 = $231,000.

The new equipment is being depreciated over a two-year period with zero residual value so the cost of the equipment equals $231,000  2 = $462,000. If the new equipment can be purchased for $462,000 or less, Susan Smith will be willing to purchase it because the performance evaluation model would be consistent with the decision model.

Note that over the two-year period, Sanchez Manufacturing will be better off purchasing the new equipment for $462,000 by $144,000, as the following presentation of the analysis done in requirement 2 shows:

Try It 11-1 Solution

The relevant revenues and costs are the expected future revenues and costs that differ as a result of Rainier accepting the special offer:

Revenues ($60 per hour × 1,000 hours)	$60,000
Variable landscaping costs ($50 per hour	50,000
Increase in operating income by accepting the one-time special order	$10,000

The fixed landscaping costs and all marketing costs (including variable marketing costs) are irrelevant in this case because these costs will not change in total whether the special order is accepted or rejected. In this example, by focusing only on the relevant amounts, the manager avoids a misleading implication: to reject the special order because the $60-per-hour selling price is lower than the landscaping cost per hour of $62, which includes both relevant variable landscaping costs and irrelevant fixed landscaping costs.

Try It 11-2 Solution

Rainier could use either the Total Alternatives Approach or the Opportunity-Cost Approach to make a decision.

Total Alternatives Approach

The two options available to Rainier are

The table below presents the relevant revenues and relevant costs, those future revenues and costs that differ between the alternatives. It shows that Rainier is better off rejecting Victoria’s offer because it reduces operating income by $12,000.

The Opportunity Cost Approach

In the opportunity-cost approach, the options are defined as follows

The analysis focuses only on the Victoria offer.

We first calculate the opportunity cost of accepting Victoria’s offer.

There is no opportunity cost for the first 1,000 hours of equipment time since Rainier has 10,000

We next focus only on Victoria’s offer and the effect on operating income from accepting it.

The opportunity cost approach yields the same conclusions as the total alternatives approach. Rainier’s operating income decreases by $12,000 if it accepts Victoria’s offer. Note that by considering only the incremental revenues and incremental costs, it would appear that Rainier should accept Victoria’s offer because incremental revenues exceeds incremental costs of the Victoria offer by $14,000 ($120,000 − $106,000). But there is an opportunity cost of $26,000 by using the equipment for Victoria’s business because the next-best use of this equipment by Rainier would result in using 1,000 hours to service existing customers that would increase operating income by $26,000. Unless the contract with Victoria results in more than $26,000 in operating income, Rainier should reject the offer.

Try It 11-3 Solution

This problem is one of making product (or customer)-mix decisions with capacity constraints.

Rainier’s managers should choose the product with the highest contribution margin per unit of the constraining resource (equipment hours). That’s the resource that restricts or limits the sale

To maximize operating income, Rainier should allocate as much of its capacity to customers who generate the most contribution margin per unit of the constraining resource (equipment). That is, Rainier should first allocate equipment capacity to existing customers ($26 per hour) and only the balance to Hudson Corporation ($21.50 per hour). Rainier maximizes total contribution margin by allocating 9,000 hours of equipment capacity to existing customers yielding contribution margin of $234,000 ($26 per hour × 9,000 hours) and only the balance 1,000 hours to Victoria Corporation yielding contribution margin of $21,500 ($21.50 per hour × 1,000 hours) for a total contribution margin of $255,500 ($234,000 + $21,500).

Try It 11-4 Solution

The key reason that Irving’s operating income increases either if it closes down the Oakland store or if it opens another store like it is the behavior of corporate overhead costs. By closing down the Oakland store, Irving can significantly reduce corporate overhead costs presumably by reducing the corporate staff that oversees the Oakland operation. On the other hand, adding another store like Oakland does not increase actual corporate costs by much, presumably because the existing corporate staff will be able to oversee the new store as well.

EXHIBIT TRY-IT 11-4

Relevant-Revenue and Relevant-Cost Analysis of Closing Oakland Store and Opening Another Store Like It.

Is costs that were incurred in the past and Cannot be changed regardless of which future action is taken?

What is an incurred cost that Cannot be changed?

What type of cost Cannot be changed by future decisions?

Have already been incurred and Cannot be changed now or in the future?