Chap 021

CHAPTER 21INCREMENTAL ANALYSIS

Brief LearningExercises Topic Objectives Skills

B. Ex. 21.1 Using average unit costs 1, 3 Analysis B. Ex. 21.2 Make or buy 2–4 Analysis, judgmentB. Ex. 21.3 Joint cost allocation 1, 2, 4 Analysis, judgmentB. Ex. 21.4 Outsource a product 2, 4, 5 Analysis, judgmentB. Ex. 21.5 Opportunity costs 2 AnalysisB. Ex. 21.6 Identifying costs 2 Analysis, judgmentB. Ex. 21.7 Allocating productive capacity 4 AnalysisB. Ex. 21.8 Match decision and relevant costs/revenues 1, 3, 4 AnalysisB. Ex. 21.9 Sell at split-off or process further 2–4 AnalysisB. Ex. 21.10 Scrap or rebuild 2–4 Analysis

LearningExercises Topic Objectives Skills

21.1 Accounting terminology 1–5 Analysis21.2 Real World: Home Depot 1, 2 Analysis, communication,

Incremental, sunk, and opportunity costs judgment21.3 Incremental analysis: Accepting a special

order1–3 Analysis

21.4 Scarce resources 1–4 Analysis21.5 Special order decisions and opportunity costs 1–4 Analysis

21.6 Incremental analysis: Make or buy decision 1–4 Analysis21.7 Make or buy decision 1–4 Analysis21.8 Sunk costs: Scrap or rework decision 1–4 Analysis21.9 Scarce resources 1–4 Analysis21.10 Joint products 1–4 Analysis, communication,

judgment

21.11 Joint processes: Sell or process further 1–4 Analysis21.12 Pricing a special order 1–3 Analysis, judgment21.13 Evaluating a special order 1–3 Analysis21.14 Scarce resources 1–5 Analysis, judgment21.15 Real World: Home Depot’s charitable

contributions1–3 Analysis, communication,

research

OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL THINKING CASES

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Topic Skills21.1 A,B Evaluating a special order 1–3, 5 Analysis, communication,

judgment

21.2 A,B Make or buy decision 1–4 Analysis21.3 A,B Make or buy decision 1–4 Analysis21.4 A,B Determining the most profitable product 1–4 Analysis, communication

Given scarce resources21.5 A,B Sell or rebuild deficient units 1–5 Analysis, communication 21.6 A,B Sell or rebuild 1–5 Analysis, communication,

judgment

21.7 A,B Joint products 1–4 Analysis21.8 A Pay off or pay up? 1–3, 5 Analysis, communication,

judgment

21.8 B Scarce resources 1–5 Analysis, communication, judgment

21.1 Factors that limit capacity 4 Analysis, communication, judgment

21.2 Relevant information and opportunity costs 1–3, 5 Analysis, communication, judgment

21.3 Real World: Dow Chemical Co. 3–5 Analysis, communication,(Internet) judgment, research,

technology

21. 4 SEC enforcement fines 1–3 Analysis, communication,(Ethics, fraud and corporate governance) judgment

Critical Thinking Cases

ProblemsSets A, B

Learning Objectives

© The McGraw-Hill Companies, Inc., 2012CH21-Overview (p.2)

DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASES

Problems21.1 A,B D. Lawrance/Swirl Incorporated 25 Easy

Use of incremental analysis to determine whether it would be advantageous to accept a large special order at a sales price below average unit cost. Student is also asked to identify other considerations in this type of decision.

21.2 A,B Easy Use Tool Co./Matchless Corp. 30 MediumUse incremental analysis in a make or buy decision. Includes an assumption that facilities can be put to an alternative productive use.

21.3 A,B Parsons Plumbing & Heating/James Lighting 30 MediumUse incremental analysis in a make or buy decision. Includes an assumption that facilities can be put to an alternative productive use.

21.4 A,B Insiteful Instruments/Superior Instruments 30 MediumDecision regarding which product should be produced when machine hours create a production constraint.

21.5 A,B BestView/Bold Face 25 MediumDecision of whether older models should be discontinued or upgraded. Involves sunk costs, opportunity costs, and capacity considerations.

21.6 A,B Silent Sentry/Fire Code 25 MediumDecision of whether gas leak detectors/smoke detectors should be repaired, sold at a discount, or shipped overseas. Also requires students to consider ethical and legal implications of decision.

21.7 A,B Kelp Company/Vitamin Bits Company 25 MediumDecision of whether to sell products at the split-off point or to process them further.

Below are brief descriptions of each problem, case, and the first Internet assignment. These descriptionsare accompanied by the estimated time (in minutes) required for completion and by a difficulty rating.The time estimates assume use of the partially filled-in working papers.

© The McGraw-Hill Companies, Inc., 2012Description of Problems

21.8 A McKay Chemical Company 35 StrongA chemical company that for years has been engaged in illegal dumping and now is threatened with public exposure. Superb ethics problem.

21.8 B Home Run Corporation 20 MediumDirect Labor hours constrain production and there are complementary products.

© The McGraw-Hill Companies, Inc., 2012Desc. of Problems (p.2)

Critical Thinking Cases21.1 I Knew That 35 Medium

A limiting resource problem that relates this accounting concept to students’ everyday experiences. Students are to develop strategies for maximizing contribution margin in familiar business settings. (We always assign this one.)

21.2 McFriendly Software 15 MediumA short, single-concept problem focusing upon the importance, and also the subjectivity, of opportunity costs.

21.3 The Dow Corporation 20 EasyInternetThis assignment focuses on the types of incremental decisions that might be made at this firm. In addition, the student is asked to think of qualitative factors that might be considered in the decision-making process.

21.4 SEC Enforcement Fines 20 MediumEthics, Fraud & Corporate GovernanceStudents consider how the SEC fines policy creates relevant costs that managers may (or may not) consider when thinking about undertaking fraudulent reporting.

© The McGraw-Hill Companies, Inc., 2012Desc. of Cases

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1.

2.

3.

4.

5.

6.

7.

8. When thinking about outsourcing the production of a part, Harley-Davidson Motorcycle Company should consider additional factors such as the quality of the part, the reliability and financial stability of the potential outsource companies. In addition, any legal, ethical, or environmental issues that might arise because of the outsourcing should be investigated.

These are complementary products. That is, the sale of razors supports the demand for the more profitable razor blades.

Incremental costs, defined as the difference in costs between alternative courses of action and incremental revenues, defined as the difference in revenues between alternative courses of action, are compared to each other to determine the incremental profits between alternative actions. If the incremental revenue less the incremental cost of action one is higher than the incremental revenue less the incremental cost of action two, then action one is preferred to action two (all else equal).

Short-run decisions are made with a fixed set of resources and must meet the demands of the current marketplace. There is no time to create demand or acquire a significantly different set of resources. For long-run decisions, plans are created to acquire the resources necessary to create the additional demand and then meet that demand.

Opportunity costs are an important factor in decision making; they are costs of taking some action in terms of the value foregone (given up) because that particular action was taken. Because opportunity costs are not recorded in the accounting records and are often difficult to quantify, they are often ignored in making decisions. Failure to consider the potential benefits of alternative actions that cannot be taken because another course of action is selected represents a common error in cost analyses and decision making.

A sunk cost is an outlay that has been irrevocably incurred at some time in the past; sunk costs cannot be changed no matter what course of action is taken and are irrelevant for purposes of decisions involving the future. An expenditure of current funds (cash or other liquid resources) is known as an out-of-pocket cost.

Nonfinancial questions regarding a special order decision may include (1) Is there excess capacity, or will regular customers have to be turned away? (2) If regular customers are turned away, will they return? (3) Will the special order customer eventually become a regular customer if we fill the order? (4) Will the quality of the special order be of the same quality as our regular products or services?

Costs incurred up to the split-off point are sunk costs. These costs will be incurred regardless of the products chosen in the decision-making process. Thus, they should not influence future decisions.

© The McGraw-Hill Companies, Inc., 2012Q1-8

9.

10.

11.

12.

13.

14.

15. Complementary products are two or more products for which sales of one product contributes to the sales of the other(s). When making decisions about individual products, it is important to understand the impact on all products that are complementary with that product. Thus, if Gillette chose to stop selling its razor blades, it needs to be aware that sales of its razors may also decline.

When opportunity costs are ignored in a make or buy decision, the resulting decision might be wrong. For example, choosing a supplier with a poor reputation among customers may cause the market share of the product to decline and result in very large opportunity costs.

If the Wolvo Company decides to sell the products, it must consider any legal or ethical issues associated with selling a defective product. Scrapping the defective products avoids any legal customer-related complaints, but might create environmental issues that should be considered. If disposing of the product creates hazardous waste, the cost of cleaning the waste will be important. A decision to rebuild the defective products would need to identify the incremental costs and revenues from such an approach in order to compare with the costs associated with either selling the product as is, or scrapping the product.

Harry Haney is correct in his assessment about how the purchase of new equipment would affect his performance evaluation. Many companies use return on investment (ROI) type measures to evaluate divisional performance. These types of measures encourage managers to keep old equipment with a lower investment base and, as a result, frequently discourage investment in new more efficient equipment. So this is not about sunk costs, this is about how those costs are used to evaluate a manager.

Agree: a company can run the risk of filling up capacity with products and special orders that cover their variable costs, but do not provide enough contribution to cover the total fixed costs. When this happens, the firm is moving out of the short-run decision category and needs to consider the long-run implications of using those fixed resources in a more productive fashion or selling those fixed resources.

Sunk costs represent cash flows that have already occurred. No cash flow effects are associated with opportunity costs. These are cash flows that have been given up to choose another course of action. Out-of-pocket costs are planned cash outflows.

The contribution margin is important in incremental decision making because the contribution margin is typically the incremental profit that is earned on sales. The contribution margin is important for special order, make or buy, and production constraint decisions.

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SOLUTIONS TO BRIEF EXERCISES

B. Ex. 21.1

B. Ex. 21.2

B. Ex. 21.3

B. Ex. 21.4

B. Ex. 21.5

B. Ex. 21.6 a. Out-of-pocket costb. Sunk costc. Opportunity costd. Opportunity coste. Sunk costf. Out-of-pocket cost

The opportunity cost to choosing to go to the game instead of sell the ticket is $75. It is not the difference between the cost of the ticket and $75 because the cost of the ticket, $50, is sunk when the decision is made.

Joint cost allocated to fiber board 75% ×$420,000 $315,000.

The incremental cost to outsource is:($2.50 - $2.00) × (200 per month × 12 mos.) = $1,200. This is more than offset by the incremental contribution from the alternative use of the space = $3,500. Thus, the net effect of outsourcing is $3,500 - $1,200 = $2,300.

Other factors include the reputation for quality service of the outsourcing company and its financial stability.

The first consideration is whether there is idle capacity. Thus, if some regular sales of washing machines at the $180 price are displaced because there is not enough capacity to make 20,000, then the opportunity cost associated with the displaced sales must be included in the incremental analysis. The second consideration is whether $175 covers all the incremental costs associated with accepting the special order. Those incremental costs include all variable costs to make the washing machines, plus the opportunity cost of displaced sales and any other costs associated with the special order (e.g. special shipping, etc.). The company will accept the special order if the incremental revenue ($175) is greater than the incremental cost and all other non financial considerations have been taken into account. Notice that the regular selling price of $250 and the average selling price of $180 are not relevant.

The incremental cost of a fishing reel is $7.00 $4.00 $11.00. Thus, it is more expensive to buy for $12.50 than to produce for the incremental cost of $11.00. Management should not use total average costs (variable plus fixed) in making this decision unless they are sure that the fixed costs can be eliminated.

The total sales value of the joint products is $260,000 $780,000 $1,040,000. The relative sales value of wood chips is $260,000/$1,040,000 25% and for fiber board $780,000/$1,040,000 75%. Joint cost allocated to wood chips 25% × $420,000 $105,000.

© The McGraw-Hill Companies, Inc., 2012BE21.1,2,3,4,5,6

B. Ex. 21.7

B. Ex. 21.8 a. 2, 5b. 1, 5c. 1, 2, 3d. 2, 5e. 4

B. Ex. 21.9

B. Ex. 21.10

Contribution margin per hour for the cycle class is $15/2 hours = $7.50 and the contribution margin per hour for the combo class is $12/1.5 hours = $8.00. The gym could make 300 hours × $7.50 + 200 hours × $8.00 = $3,850.

Incremental cost to process further $90/1,300 pounds $0.07 per pound. Yes, the wings should be processed further because the incremental revenue per pound of $0.11 is greater than the incremental cost of $0.07 per pound.

The cost of completion to date, $1,693,000, is a sunk cost. The cost to scrap, $30,000, and to rebuild, $450,000, are out-of-pocket and incremental costs. The potential sales price, $500,000, is incremental revenue. Vickery should rebuild the equipment and earn $500,000 - $450,000 $50,000 of contribution.

Incremental revenue from processing further $0.46 - $0.35 $0.11 per pound.

© The McGraw-Hill Companies, Inc., 2012BE21.7,8,9,10

SOLUTIONS TO EXERCISES

Ex. 21.1 a.b.c.d.e.f.g.

Ex. 21.2

Ex. 21.3 a.

75$ 13 88$

75$ c.

75$ 25

100$

Average per-unit manufacturing cost at 110,000 units per month:Variable cost per unit ($45 + $25 + $5) ……………………………………

Joint productsOut-of-pocket costNone (This statement does not describe any accounting term.)

Incremental costs associated with remodeling (closing) an existing Home Depot store includes the costs of materials, labor, and overhead associated with the actual physical remodeling (closing) process. In addition, design and planning costs would also be incremental. Other incremental costs include regular store employee costs incurred to rearrange and move merchandise during the remodeling effort.

Sunk costs related to remodeling (closing) stores are the original costs of the current store, including decorations, paint, shelves, displays, carpet, and designs that will be replaced (removed) during remodeling (closing).

Opportunity costs of the remodeling (closing) project would be profits on lost sales if the store is closed during remodeling (or for good). Also customer traffic may decline during remodeling (closing) because of noise, dirt, or the inconvenience caused by the remodeling (closing). Finally, the store may lose profits on sales because they may not be able to stock the full line of products (or sell at a discount) during the remodeling (closing) efforts.

Incremental cost per paper feed drive is the product’s unit variable cost ($45 + $25 + $5)

Unit sales price for a $500,000 pretax profit on 20,000 units:Incremental cost per unit (from part b ) ……………………………………Required profit per unit ($500,000 ÷20,000 units) ………………………

Unit sales price …………………………………………………………

Incremental analysisSunk costRelevant informationOpportunity cost

b.

Fixed manufacturing cost per unit ($1,430,000 ÷ 110,000 units) …………Average per-unit manufacturing cost …………………………………

© The McGraw-Hill Companies, Inc., 2012E21.1,2,3

$10,800 84,000 5,280 $100,080

b.

Gauze: contribution margin per hr. = $9 per bolt ÷ 0.3 hrs. per bolt = $30 per hr.

Machine hrs. should first be used to make the product with the highest contribution margin per machine hour. Texteriles should make as much gauze as they can sell = 1,200 bolts × 0.3 hrs. per bolt = 360 machine hrs.; next make as much denim as they can sell = 6,000 bolts × 0.5 hrs. / bolt = 3,000 hrs.; finally, use the remaining hrs. (3,600 - 3,360 = 240 hrs.) to make chenille. The 240 remaining machine hrs. can be used to make chenille at 1 hr. per bolt resulting in 240 bolts of chenille.

The total contribution from this combination is:

a.

1,200 bolts of gauze × $ 96,000 bolts of denim × $14

240 bolts of chenille × $22 total contribution

c.

Normal crates: incremental costs are all variable costs including direct labor, direct materials and variable overhead. $5.50 $10.50 $3.50 $19.50.

Ex. 21.4

Ex. 21.5

The contribution margin per machine hr. for a bolt of each type of cloth is as follows:

Denim: contribution margin per hr. = $14 per bolt ÷ 0.5 hrs. per bolt = $28 per hr.Chenille: contribution margin per hr. = $22 per bolt ÷ 1 hr. per bolt = $22 per hr.

Special order crates: incremental costs include all variable costs for the normal crate plus an additional cost for the special labels and minus $.50 in distribution costs. $19.50 $1.00 - $0.50 $20.00.

Monthly operating profit when distributing the normal 30,000 crates can be found by multiplying the contribution margin by the number of crates sold and deducting fixed expenses as follows: CM = $26 - $19.50 = $6.50. Monthly operating profit = $6.50 × 30,000 = $195,000 - $122,000 = $73,000.

If Poppycrock accepts the special order, it will add the contribution margin for the 5,000 crates for the Boys and Girls of Canada order to its monthly profit: ($22 - $20.00) × 5,000 = $10,000. Monthly operating profit with the special order is $73,000 + $10,000 = $83,000. The opportunity cost of not accepting the special order is $10,000.

($26 - $19.50) × 35,000 crates - $122,000 = $105,500

In this case, Poppycrock is operating at full capacity. It has a production constraint that will require it to forego some normal sales in order to accept the special order. Without the special order, monthly profits at full capacity would be:

© The McGraw-Hill Companies, Inc., 2012E21.4,5

Ex. 21.6

Make the Buy the IncrementalPart Part Analysis

$ 155,000 $ 155,000 100,000 $ 100,000

160,000 (160,000) $ 255,000 $ 260,000 $ (5,000)

Ex. 21.7

Ex. 21.8

$ 83,600

$ 200,000 119,200

80,800 $ 2,800

$4.50 × 5,000 crates = $22,500.

Ex. 21.5 (continued)

With the special order, monthly profits would be:($26 - $19.50) × 30,000 crates + ($22.00 - $20.00) × 5,000 - $122,000 = $83,000.

The difference between these monthly operating profit numbers ($105,500 - $83,000 $22,500) is the opportunity cost of accepting the special order when Poppycrock is operating at full capacity. It is also equal to the difference in the normal and special order contribution margins ($6.50 - $2.00 $4.50) for the 5,000 crates being considered:

It is less costly for Bacrometer to continue to make part no. 566.

The company should sell the defective units as scrap at $4.18 per unit, rather than spending $119,200 to correct the defects and realize a unit sales price of $10 per unit, as summarized below:

Net proceeds from sale of reworked units …………Net benefit of selling the defective units as scrap ………

Scrap value of units (20,000 × $4.18) ……………………Proceeds from sale of reworked units

Less: Cost of corrective work ……………………………($10 × 20,000) …………………………………………

Compare the incremental cost to make with the incremental cost to buy. Remember the incremental cost to make includes the opportunity cost of the foregone rent revenue.

(20,000 × $8) …………………

Incremental cost to buy: $2.65 × 60,000 = $159,000.

Incremental cost to make: $2.50 × 60,000 + $5,000 = $155,000.

Variable ……………………….Fixed manufacturing overhead ……

Purchase price of part

Note to instructor: This exercise makes no mention of an alternative use for the plant facilities involved in the manufacture of the part. If we were to assume that these facilities could be utilized to generate more than $5,000 in contribution margin, the company should then consider buying the part from the outside source and converting the facilities to the more profitable use.

Totals …………………………….

The company should continue to manufacture the part rather than buying it from theoutside supplier. The supporting schedule follows:

Manufacturing costs:

© The McGraw-Hill Companies, Inc., 2012E21.6,7,8


Ex. 21.9

Android Bio-Mutant Cyclops $ 100 $ 60 $ 125 48 24 60 9 8 16 7 4 9 $ 36 $ 24 $ 40

4 2 5

$ 9 $ 12 $ 8

Ex. 21.10 a.

Amoxiphore Benidrate $ 2,700 $ 2,400 $ 4,200 $ 6,000 1,600 3,700 $ 2,600 $ 2,300

Selling price ……………………..

Proceeds if processed further ……………..

Direct labor ……………………..Direct materials …………………

In addition to contributing $2,800 to profitability, scrapping the defective units leaves the production facilities that would be utilized in the rework free for other purposes.

Note to instructor: The $123,500 already incurred in the manufacture of these units is a sunk cost and is not relevant.

To maximize its total contribution margin, the company should produce and sell the product with the highest contribution margin per direct labor hour. As shown below, this product is Bio-Mutant.

Variable overhead ……………….

Net proceeds if processed further ………..

÷ $12 per hour) ………………..

per direct labor hour …………

With 1,000 direct labor hours available, the company can produce a total of 500 Bio-Mutant games (1,000 hours ÷ 2 hours per unit). Thus, its total contribution margin will be:

500 games × $24 contribution margin per game = $12,000

It is $100 more profitable to sell Amoxiphore at the split-off point than it is to process it further ($2,700 versus $2,600). It is also $100 more profitable to sell Benidrate at the split-off point ($2,400 versus $2,300). Supporting calculations are as follows:

Direct labor hours per unit

Incremental cost of further processing …..

Proceeds if sold at the split-off point ………

Contribution margin per unit …..

Contribution margin

(direct labor cost per unit



b.

Ex. 21.11 a.

Molecue: $22 × 3,000 $ 66,000 Borphue: $15 × 10,000 150,000 Polygard: $5.50 × 1,000 5,500

$ 221,500

Joint Cost $ (60,000)Molecue additional $ (10,000)Polygard additional (1,000 × $1.50) $ (1,500)

$ (71,500) $ 150,000

c.

b.

Revenues:

Less Costs: Total Revenue

Total Cost Total Profit

The profitability of the entire joint process can be determined as follows:

The primary nonfinancial issue in this problem is an ethical consideration. If Amoxiphore is sold at the split-off point, users of the drug suffer from nausea and headaches. Even with these side effects, demand for the drug is extremely high. If the company processed the product past the split-off point, the side effects would diminish. However, the company’s profit would be reduced by $100 for each batch produced. Does the company have an ethical responsibility to forego $100 per batch in order to relieve suffering in those who must take the drug? Some would argue that the company does have this responsibility. However, others may argue that the company’s primary responsibility is to maximize stockholder wealth.

d.

Incremental revenue to process further = $22 - $5 = $17 per gallon × 3,000 gallons = $51,000. Compare to incremental cost to process further = $10,000. Incremental profit to process further is $41,000.

Incremental revenue to process Polygard further = $5.50 × 1,000 - $3,500 = $2,000. Compare to incremental cost to process further = $1.50 × 1,000 = $1,500. Incremental loss if BioMorphs accepts the offer to sell at split-off is ($500).

Sunk costs related to the decision to process Polygard further are the costs of the joint process.

© The McGraw-Hill Companies, Inc., 2012E21.11

Ex. 21.12 a.

Special Sale

$ 20 $ 6 4 6 2 18

$ 2

b.

Special Sale

$ 32 Less: Direct Materials ………………………… $ 6

Direct labor ………………………………… 4 6

Additional shipping costs ………………… 2 18 $ 14

Ex. 21.13

$ 960,000

$ 360,000

120,000

420,000 12,000 $ 912,000

$ 48,000 Estimated increase in operating income …………

(10,000 units × 12 mo. × $3.50) ………………Variable overhead

Selling price ………………………………………

Variable overhead (2/3 × $9) ………………

Contribution margin per unit …………………

Cost of rented space per year …………………

In order for the company to increase its operating income $60,000 above what it would be without the order, the contribution margin per unit included with the special order must be $2 per unit more ($2 × 30,000 units = $60,000) than the normal contribution margin. The normal contribution margin is the sales price, $28, less all variable costs ($6 + $4 + 2/3 × $9), or $12. Thus, the selling price of the special order must cover the additional shipping costs, and still result in a contribution margin of $14 ($12 normal + $2 additional requirement). Therefore, a selling price of $32 is required, as shown below:

Estimated increase in operating income:

Direct labor

(10,000 units × 12 mo. × $8.00) …………………

(10,000 units × 12 mo. × $3.00) ………………

(10,000 units × 12 mo. × $1.00) ………………

Incremental costs:

Incremental revenue

Direct materials

At a current operating level of 100,000 units, the company will not have to turn away any of its regular customers in order to fill the special order. If it wishes to increase operating income by $2 per unit included in the special order, it only needs to generate a contribution margin per unit of $2. Thus, the selling price per unit included in the special order is $20, as shown below:

Selling price ………………………………………

Contribution margin per unit …………………..

Less: Direct Materials ………………………..Direct labor ………………………………….Variable overhead (2/3 × $9) ………………Additional shipping costs …………………..


Ex. 21.14

a.

Life Vests Tow Ropes Water SkisSelling price 58$ 25$ 175$ Direct labor 20 10 80 Direct materials 12 3 75 Variable overhead 6 2 4 Contribution margin per unit 20$ 10$ 16$

Direct labor hours per unit (direct labor cost per unit ÷ $10 per hour) 2 1 8

Contribution margin per direct labor hour 10$ 10$ 2$

Total hours required to meet demand of 25,000 units, 15,000 units, and 5,000 units for vests, ropes, and skis, respectively 50,000 15,000 40,000

b.

Ex. 21.15

To maximize operating income, the company should produce those products that provide the greatest contribution margin per unit of scarce resource (direct labor hours). Thus, as shown above, it would have to produce life vests and tow ropes, each of which have a contribution margin per direct labor hour of $10. However, to do so would use the entire 65,000 hours of direct labor available (50,000 + 15,000), leaving no labor hours for the production of skis.

The least profitable product (skis) may, to a limited extent, create a demand for life vests and ropes. However, due to the large number of vests and ropes the company anticipates selling (25,000 units and 15,000 units, respectively) relative to the small number of skis the company anticipates selling (5,000 units), it would appear that the demand for vests and ropes depends very little on the sale of skis.

Home Depot's management evaluated many relevant costs and revenues before undertaking the initiative called "KaBoom!." First, they considered the out-of-pocket costs for the wages of employees who spent time on volunteer activities helping the local community. In addition, the donated materials and monetary grants offered by Home Depot to help meet community needs are both out-of-pocket and incremental costs incurred to support "KaBoom!." Alternatively, lost profits from reduced sales at stores when fewer staff members are on hand during the time spent volunteering are opportunity costs to Home Depot. Relevant potential benefits for Home Depot are reputation and brand enhancement in the communities they help. These brand and reputation effects may generate future revenues in stores. Students will likely have additional answers, but these are the most obvious relevent costs and revenues.


SOLUTIONS TO PROBLEMS SET A

PROBLEM 21.1AD. LAWRANCE

a. $ 800,000

$ 500,000 50,000 550,000

$ 250,000

b.

Expected increase in operating income ……………………Variable selling expenses ($5 × 10,000 units) …………

25 Minutes, Easy

Effect of accepting the special order:

Less: Incremental costs:Variable manufacturing costs ($50 × 10,000 units) ……

Incremental revenue ($80 × 10,000 units) …………………

A low-priced jacket that is identical to D. Lawrance jackets but that is sold through discount stores may lessen D. Lawrance’s reputation for quality goods.

(3) The sales price to Discount Apparel ($80) is so low that Discount Apparel could retail the jackets at less than the wholesale cost of the regular jackets ($150). This may create ill feelings between D. Lawrance and its regular retail outlets.

Relevant considerations other than expected effect on operating income may include:

(1) Discount Apparel may sell the jackets to customers who otherwise would buy regular D. Lawrance jackets. Thus, the special-order jackets may create difficulties for D. Lawrance in meeting its original sales forecasts.

(2)

Note to instructor: Part b is intended to be open-ended with no “correct” solution. Its objective is to get students to think about the various factors other than incremental revenue and expenses that are relevant to business decisions.

(7) Accepting the special order may allow D. Lawrance to maintain a consistent size laborforce by avoiding layoffs.

(6) The special-order jackets have a relatively low contribution margin percentage [($80 - $55) ÷ $80 = 31.25%] as compared with the regular jackets [($150 -$70) ÷ $150 = 53.33%]. This may suggest that D. Lawrance might be able to use its excess capacity to produce a product with a higher contribution margin percentage.

(4) Accepting the special order will place D. Lawrance’s scheduled production (50,000) very close to capacity (55,000). Therefore, if the regular jackets sell better than anticipated, D. Lawrance may not have the ability to meet the additional demand.

(5) This may be the beginning of a long-term relationship with Discount Apparel, in which D. Lawrance can use its excess capacity to produce a variety of “private label” merchandise.

© The McGraw-Hill Companies, Inc., 2012P21.1A

a.Make the Buy the IncrementalMotors Motors Analysis

Manufacturing costs for 12,000 motors:96,000$ 96,000$

120,000 120,000

90,000 22,500$ 67,500 114,000 108,000 6,000

0 252,000 (252,000) 420,000$ 382,500$ 37,500$

b. Effect of alternative use of factory space:

Incremental benefit of buying motors from an outside source (see part a ) 37,500$ Add: Contribution margin of alternative use of factory space

(4,000 units × $8 each) 32,000 Incremental benefit of buying motors from an outside source

and using space to produce additional power trimmers 69,500$

30 Minutes, Medium

Factory overhead:

PROBLEM 21.2AEASY USE TOOL CO.

Based upon the above analysis, the company will save $37,500 if it buys the motors from an outside source.

Totals

Direct materialsDirect labor

Variable [$90,000 - ($90,000 × 75%)]Fixed [$114,000 - $6,000]

Cost to purchase 12,000 motors at $21 each


a.Make the Buy the Incremental

Thermostats Thermostats Analysis

Manufacturing costs for 80,000 thermostats:Direct materials 156,000$ 156,000$ Direct labor 132,000 132,000 Manufacturing overhead:

Variable 168,000 $ 67,200 (1) 100,800 Fixed 144,000 134,800 (2) 9,200

Cost to purchase 80,000 thermostats at $6 per unit: 480,000 (480,000) Totals 600,000$ 682,000$ (82,000)$

(1) $168,000 - ($168,000 × 60%) = $67,200(2) $144,000 - $9,200 = $134,800


Incremental benefit (cost) of buying thermostats from an outside source (82,000)$ (see part a )

Add: Contribution margin of alternative use of factory space (6,000 units × $18) 108,000

Incremental benefit of buying thermostats from an outside source and using factory space to produce additional heat-flow regulators 26,000$

Introducing the alternative use of factory space changes the initial conclusion reached in part a. If management can use the factory space to generate an additional $108,000 of contribution margin by producing additional heat-flow regulators, a net benefit of $26,000 per year will result from buying thermostats from the outside source and using the factory space to produce heat-flow regulators.

30 Minutes, Medium

Based upon the above analysis, management will save $82,000 by continuing to manufacture thermostats rather than buying them from an outside source.

PROBLEM 21.3APARSONS PLUMBING & HEATING


a. Schedule showing contribution margin per machine-hour for each product:

Sales price per unit 200$ 215$ Less variable costs and

expenses:Direct materials 51$ 38$ Direct labor 33 30 Variable manufacturing

overhead (2/3 of total) 24 48 Variable selling expense 30 15

Total costs and expenses 138 131 Contribution margin per unit 62$ 84$ Machine-hours required

2 4 Contribution margin per

31$ 21$

b. Recommendation as to which product should be discontinued:

Model 101 should be discontinued because the contribution margin per machine-hour (the scarce resource in this case) is higher on Model 100 ($31) than it is on Model 101 ($21). The profitability of this enterprise will be aided by continuing production with the model that offers the higher contribution margin per machine-hour.

to produce one unit

30 Minutes, Medium

Model 100 Model 101

PROBLEM 21.4AINSITEFUL INSTRUMENTS

machine-hour


a. Sell toMail-Order Convert Incremental

Firm to New Model Analysis150,000$ 1,200,000$ (1,050,000)$

0 (700,000) 700,000 150,000$ 500,000$ (350,000)$

b.

c. (1)

(2) If BestView is already operating at full capacity, it probably should sell the old models to the mail-order firm. If we assume that rebuilding the old models reduces by 1,000 units the production of new models, this option involves an opportunity cost of approximately $400,000 [$1,200 sales price of new models, less $800 unit cost, times 1,000 units). This opportunity cost exceeds by $50,000 the incremental benefit of rebuilding the cameras rather than selling them “as is.”

Sunk costs: The $450,000 incurred in manufacturing the old models.

Out-of-pocket costs: The $700,000 that may be spent to convert the old models to new ones.

Opportunity costs: The profit foregone on the production and sale of new products if remanufacturing the old models forces the company to reduce production of other salable products.

Incremental sales revenue Incremental manufacturing costs

25 Minutes, Medium

Assuming excess capacity, BestView should convert the old models and realize $350,000 in incremental benefits computed in part a.

PROBLEM 21.5ABESTVIEW

Incremental cost (benefit)


PROBLEM 21.6ASILENT SENTRY

a. Incremental benefit of each option, in total and on a per-unit basis:Repair Repackage Sell to

and Sell and Sell Foreign BuyerIncremental revenue per unit 25$ 24$ 22$ Incremental cost per unit 8 3 0Net incremental benefit per unit 17$ 21$ 22$ Multiplied by total number of units 50,000 50,000 50,000 Net incremental benefit for 50,000 units 850,000$ 1,050,000$ 1,100,000$

b.

(1)

(2)

(3)

There are legal and ethical issues regarding the option to sell the inferior units to the foreign buyer. If the packaging of these units clearly states that the life of the sensory cell is 2 years, when in fact the life is only 18 months, human lives could be in jeopardy, and the company may be liable for its negligence.

There may be opportunity costs to consider such as alternative uses of production capacity other than its use to repair or repackage the defective units.

Based solely on this analysis, Silent Sentry should sell the detectors to the foreign buyer.

25 Minutes, Medium

Note: The unit costs given in the problem are not relevant because they are sunk costs.

There are several nonfinancial issues that management should consider:

If the packaging of each unit was changed to inform buyers that the sensory cells have a life of 18 months, this may cause confusion for those familiar with the 2-year life of a normal sensory cell.


PROBLEM 21.7AKELP COMPANY

a.

Sea Tea Sea Paste Sea PowderSales value if sold at the split-off point 60,000$ 80,000$ 70,000$

Sales value if processed further 90,000$ 160,000$ 85,000$ Incremental cost of further processing 35,000 50,000 14,000 Incremental proceeds if processed further 55,000$ 110,000$ 71,000$

Incremental benefit (cost) of further processing (5,000)$ 30,000$ 1,000$

b. Minimum price per pound needed to sell Sea Paste at the split-off point:

Incremental proceeds if processed further ($160,000 - $50,000) 110,000$ Sales value at split-off point 80,000 Additional benefit needed to sell at split-off point 30,000$ Divided by: Number of pounds ÷ 4,000Incremental benefit per pound needed to sell at split-off point 7.50$ Add: Current price per pound at split-off point ($80,000 ÷ 4,000 pounds) 20.00 Minimum price per pound needed to sell at split-off point 27.50$

There is an incremental benefit associated with the further processing of Sea Paste and Sea Powder, as shown above.

25 Minutes, Medium


PROBLEM 21.8APAY OFF OR PAY UP?

•

•

•

b.

This “consulting fee” is nothing more than a bribe, and I have already told this reporter to go to _ _ _ _. Not only do I find paying a bribe to this corrupt individual morally repugnant, but it would be entirely ineffective. Our past actions are known to many and soon will be made public—if not by this reporter, by another; or by a disgruntled employee; or a townsperson rightly alarmed by our dangerous practices.

But no one is going to have an opportunity to blow the whistle on us, because we are going to blow it ourselves. I have contacted the Nightline television show and will be appearing on that program tomorrow night. I will announce the changes in our disposal procedures and our intention to immediately sanitize the previous disposal site. In addition, I will call upon the Environmental Protection Agency to initiate a national effort to ensure safe disposal of hazardous waste throughout our industry.

a. The incremental analysis is deficient in numerous respects.

Ladies and gentlemen of the Board, I am addressing you today on a most important matter. It has come to my attention that for over two decades, our company has been illegally dumping toxic waste in a manner hazardous to public health.

This practice is unacceptable, and it has already been stopped. As of this morning, I have ordered implementation of new, legal, and safe waste disposal procedures. These procedures are expected to cost us approximately $10 million per year. We can and we will absorb these costs.

Related to this issue, an investigative reporter has threatened to expose our past waste-disposal procedures, which could result in very large fines and, perhaps, a widespread boycott of our products. She has offered to keep silent on this issue for a consulting fee of $1 million per year.

35 Minutes, Strong

The first option is not a viable alternative. It is illegal and unethical, and bribing this reporter would not eliminate the costs shown in the second option. At best, it would only defer the consequences of public disclosure, and probably would increase the ultimate cost.

Some figures in the analysis are annual costs, such as the bribe (consulting fee) and additional waste disposal costs, while some are “one-time” costs.

The second option, public disclosure, is a “worst case scenario,” showing the worst possible outcome. The first option, on the other hand, is overly optimistic from any realistic cost perspective.


PROBLEM 21.8APAY OFF OR PAY UP? (concluded)

The course that I am proposing is not only the right thing to do, it is the only thing to do. Yes, it will be expensive; but it will minimize the damage to our public image and also any fines and penalties that we may incur. It brings upon us no costs that we will not soon incur anyway.

Let me add, however, that if we cannot operate profitably without illegally jeopardizing public safety, then we should close our doors. I ask the Board to support me in this matter. If you choose not to do so, I will submit my resignation. But I will still be appearing on Nightline.

© The McGraw-Hill Companies, Inc., 2012P21.8A (p.2)

SOLUTIONS TO PROBLEMS SET B

PROBLEM 21.1BSWIRL INCORPORATED

a. $ 990,000

$ 720,000 90,000 810,000

$ 180,000

b.

(1)

(2)

(3)

(4)

(5)

(6)

(7)

25 Minutes, Easy

Note to instructor: Part b is intended to be open-ended with no “correct” solution. Its objective is to get students to think about the various factors other than incremental revenue and expenses that are relevant to business decisions.

Expected increase in operating income ……………………………

Relevant considerations other than expected effect on operating income may include:

Discount Fashions may sell the skirts to customers who otherwise would buy regular Swirl skirts. Thus, the special-order skirts may create difficulties for Swirl in meeting its original sales forecasts.

A low-priced skirt that is identical to Swirl skirts but that is sold through discount stores may lessen Swirl's reputation for quality goods.

The sales price to Discount Fashions ($55) is so low that Discount Fashions could retail the skirts at less than the wholesale cost of the regular skirts ($180). This may create ill feelings between Swirl and its regular retail outlets.

Accepting the special order will place Swirl’s scheduled production (68,000) very close to capacity (70,000). Therefore, if the regular skirts sell better than anticipated, Swirl may not have the ability to meet the additional demand.

This may be the beginning of a long-term relationship with Discount Fashions, in which Swirl can use its excess capacity to produce a variety of “private label” merchandise.

The special-order skirts have a relatively low contribution margin percentage [($55 - $45) ÷$55 18.2%] as compared with the regular skirts [($180 - $55) ÷ $180 = 69.44%]. This may suggest that Swirl might be able to use its excess capacity to produce a product with a higher contribution margin percentage.

Effect of accepting the special order:

Accepting the special order may allow Swirl to maintain a consistent size labor force by avoiding layoffs.

Incremental revenue ($55 × 18,000 units) …………………………Less: Incremental costs:

Variable manufacturing costs ($40 × 18,000 units) ……………Variable selling expenses ($5 × 18,000 units) …………………

© The McGraw-Hill Companies, Inc., 2012P21.1B

PROBLEM 21.2BMATCHLESS CORP.

a.Make the Buy the IncrementalRadios Radios Analysis

Manufacturing costs for 20,000 radios:Direct materials 400,000$ 400,000$ Direct labor 500,000 500,000 Factory overhead:

Variable [$350,000 - ($350,000 × 80%)] 350,000 70,000$ 280,000 Fixed [$450,000 - $5,000] 450,000 445,000 5,000

Cost to purchase 20,000 radios at $50 each 0 1,000,000 (1,000,000) Totals 1,700,000$ 1,515,000$ 185,000$


Incremental benefit of buying radios from an outside source (see part a ) 185,000$ Add: Contribution margin of alternative use of factory space

(8,000 units × $15 each) 120,000 Incremental benefit of buying radios from an outside source

and using space to produce additional timepieces 305,000$

30 Minutes, Medium

Based upon the above analysis, management will save $185,000 if it buys the radios from an outside source.


a.Make the Buy the IncrementalSwitches Switches Analysis

Manufacturing costs for 100,000 switches:Direct materials 150,000$ 150,000$ Direct labor 100,000 100,000 Manufacturing overhead:

Variable 200,000 $ 60,000 (1) 140,000 Fixed 50,000 31,000 (2) 19,000

Cost to purchase 100,000 switches at$4 per unit: 400,000 (400,000) Totals 500,000$ 491,000$ 9,000$

(1) $200,000 - ($200,000 × 70%) = $60,000(2) $50,000 - $19,000 = $31,000


Incremental benefit (cost) of buying switches from outside source 9,000$ (see part a )

Add: Contribution margin from alternative use of factory space (10,000 units × $14) 140,000

Incremental benefit (cost) of buying switches from outside source (see part a) and using space to produce dimmers 149,000$

Introducing the alternative use of factory space only reinforces (does not change) the initial conclusion reached in part a. If management can use the factory space to generate an additional $140,000 of contribution margin by producing additional dimmers, a total benefit of $149,000 per year will result from buying switches from the outside source and using the factory space to produce dimmers.

Based upon the above analysis, management will save $9,000 by purchasing the switches from an outside source rather than making them.

30 Minutes, Medium PROBLEM 21.3BJAMES LIGHTING


a. Schedule showing contribution margin per machine-hour for each product:

Sales price per unit 300$ 150$ Less variable costs and

expenses:Direct materials 60$ 50 Direct labor 40 20 Variable manufacturing

overhead (2/3 of total) 48 16 Variable selling expense 62 25

Total costs and expenses 210 111 Contribution margin per unit 90$ 39$ Machine-hours required

3 1 Contribution margin per

30$ 39$

b.

30 Minutes, Medium

Model A Model B

PROBLEM 21.4BSUPERIOR INSTRUMENTS

machine-hour

Recommendation as to which product should be discontinued:

Model A should be discontinued because the contribution margin per machine-hour (the scarce resource in this case) is higher on Model B ($39) than it is on Model A ($30). The profitability of this enterprise will be aided by continuing production with the model that offers the higher contribution margin per machine-hour.

to produce one unit


a. Sell toConvert mail order Incremental

to High Def. firm Analysis500,000$ 40,000$ 460,000$ 200,000 0 (200,000) 300,000$ 40,000$ 260,000$

b.

c. (1)

(2)

25 Minutes, Medium PROBLEM 21.5BBOLD FACE

Incremental profit (loss)

Incremental sales revenue Incremental costs

Assuming excess capacity, Bold Face should convert the TVs to high definition and realize $260,000 in incremental gross profit computed in part a.

If Bold Face is already operating at full capacity, it probably should sell the standard definition TVs to the mail-order firm. If we assume that rebuilding the standard definition TVs reduces by 500 units the production of new high definition TVs, this option involves an opportunity cost of approximately $295,000 [$1,000 sales price of high definition TVs, less $410 unit cost, times 500 units). This opportunity cost exceeds by $35,000 the incremental benefit of rebuilding the TVs rather than selling them “as is.”

Sunk costs: The $150,000 incurred in manufacturing the standard definition TVs.

Out-of-pocket costs: The $200,000 that may be spent to convert the standard definition TVs to high definition.

Opportunity costs: The profit forgone on the production and sale of new products if rebuilding the standard definition TVs forces the company to reduce production of other saleable products.


PROBLEM 21.6BFIRE CODE

a. Incremental benefit of each option, in total and on a per-unit basis:Sell as Repackage Sell toScrap and Sell Foreign Buyer

Incremental revenue per unit 20$ 18$ 17$ Incremental cost per unit 6 2 0 Net incremental benefit per unit 14$ 16$ 17$ Multiplied by total number of units 80,000 80,000 80,000 Net incremental benefit for 80,000 units 1,120,000$ 1,280,000$ 1,360,000$

b.

(1)

(2)

(3)

There are legal and ethical issues regarding the option to sell the inferior units to the foreign buyer. If the packaging of these units clearly states that the life of the sensory cell is 2 years, when in fact the life is only 18 months, human lives could be in jeopardy, and the company may be liable for its negligence.

There may be opportunity costs to consider such as alternative uses of production capacity other than its use to repair or repackage the defective units.

Based solely on this analysis, Fire Code should sell the detectors to the foreign buyer.

25 Minutes, Medium

Note: The unit costs given in the problem are not relevant because they are sunk costs.

There are several nonfinancial issues that management should consider:

If the packaging of each unit was changed to inform buyers that the sensory cells have a life of 18 months, this may cause confusion for those familiar with the 2-year life of a normal sensory cell.


PROBLEM 21.7BVITAMIN BITS COMPANY

a.

B1 B3 B15

Sales value if sold at the split-off point 110,000$ 100,000$ 90,000$

Sales value if processed further 200,000 180,000 110,000 Incremental cost of further processing 50,000 60,000 21,000 Incremental proceeds if processed further 150,000$ 120,000$ 89,000$

Incremental benefit (cost) of further processing 40,000$ 20,000$ (1,000)$

b. Minimum price per pound needed to sell B3 at the split-off point:

Final sales value if processed further 120,000$ Sales value at split-off point 100,000 Additional benefit needed to sell at split-off point 20,000$ Divided by: Number of pounds ÷ 5,000Incremental benefit per pound needed to sell at split-off point 4.00$ Add: Current price per pound at split-off point ($100,000 ÷ 5,000 pounds) 20.00 Minimum price per pound needed to sell at split-off point 24.00$

There is an incremental benefit associated with the further processing of B1 and B3, as shown above.

25 Minutes, Medium


PROBLEM 21.8BHOME RUN CORPORATION

a.

Bats Gloves BallsSelling price 48$ 80$ 12$ Direct labor 8 24 4 Direct materials 14 10 1 Variable overhead 1 1 1 Contribution margin per unit 25$ 45$ 6$

Direct labor hours per unit (direct labor costper unit ÷ $8 per hour) 1 3 0.50

Contribution margin per direct labor hour 25$ 15$ 12$

Total hours required to meet demand of60,000 units, 20,000 units, and 100,000units for bats, gloves, and balls, respectively 60,000 60,000 50,000

b. The least profitable product (balls) may, to a limited extent, create a demand for bats and gloves. Since the company is at full capacity, it is not interested in further support of its product unless capacity is increased. The company should spend its greatest effort on expanding capacity, then marketing will follow.

20 Minutes, Medium

To maximize operating income, the company should produce those products that provide the greatest contribution margin per unit of scarce resource (direct labor hours). Thus, as shown above, it should produce bats, which have a contribution margin per direct labor hour of $25. However, to do so would use the entire 60,000 hours of direct labor available, leaving no labor hours for the production of gloves or balls.


SOLUTIONS TO CRITICAL THINKING CASES

CASE 21.1I KNEW THAT

1.

2.

3.

35 Minutes, Medium

The doctor’s or dentist’s time (direct labor) is the limiting factor. (This is why most doctors no longer make “house calls.”)

To increase contribution margin per hour, the practitioner tries to see as many patients as possible. This involves scheduling appointments well in advance to ensure that each day is “fully booked.” (Many physicians tend to “overbook,” which explains why they may be running late and the “waiting room” is crowded.)

By having multiple examining rooms (or dental chairs), the professional can schedule several appointments for the same time slot, allowing nurses (or dental hygienists) to perform many of the routine procedures. Perhaps the doctor will actually be in each room for only a few minutes out of a 15- or 20-minute appointment.

Another strategy is to promote “take-out” orders, which allows the restaurant to serve more people than it can seat.

With today’s computerized checkout stands, there is almost no limit to the number of customers a supermarket can service. Thus, the factor that limits its output is its ability to deliver products, which—in turn—is limited by shelf space. (This explains why modern supermarkets are so large.)

High-technology equipment also may assist the professional in performing procedures more quickly.

Seating capacity is the factor that limits restaurants’ potential output. One means of increasing contribution margin per seat (or table) is to promote sales of the highest-margin products, such as beverages and desserts. Another is to speed up the “turnover” at each station through faster service and rapid food preparation techniques.

Many restaurants use “peak pricing” strategies. This means charging higher prices when the restaurant is most crowded (such as the dinner hour), and lower prices to bring in customers during the slower parts of the day (such as “happy hour” and “early-bird” specials).

Restaurants operating near full capacity often do not accept reservations, because this often results in the reserved tables standing vacant for more time than necessary.

© The McGraw-Hill Companies, Inc., 2012Case 21.1

CASE 21.1I KNEW THAT (continued)

4.

5.

For a market of any given size, there are several strategies for increasing contribution margin per square foot of shelf space. An obvious strategy is to sell more of those products with the highest profit margins. These products might be placed at the front of each aisle, near the checkout stands, or near the “basic” products, such as milk and bread. In this way, the high margin products will be seen by more shoppers.

But of even greater importance than the contribution margin per unit is turnover. Some items can “turnover” their shelf space several times each day.

The key to rapid turnover is twofold—first, attract more customers. This is done largely through advertising, low-price specials, “double-coupons,” and other sales promotions. Second, never run out of product. This involves scheduling merchandise purchases to ensure adequate supplies, and constantly restocking the shelves to keep merchandise available to shoppers.

The output of many residential builders is limited by available land. Contribution margin per acre is increased by building higher density projects, meaning more housing units per acre. This is accomplished by smaller lot sizes, attached units, and—where land is extremely scarce—high-rise construction.

In the service department of an auto dealership, skilled labor hours (mechanics’ time) usually is the factor limiting potential. Output per hour can be increased by providing mechanics with highly automated equipment, such as impact tools and computer diagnostic equipment. In addition, time can be saved by simply replacing nonfunctional parts rather than attempting to repair them. Piecework compensation—that is, paying mechanics by the job, rather than by the hour, also may increase the number of jobs mechanics complete during a day.

Note to instructor: Many garages charge customers for “standard” labor hours, published in an industry guidebook, rather than for actual labor hours. The published standard hours do not assume that the mechanic is a specialist with respect to the make of car or specific type of repair, nor that the mechanic has access to anything other than standard types of tools. Thus, mechanics in auto dealerships can effect repairs in substantially less than standard times. (This is why you can bring in your car at 8:00 a.m., pick it up at noon, and still be charged for seven hours’ labor.)

Also, the contribution margin per acre is increased by building “upscale” projects, which provide higher contribution margins. (This explains why “affordable housing” developments tend to be built only in areas in which land is readily available.)

© The McGraw-Hill Companies, Inc., 2012Case 21.1 (p.2)

CASE 21.1I KNEW THAT (concluded)

One might question the ethics of this practice. Actually, we see nothing wrong with charging the customer a standard price for repair. In fact, we encourage it—providing the customer is given a fair estimate in advance. However, we consider it unethical to mislead the customer to believe a repair took much longer than it really did.

In effect, standard times enable dealers to bill customers for more labor hours than the mechanics actually work and to benefit substantially from special tools and other strategies that increase the mechanics’ actual output.

© The McGraw-Hill Companies, Inc., 2012Case 21.1 (p.3)

CASE 21.2MCFRIENDLY SOFTWARE

a.

b. (1)

(2)

c.

d.

The $10 million opportunity cost of not accepting Jupiter’s offer is known to McFriendly’s management at the time of making the decision. However, the opportunity cost of accepting the offer—that is, the profits foregone by not producing and marketing the software—can only be estimated.

There are unlimited opportunity costs, just as there are unlimited alternative possible courses of action. For example, McFriendly’s management might consider such alternatives as developing and marketing the software in a joint venture with Jupiter, licensing the software to Jupiter for a percentage of Jupiter’s sales of the product, selling the software rights to someone other than Jupiter, or marketing the software through channels other than mail order. Every possible alternative course of action has its own opportunity costs. Thus, management wants to be sure that it is aware of the most profitable alternatives.

15 Minutes, Medium

Yes, the $10 million is “relevant” because it represents revenue that varies between alternative courses of action. If the software rights are sold, this $10 million will be received; if they are not sold, it will not be forthcoming.

If McFriendly accepts Jupiter’s offer, its opportunity cost will be the profit that it might have made by producing and marketing the software itself.

If McFriendly turns down the offer, its opportunity cost is the $10 million that it could have received by selling the rights to the software.

Opportunity costs relate to the action not taken, rather than the action that is taken. Thus, opportunity costs are not recorded in the accounting records.


CASE 21.3

INTERNET

a.

b.

c.

Specific incremental decisions may vary by product line, but would likely include special order, make or buy, and joint product decisions.

A likely limiting resource would be the production capacity of existing machinery.

One important qualitative factor that should be considered is the impact of a particular product or process on the environment.

20 Minutes, Easy

THE DOW CORPORATION


20 Minutes, Medium CASE 21.4SEC ENFORCEMENT FINES

Answers among groups will vary significantly. However, some of the relevant costs and earnings that should be mentioned include the impact that reported financial statements will have on the manager’s future out-of-pocket costs and future earnings potential. For example, if the manager has stock options or bonuses tied to reported earnings these type of incentive systems may motivate managers to commit accounting fraud to keep the stock price high (or allow them to earn their bonus) by keeping the accounting earnings fraudulently high.

In addition, students might discuss the opportunity cost to the manager of getting caught. The SEC policies and processes can create significant opportunity cost for the manager. Fines and potential jail time have immediate impacts on the manager’s cash flows. Another opportunity cost relates to the damaged reputation of those involved in the fraud. The impact on the manager’s future earnings’ potential could be enormous.

Finally, it is debatable whether having objective measures for SEC penalties will have any impact on management fraud. If managers do not recognize (or if they discount) the opportunity cost of getting caught, it is unclear whether objective measures for the type and level of an SEC fine will enter into the decision processes of those managers.

ETHICS, FRAUD & CORPORATE GOVERNANCE


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