CHAPTER 6 DECISION MAKING IN THE SHORT TERM SOLUTIONS REVIEW QUESTIONS 6.1
The temporary gaps between the demand and supply of available capacity.
6.2
The maximum volume of activity that a company can sustain with available resources.
6.3
Because organizations make capacity decisions based on the expected volume of operations over a horizon spanning many years. They build plants, buy equipment, rent office space, and hire salaried personnel in anticipation of the demand for their products and services.
6.4
(! "ecisions that deal with excess supply. #xamples include reducing prices to stimulate demand, running special promotions, processing special orders, and using extra capacity to make production inputs in$house% (&! "ecisions that deal with excess demand. #xamples include increasing prices to take advantage of favorable demand conditions, meeting additional demand by outsourcing production, and altering the product mix to focus on the most profitable ones.
6.5
This method focuses only on those costs and revenues that differ from the benchmark option.
6.6
This method considers the gross revenues and associated option. with each option, rather than the incremental amounts relative tocosts the benchmark
6.7
The totals approach requires more computations because it includes some noncontrollable benefits and costs.
6.8
'n decisions involving many costs and benefits it helps us ensure that we do not )forget* to include a relevant cost or benefit.
6.9
#xcess supply usually, the firm cuts prices to stimulate demand.
6.1
'n a make or buy decision, the firm is deciding whether to make a product, or piece thereof, internally or outsource and buy them from a supplier.
6.11
+hen demand is high and a resource is in short supply.
6.12
To maximize profit when capacity is in short supply, maximize the contribution margin per unit of capacity.
6.13
Typically on a qualitative basis by considering how customers, suppliers, and competitors might respond to the decision being made.
;$& DISCUSSIONQUESTIONS 6.14 es, the definition of what is short$term and what is long$term depends on the business context. -or eneral /otors anywhere from few weeks to a few months may be considered short$term, as pricing and promotion decisions depend on how fast different models of cars and trucks are moving from the dealers0 inventories. -or a baker, a day or two days may be too long as baked goods do not retain their )freshness00 for long. Thus, product characteristics often play a critical role in determining how )long* the short$term horizon is. 6.15 The reason why the lots are overflowing is that are not being sold at to the expected rate. 1nsold vehicles occupy space in vehicles the lot. Thus, it is not correct define capacity in terms of the lot space available. 2ather, capacity should be defined in terms the number of vehicles that can potentially be sold per day. +hen demand falls short of supply based on the anticipated number of vehicles to be sold per day, lots overflow, and price$cutting and other promotions become necessary to move the vehicles. 6.16 2aising prices, when unexpected demand for any product or service creates temporary shortages, can often hurt businesses in the long run because such actions can create customer ill will and lead to a loss in reputation. This is especially the case when it comes to emergency situations. Think of how you will feel when a grocery store that you frequent in your neighborhood raises prices on bottled water as you prepare to deal with an approaching 3ategory 4 hurricane5 6.17 /ost of us drive to work, and so the demand for gasoline is fairly stable. 6ne way to economize on gasoline consumption is to car pool effectively with your colleagues or others that work near where you work. 6.18 es, it is. The gross method considers all cash inflows and cash outflows that are associated with the options being considered in the context of a particular decision, even though some of them may be non$controllable. But, it does not consider cash flows associated with many other decisions that the companies may be considering. -rom an overall organizational standpoint, each decision has an incremental effect, and, therefore, the gross method is also incremental when viewed in this context. 6.19 'ncreasing prices is a natural way of decreasing demand. 'n fact, in most market settings, demand for a product decreases as its price increases. +hen a firm does not have enough capacity to meet a sudden spurt in demand, it can reduce the demand by increasing prices and )turning away* some customers to a point where the demand can be met. The airline industry is a good example. 'n peak times, an increase in airfare induces some travelers to seek other means of travel or postpone their travels. 6nly those that are able to afford the higher prices, or have rigid and
noncancelable schedules, will continue to travel. 7irline companies usually face no long$term adverse implications from increasing prices to deal with peak demand situations. 7ir travelers usually understand this Balakrishnan, /anagerial 7ccounting e
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;$? behavior and plan their travel accordingly. 6n the other hand, consulting companies rely on longstanding relationships with their customers. 2aising their rates when their business is good usually backfires because it hurts reputation and goodwill in the long$run. 6.2 es, it does. This is typically referred to as )production smoothing* and makes good business sense as long the product is storable for sale in the future period, and as long as inventory carrying costs are manageable. The toy industry and the apparels industry are good examples. 6.21 3ompanies can produce and stock up during periods of lean demand to be ready for peak periods whenever demand outstrips capacity.
supply is undesirable. To avoid such situations, it makes more economic sense to install excess capacity in other resources. 6.24 +hen a resource is in short supply, and it is used in a lumpy manner, calculating contribution margin per unit of the resource to allocate its use to various products is at best approximate and can often lead to wrong decisions. 7dvanced techniques such as integer programming may have to be employed to come up with the right way to allocate scarce resources to products in such settings. 6.25 >roducts requiring minimum production quantities involve committing requisite amounts of capacity to these products if they are chosen production. +henever capacity is in short supply, such products may well necessitate leaving out products with higher contribution margins per scarce capacity unit in order to meet their minimum production requirements. The alternative is to not lock up capacity by scheduling such products, but instead use the capacity to schedule products that yield lower contribution margins per unit of the scarce capacity resource. The
consequent trade$off will determine whether it is profitable to make products with minimum production requirements.
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;$4 6.26 6utsourcing reduces the amount of capital that needs to be invested in capacity resources. 't reduces the fixed costs in the cost structure, but increases the variable costs. 'n other words, outsourcing increases the operating leverage. 1nit variable costs are usually higher with outsourcing relative to in$house production because the profit margins of suppliers are part of the variable costs with outsourcing. Therefore, unit contribution margins are usually lower with outsourcing.
course. 6.27 Test marketing is a way to minimize risk associated with large investments. 6ffering a new product often involves putting in place and committing to various organizational resources. 6nce the product is launched it is often extremely costly to cut back should the product fail. >lants and offices have to be closed down and people have to be fired and so on. 2isk of failure is an inherent part of business, and products do fail. But one way to reduce this risk is to do a small scale launch aimed at representative customers. 'f this test marketing effort fails, then a larger scale launch is unadvisable. /oreover, feedback from the test market is often useful in redesigning the product to reduce the risk of failure subsequently. 6.28 #mployee morale is an important factor in outsourcing decisions, especially if outsourcing is a sign of things to come. :oss of morale leads to a loss in productivity which might make outsourcing even more attractive. The company may lose talented and experienced personnel, who may prefer =obs elsewhere to being fired. /anagers therefore have to be clear about the impact of outsourcing on employee morale so that they can make the appropriate trade$off between immediate cost savings from outsourcing and longer$term adverse impact of a loss in morale. 3ertain critical activities are better done in$house for strategic reasons, while others can be outsourced.
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;$F
E!ERCISES 6.29
a. 7=ay0s decision deals with excess demand. "ue to the holidays, 7=ay expects a surge in gift$wrapping needs. To handle this surge, 7=ay is considering hiring a helper. This is akin to a manufacturing firm outsourcing some production in periods of high demand. b. :et us calculate profit @ revenues variable costs fixed costs. +e can construct the entire 3A> model for 7=ay. +e then compare the profit under each option, selecting the option with the higher profit. +ith the information provided, we have
"aily revenue (D? × ;C% D? × C! "aily variable costs (D × ;C% D × C! "aily pay for help (C% DE.FC × C! "aily contribution 2ow rows & G ? Total contribution 2ow 4 × ?C Total fixed costs iven >rofit
+ithout
er day DEC.CC ;C.CC C.CC D&C.CC D ?,;CC.CC ;CC.CC "3#.
+ith
3omparing the total profit, we find that 7=ay0s profit increases by "45 (D?,4FC D?,CCC! for the season, if he hires the helper. 7ccordingly, if he wishes to maximize profit then 7=ay $%&'() %*+, -%, %,(,+. 'n constructing the income statement for each option, we could leave out the non$ controllable fixed costs of D;CC. +hile the absolute profit numbers would change, the difference in profit would be preserved. Thus, the gross approach provides decision makers some flexibility in terms of what is included and excluded from the income statement. c. 1nder this approach, we compute only the incremental revenues and costs associated with a particular decision option relative to the status quo. 9ince operating without the helper is the status quo, we have
'ncremental revenue 'ncremental variable cost (packages!
FC packages per day × D? FC packages per day × D
'ncremental cost (helper! 'ncremental profit per day V/(', &0 %*+* %,(,+
DE.FC × C hours
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DF × ?Cdays
DFC FC DF
EF "45
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;$; 7gain, we see that 7=ay increases monthly profit by "45 if he hires a helper. The difference in profit derived with controllable cost analysis exactly equals the difference in profit under the gross approach. This underscores the equivalence of the two approaches.
a. /agic /aids0 decision appears to feature both excess supply and excess demand. 't is likely that /agic /aids fixed overhead costs (rent and administrative will notcapacity change to due to thethe special =ob itisappears there is enoughsalaries! administrative handle =ob. There excess that demand for cleaning supplies% if the current =obs do not use up available stock, the firm could store the supplies for use later. -inally, there might be limited excess capacity for some resources. 'f ;CH of the =ob could be completed during normal business hours, then the company clearly has some slack and excess capacity in terms of labor hours. -or the remaining 4CH of the =ob, however, /agic /aids0 employees will have to work overtime thus, there is excess demand for this input. This shows us that different resources in the firm have differing capacity levels a decision may impose constraints on one resource but not another. +e have to consider the opportunity cost of each resource when computing the total cost of a =ob. N&-, 7 precise definition of capacity is at the level of individual resources. Thus, when computing the cost of an option, we have to consider opportunity costs at the level of individual resources.
b. The following table details the incremental cost associated with cleaning the FC offices, compared to the status quo of not cleaning the offices
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;$K 'tem 3leaning materials :abor Aariable overhead 'ncremental cost
"etail FC offices I J&.FC per office FCI?I.4CIFI.F FC offices I JK.FC per office
7mount J,EKF J4,CFC J,&F 7#5
There are FC offices that need to be cleaned, and each office requires ? hours to clean. 9ince ;CH of the =ob could be completed during regular business hours, /agic /aids will only have to provide extra remuneration for 4CH of the hours. -urther, employees are paid .FC times their hourly wage of JF for each overtime hour worked.
8ote that fixed overhead, which is comprised of rent and administrative salaries, is not relevant as it is very unlikely that the total amount of fixed overhead will change if /agic /aids accepts the engagement. /agic /aids incremental costs associated with cleaning the conglomerates FC offices amount to 7#5. c. /agic /aids can use the cost number for pricing the local conglomerate0s request to clean the FC offices. JK,CFCLFC @ J4K per office likely would represent the minimum price that /agic /aids would charge. This price is well below /agic /aids normal price of J&C. The actual price charged will consider other factors. -or instance, the client0s other options become relevant. 'f this is a one$time deal with no prospect of repeat business, then /agic /aids might well charge a premium over the normal price. The prospect of )getting a foot in the door* to bid for future business would push the price downward. :ong$term implications also matter. 'f the conglomerate becomes part of /agic /aids client base, then the company likely would wish to make sure that the price charged in the long term would cover all incremental costs (measured over the long term!, and not only the incremental costs measured over the short$term. 6.31
a. +hile set in a service setting, this is a classic example of an organization that has excess capacity and is attempting to figure out how to price a special order. 't is like having open seats at a sporting event it appears that the rooms would otherwise remain idle if #rin and Myle do not accept the customer0s offer. b. Because the rooms would otherwise remain idle, the lost profit associated with turning down the customer is D&CC (? × DC! @ DKC per customer, for a total of DKC × 4 @ "78 0&+ 0&'+ '$-&,+$.8otice that the standard rate of DEC
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;$E per day is not relevant for computing this amount. #rin and Myle might be concerned that renting the rooms for a substantial discount will tarnish the image of their 'nn or adversely affect weekend (or other! rentals. 't is unlikely that this will occur because )time$based0 pricing is very common.
6.32
a. Nen0s decision deals with excess supply due to the reduced demand for her work, Nen finds herself with time to spare. b. Nen0s variable cost of 0+/* %,+ & &+ *$ "3@ DC × ?C.
c. Nen0s problem is now more complex. By outsourcing the framing, Nen is able to produce and sell an additional F prints% in turn, these prints generate an additional contribution margin of DKF D&F D E @ D4& per print or D4& × F @ D;?C in total. 2ightfully, we should add this amount to the cost of framing of DCC per print or DCC × F @ DFC for F prints, to obtain a total framing cost of DFC O D;?C @ DKEC. 8ow, we see that Nen prefers to use the framing shop rather than do her own framing. +hat does our answer changeP 3ompared to part QbR, Nen does not have enough idle time to keep up her current volume of prints and do her own framing. Thus, Balakrishnan, /anagerial 7ccounting e
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;$S the problem switches from one of excess supply (where we assumed the opportunity cost of Nen0s time to be DC! to one with excess demand, where we find the opportunity cost of Nen0s time to be D;?C. The nature of the imbalance drives Nen0s preferred solution. N&-, 7 superior option is to frame some but not all of the prints. 1sing the notion of allocating time per the contribution margin per unit of the scarce resource, we could derive this formally. 6.33
a. The following table provides the estimated profit impact at the two prices considered 'tem
2evenue from service (4CC I DF% ?CC I DC! 2evenue from new members (&C I DCC% C I DCC! 3ost of new members (&C I D?F% C I D?F! 3ost of valet service (given! 8et profit
>rice for valet parking DF per DC per month month D&,CCC D?,CCC &,CCC
,CCC
KCC
?FC
&,FCC
&,FCC
"8
D,FC
Based on the above estimates alone, Tom and :ynda should offer the valet service and price it at DC per month (not DF!. >lease note the tradeoff between price and quantity. 7t a lower price, the feature has more takers. This tradeoff depends on how much demand (for different products! changes as price changes. The tradeoff from increasing price is favorable if we consider the revenue from current members only. lease also note that we are not considering any change in the club0s fixed costs from adding new members. 7s we know from the earlier chapters,
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;$C inconvenienced, leading to some lost memberships. 9econd, we have to consider if the service sets the club on the path of tiers of members, which feature has both costs and benefits.
6.34
a. Tom and :ynda0s decision turns on alternate uses for the space, or its opportunity cost. The problem indicates the room is unused during this time. There is minimal disruption of operations. 'ncreases to direct costs, if any, are small. Thus, the D;CC offered by /ar=orie would flow directly to profit. ualitatively, the service might even attract new membersUfor example, the expectant women might wish to use the swimming pool or the sauna to relax, and see
DCC (DECC!
DKCC$D;CC E I DCC
D&EC <"42=
E I D?F
Based on the above, adding the evening class is an unwise move. Balakrishnan, /anagerial 7ccounting e
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;$
8otice that the value of the daytime only option is D;CC (as calculated in part QaR.! The incremental value of the evening class, relative to the daytime class, is a loss of D4&C, as calculated above. 7dding these two numbers together, leads to DEC, the value (relative to status quo or doing nothing! for the evening option. 6.35
9imilar to the 9uperior 3ereals problem in the text, the key to this problem is to realize that the variable costs associated with manufacturing the greeting cards are sunk thus, they are not relevant to "V=W Au0s decision. 7dditionally, "V=W Au0s fixed costs arethe non$controllable decision, as they are not expected to change. Thus, problem is onefor ofthe revenue maximization. 7t a FCH off sale, "V=W Au0s profit increases by DC.FC I ,FCC @ DKFC. 7t an ECH off sale, "V=W Au0s profit increases by DC.&C I 4,CCC @ DECC. Thus, "V=W Au maximizes its profit by holding the ECH off sale, even though the resulting price is below the DC.&? (@ DC.FODC.CE! in variable costs associated with producing and selling a card. +hat we need to remember is that this is the variable cost of a card yet to be produced, not a card that has already been produced. N&-,> This problem links to a common business practice. 9pecifically, we often observe stores employing a staggered discounting strategy the store starts with, for example, a &FH discount and increases the discount rate over time (perhaps by
as much assurplus F$&FH a week!. 'n this the store attemptscustomer to capture as much consumer (gross revenue! asway, possible by grouping types according to their willingness to wait and run the risk of having the item selling out. 9uch a strategy may work quite well for "V=W Au i.e., the company could sell the first ,FCC cards at DC.FC and 4,CCC ,FCC @ &,FCC cards at DC.&C. By employing such a strategy, "V=W Au could earn #xpected >rofit @ (DC.FC I ,FCC! O (DC.&C I &,FCC! @ D,&FC. This amount represents a D4FC (@ D,&FC $ DECC! increase over its best option. 6.36
a. 1nder the gross approach, we include all of the costs connected with each decision. +e do not worry too much about whether they are controllable or not.
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;$& 1sing the gross approach, we arrive at the following per$person, round$trip cost of driving
'tem 7utomobile$related costs 3ost of refreshments
"etail DC.?C per mile I ECC miles I & segments D&C per person per segment I F persons I & segments
Total 3ost
3ost per >erson DS;
Total 3ost D4EC D&CC
D4C
D;EC
"136
The following table summarizes the per$person, round$trip cost of flying
"etail 'tem 7irlineticket 3ost of refreshments 3ost of travel to and from airport Total 3ost
Total3ost
D;SIFpersons DF per person per segment I F persons I & segments D; per person per segment I F persons I & segments
3ost per >erson
DE4F DFC
D;S DC
D;C
D&
DSFF
"191
't is DS D?; @ "55 ,+ ,+$& %,/,+ -& )+*:, -%/ -& 0(;. -rom a cost structure perspective, the bulk of the savings obtain because the auto$related costs are fixed. The automobile operating costs will be DC.?C per mile, or D4EC in total for the round$trip, regardless of the number of persons traveling. 9plitting this cost five ways results in a relatively low cost per person. 'n contrast, the cost of airfare is variable with respect to the number of persons traveling. There is no )scale economy* that results. 7lternatively, with the airline trip, the cost is DS for each person traveling, regardless of the number of people. 'n contrast, the additional cost for person X& in the auto trip is only D&C each way the remainder of the cost is committed even if only one person is traveling. The scale economy for driving results because the cost structure contains more fixed and less variable cost (per person! than the amounts for flying.
N&-,: This problem also highlights the subtle distinction between the timing of cash flow and cost. The immediate cash outflow connected with flying will equal
the number computed above.
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;$? need not coincide with the duration of the trip. 8aturally, costs related to gas (which are included in the DC.?C per mile rate! will lead to immediate cash outflows. b. The key here is to realize that the per$person cost of flying will not change even though the group0s size has changed. The entire cost of flying is variable with respect to the number of persons traveling. Thus, the total cost will change, but the per$person cost (DS! will be the same regardless of group size. This can readily be seen in the following table
'tem 7irlineticket 3ost of refreshments 3ost of travel to and from airport Total 3ost
"etail D;SI&persons DF per person per segment I & persons I & segments D; per person per segment I & persons I & segments
Total 3ost D??E D&C
3ost per >erson D;S DC
D&4
D&
D?E&
"191
The per$person cost of driving, however, will change.
"etail DC.?C per mile I ECC miles I & segments D&C per person per segment I & persons I & segments
Total 3ost
Total 3ost D4EC
>erson D&4C
DEC
D4C
DF;C
"28
't is now cheaper to fly than to drive. The logic essentially is the same as in part QaR. -rom a cost structure perspective, the cost of driving is essentially fixed in other words, it will be DC.?C per mile, or D4EC in total for the round$trip, regardless of the number of persons traveling. 9plitting this cost only two ways, rather than five ways, results in a relatively high cost per person. 'n contrast to part QaR, you are not taking advantage of the potential scale economies associated with driving. N&-,: 'nstructors also can relate the above discussion to the rationale for a monopoly, as discussed in students0 economics courses. +hat is the scale economy associated with a cable company or an electric utilityP
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;$4 c. There are numerous other factors that might come into play regarding this decision, including the following three •
•
•
-rom an en=oyment perspective, the trip is potentially a great deal more fun, if you drive together rather than fly separately (i.e., road trip5!. #ach method offers differing types of flexibility. "riving allows the group to plan around the weather, while internet$only tickets come with numerous restrictions and change penalties. "riving also provides you with available transportation at home over winter break.
d. +e characterize this problem as one of excess demand. /oney is the resource in short supply. Then, because the )revenue* is the same for both options, we wish to find the option that uses the smallest amount of the scarce resource, or equivalently, has the lowest cost. 6.37
a. :et us begin by calculating relative sales values. ravel 9and Total
S,CCC tons I C.E I D?C S,CCC tons I C.& I D4C
D&;,CCC DK&,CCC D&EE,CCC
Thus, KFH of the =oint cost (@D&;,CCCLD&EE,CCC! would be allocated to gravel and the &FH to sand. +e have the cost allocated as C.KF I D&&F,CCC @ D;E,KFC and C.&F I D&&F,CCC @ DF;,&FC. 7lternatively, we can calculate the rate per sales D at the split off as D&&F,CCCLD&EE,CCC @ DC.KE&F. +e then allocate D&;,CCC I DC.KE&F @ "168#75 to gravel and DK&,CCCI C.KE&F @ "56#25 to sand.
b. +e know that only incremental revenues and costs are important for this decision. :et us therefore calculate the net gain from processing the sand further. Aalue of sandbox quality :ost value at split off
SCC tons I D;C S,CCC tons I C.& I D4C
D44,CCC DK&,CCC
8et gain in revenue 3ost ofadditional processing 8et value
given
DK&,CCC (DE,CCC! "54#
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;$F Thus, M;,+$ $%&'() +&,$$ -%, $/) /- $(*- &00 *-& $/)?& @'/(*-; $/) ?,/'$, *- *+,/$,$ +&0*- ?; "126#1 "72# B "54#. 8ote The important point to note is that the =oint cost, or how it is allocated, is not relevant for the decision in QbR. That =oint cost is sunk for this decision. These allocations are usually done only for the purpose of valuing inventory. 6.38
/ihir has two options (! run the promotion or (&! do not run the promotion. 6ption (!, or not running the promotion, is the status quo. +e can then answer the question costs regarding whether /ihir should runrunning the promotion by calculating the incremental and revenues associated with the promotion. Based on the information provided, the incremental revenues and costs are "ecreased ticket sales (&CC tickets Y D?.SF per ticket! (DKSC! 'ncreased profit from concession stand 8umber of customers &FC @ FCH of FCC 7veragerevenue D;.CCperpatron 'ncreased concessions sales (&FC patrons Y D;.CC per patron! D,FCC 7veragecost DC.SC@C.F × D;.CC 'ncreased concessions cost (&FC patrons Y DC.SC per patron (D&&F! 8et profit D,&KF Aalue of promotion
D4EF
/ihir should run the promotion as weekly profit is expected to increase by D4EF. N&-, This problem is one of excess supply as /ihir has available seats during the matinee shows. 6.39
a. 6ne approach is to construct a profit model for the laser tag arena, a profit model for the video arcade, and a profit model for :azer:ite as a whole. This problem, though, lends itself nicely to employing an incremental approach. Because we know the status quo, we can figure out controllable costs and revenues. -rom reg0s perspective, we can delineate the following incremental benefits and costs 'ncrease in contribution margin from customers attracted by after$school special @ FCC I (DF.CC D?.CC! @ D,CCC "ecrease contribution margin from losing customers paying normal price @ ?CC I (DK.FC inD?.CC! @ D,?FC
D&;,CCC @ Aalue of sandbox quality minus further processing costs @ D44,CCC $ DE,CCC.
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;$;
'ncremental fixed costs @ DFC The overall effect is to ),+,/$, -%, (/$,+ -/ /+,/ +&0*-/?*(*-; ?; "5 ,+ ,, @ D,CCC D,?FC DFC. Thus, from reg0s standpoint the after$school special probably is not such a hot idea. The annual profit of the laser tag arena will decrease by DFCC I F& weeks @ "26#. 8ote 't is alsois,possible to employ solve thethe problem by computing profit under the two options. That we could gross approach. 1nderthe this approach, profit reported decreases from D?,ECC per week to D?,?CC per week. b. -rom :azer:ite0s perspective, we also need to consider the effect of the after$ school special on the video arcade. The effect on the video arcade can be calculated as follows 'ncremental profitarcade @ (net increase in laser tag customers I .KF! I Q;.CC (.C I ;.CC!R @ (&CC I .KF! I (;.CC .;C! @ "81 *+,/$, ,+ ,,. Thus, L/,+L*-, /$ / %&(, *+,/$,$ ,,(; +&0*-$ ?; "31 ,+ ,,@ DEC DFCC, or approximately D?C I F& weeks @ "16#12 ,+ ;,/+. 3onsequently, the after$school special is a profitable move for :azer:ite as a whole. The key point of this exercise is to emphasize that we cannot look at each product in isolation (e.g., laser tag sales only! when the business model has considerable product interdependencies. /oreover, numerous laser tag operations attempt to lure customers in with the hopes that they will spend considerable sums of money on video games and other ancillary activities. 6ther examples of this behavior include software firms giving away the reader (e.g., 7dobe 7crobat! in the hope of making money selling the writing software. This idea of a loss leader, covered in microeconomics, often occurs in casinos (cheap food and free drinks! and supermarkets (low milk prices! or restaurants (kids eat free!. N&-,> reg0s compensation arrangement appears to be misaligned with the company0s goals. To this end, :azer:ite probably is better off if reg0s compensation is linked to overall company profitability. 'n this way, reg will not believe that he is competing for customers with the video arcade.
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;$K
6.4
a. Based on the problem data, erry has two options (! 3ontinue with the current arrangement of using the upstairs space for music lessons, or (&! 3onverting the upstairs space to retail space. 6ption (! is the status quo, and evaluating option (&! relative to the status quo yields 'tem 2evenue from new space Aariable costs from new space 3ontribution margin from retail space $ 2evenue from cubicle rentals
$3ostofadditionalsalespersons $7dditionalfixedcosts I+,/$, * +&0*-
"etail FC square feet I DF,CCC per square foot
Total DKFC,CCC
DKFC,CCC I KFH variable costs DF;&,FCC DKFC,CCC I &FH contribution per D of revenue DEK,FCC ; cubicles I 4C rentals per week I FC weeks per year I DF ;C,CCC per rental &IFC,CCC CC,CCC DC,CCCDK,FCC &,FCC "25#
6ur calculations reveal that erry0s profit will increase by D&F,CCC if he decides to convert the upstairs to retail space. 'n arriving at this solution, notice that the contribution margin from the existing retail space is not included because it is assumed to be the same with and without the remodel. 7dditionally, the cost of existing sales persons is also constant in the decision to remodel as are the downstairs fixed costs of DS&,FCC (@ DCC,CCC DK,FCC!. b. 6ftentimes, decision makers need to consider the implicit assumptions contained in the numerical computations. The following assumptions seem particularly important •
•
The lessons must surely generate a lot of goodwill and traffic through the store. They also help erry keep himself in the )loop* of the music business in the city. 3losing the cubicles likely will trigger a loss in sales. 't is unlikely that the new space will have the same sales per square foot. 'ndeed, closing the cubicles may lower the sales in the existing space as well. The above computations also ignore the one$time cost of the remodel. erry0s decision has to incorporate whether the remodel will cost DF,CCC, DF,CCC, or DFC,CCC. The latter involves a much riskier gamble.
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;$E •
6.41
a. The key is to realize that Nustin has ,,$$ ),/) as the pumps currently use all available capacity. Thus, taking the order requires Nustin to give up some pumps. 7t FCC valves x ? hours per valve, the valve order will consume ,FCC hours. "ividing the total C,CCC hours available by the total production of &,FCC pumps, Nustin calculates that it takes 4 hours to produce a pump. 7t this rate, ,FCC hours can be used to make ?KF pumps. Nustin divides the D&F,CCC in monthly contribution by &,FCC pumps to calculate that each pump yields DFC in contribution margin. Thus, we have 3ontribution from Aalves :ess :ost contribution from pumps N,-%/*, +&0*-
FCC valves I D?C per valve DF,CCC ?KF pumps I DFC per pump E,KFC <"3#75=
Nustin will lose D?,KFC if it takes the order. The fixed costs of DKF,CCC (3/ of D&F,CCC profit of DFC,CCC! are not relevant for this decision.
Alternate approach +e could also solve the problem by examining the contribution per labor hour. #ach pump yields a contribution of DFC L 4 hours @ D&.FC per labor hour. 'n turn, each valve yields a contribution of only D?CL? hours @ DC per labor hour. 7ccepting the valve order diverts resources toward less profitable uses. Because ,FCC hours would be diverted, the loss is ,FCC hours I (D&.FC DC.CC! per hour @ D?,KFC. b. >rofit will be unchanged if valves also contributed DE,KFC to profit. Thus, the price per valve should be DE,KFCLFCC valves @ "37.5 ,+ :/(:,. 7lternately, profit will be unchanged if valves also contribute D&.FC per labor hour. 7s each valve consumes three hours, the minimum price is D&.FC x ? hours @ D?K.FC per valve. c. There are many potential qualitative factors. -irst, Nustin0s management has been trying to diversify into valves. This order might give them an opportunity to test out their production methods and establish their reputation for quality valves. The order might also help them learn the process and reap the cost gains from such learning. 9econd, the order might be the precursor to a larger order at better prices. Third, this might be an order from a large customer (for pumps!, prompting Nustin to accommodate the order even it means losing money. 't is difficult to estimate the monetary value of these considerations. 8evertheless, managers routinely make such tradeoffs everyday.
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;$S
6.42
a. The )traditional* allocation of a sales person0s &F hours would lead to the following revenue per month for a typical sales territory C'$-&,+ T;,
:arge /edium 9mall
&0 C'$-&,+$ C &F
&F
T*, T&-/( ,+ V*$*T*, Fhours FChours &hours FChours
hour
&Fhours
T*, L,0- KFhours &Fhours
C
R,:,', ,+ V*$*D4F,CCC D?C,CCC
T&-/( R,:,', D4FC,CCC DKFC,CCC
DF,CCC
D?KF,CCC "1#575#
Total Revenue Z @ (X of customers! × (Time per visit!. ZZ @ &F hours cumulative total time. Thus, the typical sales person generates monthly revenue of "1#575#. b. The key to Trey0s success is to realize that time is a scarce resource. 9ince sales persons cannot visit all potential customers, the revenue$maximizing strategy prioritizes customers by their revenue per hour of time (spent in visits!. 7s shown below, this ranking changes the traditional ordering of customers C'$-&,+ T*, R,:,', R,:,', ,+ T;, ,+ V*$*,+ V*$*H&'+ &0 T*, :arge F.Chours D4F,CCC DS,CCC /edium &.Chours D?C,CCC DF,CCC 9mall .Chours DF,CCC DF,CCC Thus, medium and small customers should get top priority because they generate DF,CCC in revenue per hour of time spent whereas large customers generate only DS,CCC in revenue per hour of time spent. 9uch an allocation leads to the following revenue per month C'$-&,+ T;,
/edium 9mall :arge
&0 T*, T&-/( C'$-&,+$ ,+ V*$*T*, &F &hours FChours FC hour FChours FZ Fhours &Fhours
T*, R,:,', T&-/( L,0- ,+ V*$*R,:,', KFhours D?C,CCC DKFC,CCC &Fhours DF,CCC DKFC,CCC C D4F,CCC D&&F,CCC "1#725#
Total Revenue
Z @ (X of customers! × (Time per visit!. ZZ @ &F hours cumulative total time.
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;$&C Thus, we see why Trey is 9uper9ound0s top sales person he generates revenue of "1#725#, or D,K&F,CCC D,FKF,CCC @ DFC,CCC more than other sales persons. /oreover, Trey optimally allocates his time across 9uper9ound0s customer base. 8ote "oes prioritizing by sales per visit hour maximize not only revenue but also company profitP The answer is )it depends* such a strategy also maximizes profit only if the contribution margin ratio is the same for all three customer types. 'f different customer groups order a different mix of products (resulting in different contribution margin ratios!, the firm needs to prioritize customers by their contribution per visit hour to maximize profit. 8ote (advanced! 'nstructors could also use this problem to underscore the agency conflict and choice of performance measures. -or instance, the provided solution of maximizing revenue might be optimal from the sales person0s perspective if their incentives are based on revenue.
a. The following table summarizes the quantitative analysis, or the net monetary benefit associated with accepting the assignment (compared to the status quo of not accepting the assignment! I-, D,-/*( -eefromnewassignment iven $7dditionaltuitioncost iven $ 9alary given up due to DC,CCC per month delayed graduation I 4 months 8et benefit to accepting offer
A&'DFC,CCC E,CCC 4C,CCC "2#
-rom a purely financial perspective, 3hristine should accept the assignment. 'n this context, notice that •
3hristine0s savings prior to entering the /B7 program and the amount of her loan are not relevant as they do not differ between her two decisions.
•
The D&,CCC a month in living expenses (e.g., rent, utilities, and groceries! is not relevant as 3hristine will incur this cost regardless of her decision. That is, 3hristine expects to spend D&,CCC a month in living expenses regardless of whether she is working or in college.
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;$& b. The net QimmediateR monetary benefit associated with accepting the assignment is somewhat small and likely is not large enough for 3hristine to accept the assignment. 3onsequently, 3hristine0s decision likely will hinge on qualitative considerations. 9ome qualitative considerations include •
"oes 3hristine desire to return to her old employer upon graduatingP 'f so, the prospects for doing so certainly increase if she accepts the assignment.
•
+ill the assignment help 3hristine land a better =ob by, for example, demonstrating how her /B7 degree has allowed her to go solo on pro=ectsP
•
+ill this assignment provide a nice change of pace from the grind of schoolworkP
•
+ill accepting the assignment unduly disrupt 3hristine0s /B7 studiesP 3hristine may worry about getting off track andLor being able to even take the same classes next trimester (i.e., some classes are only offered periodically! andLor graduating with her cohort (classmates and friends she developed in the first & trimesters!.
7ll in all, 3hristine0s decision is not clear cut.
a. 3harlie0s decision deals with ,,$$ ),/). There are competing demands for 3harlie0s time this evening, as he could either attend the Mnick0s game or have dinner with the important client. 3harlie cannot perform both activities this evening, giving rise to his dilemma. b. The price paid for the two tickets is sunk and is not relevant to 3harlie0s decision. The D;CC is spent regardless of whether 3harlie attends the game or has dinner with the client. /oreover, 3harlie faces the same tradeoff if he had found the tickets on the street or if he had paid D&,CCC for the tickets. N&-, 'n such decisions, many people do consider the price paid for the tickets, in seeming contradiction to the idea that a sunk cost is not relevant.
One explanation could be that the price paid is a good measure of the minimum opportunity cost of attending the game . (3harlie must expect to get at least D;CC worth of =oy from the game. +hy else would he pay that much for the ticketsP!. -rom a psychological perspective, having a readily available estimate of the lower bound for a qualitative cost may cause people to focus on the number as the opportunity cost.
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;$&& c. 1nless 3harlie can sell the tickets under the )dinner with the client* option, his decision hinges on qualitative factors. 3harlie needs to weigh the lost en=oyment from not being able to attend the Mnicks game against the cost of upsetting the client if 3harlie chooses to go to the game (and not have dinner with the client!. Both of these factors are qualitative the en=oyment from the game is a function of 3harlie0s interest in sports, who he is going with, the Mnicks0 chances of winning the series, and so on. 9imilarly, the cost of upsetting the client depends on the client0s personality, the volume of business, the client0s options, and so on. #ssentially, 3harlie has to sub=ectively determine which option has the greater utility per hour. 3harlie has a difficult decision to make. PROFLEMS 6.45
a. 'n this problem, it perhaps is easiest to construct an entire income statement for >ete0s >ets assuming he drops the birds and fish line and compare overall profit to that reported in the problem text. The following table computes the profit associated with the choice to discontinue selling birds and fish, and use the space to expand dog and cat offerings.
2evenue Aariable costs&
D&$ D&44,;C SK,;;4
C/-$ DFS,;CC 4K,EEC
T&-/( D4C?,K;C 4F,F44
3ontribution margin Traceable fixed costs? 3ommon fixed costs4 >rofit
D4;,4S; 44,CCC F&,FCC D4S,SS;
D,K&C ?C,;CC F&,FCC D&E,;&C
D&FE,&; K4,;CC CF,CCC DKE,;;
"og revenue @ D&E,CCC DFS,;CC.
×
.& @ D&44,;C% 3at revenue @ D4&,FCC
×
.& @
&
"og variable costs @ DEK,&CC × .& @ DSK,;;4% 3at variable costs @ D4&,KFC × .& @ D4K,EEC. ?
"og traceable fixed costs @ D?,FCC O D&,FCC @ D44,CCC% 3at traceable fixed costs @ D&&,;CC O DE,CCC @ D?C,;CC. 4
The common fixed rental cost would not decrease as >ete would incur this cost
whether or not he chooses to discontinue selling birds and fish. ete would not need aquariums and equipment for cleaning fish tanks.
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;$&? F/$,) & &'+ //(;$*$# P,-, $%&'() &- )*$&-*', $,((* F*+)$ /) *$% /$ )&* $& (&,+$ %*$ +&0*- ?; "11#584# 0+& "9#2 -& "78#616 .
This problem helps reinforce that, while change can be good, oftentimes individuals and organizations are often doing better than we think we are doing5 ete organizes his data at a very broad level, classifying all revenues and costs vis$W$vis the type of pet (i.e., is the item related to it dogs, cats, orthat birds andwould fish!. benefit +hile this one the snapshot business, is possible >ete frompresents organizing data of the differently. -or example, the current format does not lend itself to examining whether certain types of dogs or dog supplies are losing money. 't may be that the overall profitability of dogs is hiding losses on a certain types of dog treats, dog apparel, etc. To examine such issues, >ete may opt to report data at a finer level for example, in the )dogs* category he may wish to report data by breed of dog and type of supply. 'n such a way, it may be possible for >ete to perform a more comprehensive evaluation of his business. 8aturally, >ete needs to balance the benefits of more detailed reporting against the increased costs of collecting and reporting more disaggregated data. -or instance, detail might lead to more classification errors (e.g., it may be difficult to parse out the direct fixed costs associated with a particular breed of dog or dog supply!. 'n turn, this error may lead >ete to draw an incorrect inference about the profitability of a particular breed or supply!. 6.46
a. 9ince fixed costs are unlikely to change, the criterion is that the incremental contribution margin should be at least equal to the value of the prize (D;,CCC!. 7ccordingly, we start by figuring out the contribution margin on each table. 1sing the data provided, we have 3ontribution margin per table @ DEK,FCCL,FCC @ D&F. Thus, salespersons would need to sell an additional D;,CCCLD&F @ 48 -/?(,$ ,/% @'/+-,+ -& '$-*0; +'* -%, $/(,$ &-,$-. 3ompanies frequently offer a bonus or prize only after a certain goal is met% this goal may be based on sales in units, sales in dollars, net income, return on investment, or residual income. 'n this example, >ippin may stipulate that the prize will only be awarded if at least ,FFC tables are sold, which is FC more than the current level of table sales. This effectively ensures that >ippin will not lose money on the contest, thereby minimizing the downside risk of offering the prize.
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;$&4
b. 1sing the information from part QaR, the incremental contribution margin associated with selling &EE more tables at D&F per table is D?;,CCC. Thus, profit on the tables product line is expected to increase by D?;,CCC D;,CCC @ "3#. c. /erry0s concerns probably are well founded. 'ndeed, the contest will stir most salespersons0 competitive =uices and, as a result, shift much of their attention to the sales of tables. >eople have limited attention and effort (there are only so many hours in the day! thus, while the contest may increase salespersons0 overall is bound to 'n re$allocate effort from likely the chairs producteffort line tosomewhat, the tables itproduct line. turn, sales of chairs will suffer. +e calculated in part QbR that the sales contest is expected to increase profit on tables by D?C,CCC. Thus, profit on chairs could decrease by D?C,CCC before overall company profit decreases. 9ince the contribution margin on each chair @ D?&C,CCCLE,CCC @ D4C, this translates to D?C,CCCLD4C @ 75 %/*+$. >ippin would need to assess whether the sales contest will actually decrease sales on chairs by this amount. >ippin may wish to consider offering trips to ippin needs to ensure that any incentive he provides encourages salespersons to allocate their effort in a manner that maximizes overall company profits, not =ust the profit on one product line. d. 'n addition to concerns about whether the contest will adversely affect chair sales, there are several other considerations, including •
The contest is based on units. >ippin would need to put controls in place to ensure that salespersons do not offer price discounts to increase their sales numbers. That is, sales persons could actually sell more units without increasing overall profit (i.e., there is a price, quantity tradeoff!. This is perhaps why companies frequently set fixed prices on their products and do not allow salespersons much leeway in altering prices.
•
>ippin would need to consider the effect on employee morale. 9uch contests pit salesperson against salesperson and could adversely affect cooperation.
6.47
a. Based on the information provided, 3ottage Bakery0s opportunity set consists of three options the first option is the status quo and, indeed, this option is viable . "o nothing with the remaining counter space. That is, continue to donate the excess muffins and do not sell raspberry$filled croissants. Balakrishnan, /anagerial 7ccounting e
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;$&F
&. 1se the remaining counter space to sell day$old muffins. That is, do not donate the excess muffins to the homeless shelter and do not sell raspberry$ filled croissants. ?. 1se the remaining counter space to sell raspberry$filled croissants. That is, continue to donate the excess muffins to the homeless shelter and donate any excess raspberry$filled croissants to the homeless shelter. b. 6ption & 1se the remaining counter space to sell day$old muffins. That is, do not donate the excess muffins to the homeless shelter and do not sell raspberry$filled croissants. 2evenue from )day old* muffins 8et increase in profit
F
×
D.FC × F CH
D.&F per day "11.25 ,+ )/;
8otice that the cost of making the muffins is not relevant it is a sunk cost. 3ottage incurs this cost regardless of whether the excess muffins are sold as )day old* or donated to the homeless shelter. 6ption ? 1se the remaining counter space to sell raspberry$filled croissants. That is, continue to donate the excess muffins to the homeless shelter and donate any excess raspberry$filled croissants to the homeless shelter. 2evenue from raspberry croissants 3osts of making raspberry croissants 8et increase in profit
&C ×D&.CC && ×D.&C
D4C.CC per day (D&;.4C! per day "13.6 ,+ )/;
8otice that the cost of making the croissants is relevant because this cost will only be incurred if management decides to make the raspberry$filled croissants. c. The C&--/, F/,+; $%&'() %&&$, &-*& 3and use the remaining counter space to sell raspberry$filled croissants, continuing to donate the excess muffins to the homeless shelter, in addition to donating any excess raspberry$ filled croissants to the homeless shelter. This option leads to the largest increase in 3ottage Bakery0s daily profit, or D?.;C. This option also seems to be preferred from a social standpoint the homeless shelter will now receive an average of & croissants per day, in addition to the &C muffins they currently receive. N&-, +hile the problem examines profit before tax, we note that tax
considerations also arise. -or example, the donation to the charity might be tax deductible.
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;$&; 6.48
a. :et us begin by calculating relative revenue. N7A$CC 7[$&CC Total
DEC,CCC D4C,CCC D&C,CCC
Thus, &L?rd of the =oint cost (@ (DEC,CCCLD&C,CCC! I DCC,CCC @ D;;,;;K! would be allocated to N7A$CC and the remainder to 7[$&CC. +e then have 'tem
N7A$CC 7[$&CC 2evenue DEC,CCC D4C,CCC 7llocated cost D;;,;;K D??,??? >rofit "13#333 "6#667
Total D&C,CCC DCC,CCC D&C,CCC
b. :et us begin by calculating relative revenue. N7A$CC 7[$4CC Total
DEC,CCC DEC,CCC D;C,CCC
Thus, half the =oint cost is allocated to either product. 'tem
N7A$CC 2evenue cost 7llocated Traceablecost >rofit
7[$4CC DEC,CCC FC,CCC "3#
Total
DEC,CCC DFC,CCC &F,CCC "5#
D;C,CCC DCC,CCC &F,CCC D?F,CCC
c. 3omparing the product$level profits alone, it would appear that 3hemco should not process 7[$&CC further. "oing so reduces profit from D;,;;K to DF,CCC.
DEC,CCC (D4C,CCC! D4C,CCC (D&F,CCC! "15#
Thus, C%,& /*$ "15# ?; +&,$$* AJ2 0'+-%,+.The amount of the =oint cost, or how it is allocated, is not relevant for this decision.
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;$&K 6.49
a. The following table classifies each of the aforementioned items as being relevant or not relevant and provides a succinct explanation for each classification.
I-, 2egular selling price (DKF!
R,(,:/- < &+N= N&
9pecial order selling price (DCC!
,$
"irect materials cost
,$
"irect labor cost
,$
-ixed manufacturing cost
N&
-ixed marketing G administrative cost
N&
R,/$& The regular sales price is not relevant because 7ward >lus will not receive this amount from the little$league
organization. 7dditionally, even with the special order, 7ward >lus will be operating below CCH of their production capacity (i.e., K,FCC O ,ECC \ C,CCC!% thus, 7ward >lus will not sacrifice any regular business by accepting the special order. The additional revenue associated with the special order clearly depends on this value. >resumably, the special order medals will require the same amount of materials as other medals. Thus, the cost is relevant. >resumably, the special order medals will require the same amount of labor as other medals. Thus, the cost is relevant. -ixed manufacturing costs will be the same in total regardless of whether the special order is accepted. (9ince 7ward >lus will still be operating in the relevant range if they accept the special order!. -ixed marketing and administrative costs will be the same in total regardless of whether the special order is accepted. (9ince 7ward >lus will still be operating in the relevant range if they accept the special order!.
b. 1sing the classifications in the above table, the following table summarizes the amounts by which each relevant cost or revenue will change if the special order is accepted. The net of the increased revenues less the increased costs Balakrishnan, /anagerial 7ccounting e
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;$&E provides us with the incremental profit (or loss! associated with accepting the special order. That is, we are using the incremental approach with status quo as the benchmark option. ('n the text, we also called this method )3ontrollable 3ost 7nalysis.*! 'tem 7dditional revenue "irectmaterialscost "irectlaborcost I+,,-/( +&0*-
"etail DCCI,ECCmedals DFCI,ECCmedals D4CI,ECCmedals
Total DEC,CCC DSC,CCC DK&,CCC "18#
Thus, 7ward >lus0s profit is expected to*+,/$, ?; "18# if they accept the special order. c. 2eferring to part QaR of the problem, the regular sales price is now relevant since, by accepting the special order, 7ward >lus will sacrifice sales of ?CC medals to their regular customers. /oreover, 7ward >lus will lose (DKF DFC D4C! × ?CC @ D&F,FCC in contribution margin on regular business if they accept the special order. Thus, the net benefit from accepting the special order @ DE,CCC D&F,FCC @ (DK,FCC!. 'n other words, A/+) P('$$ +&0*- *(( ),+,/$, ?; "7#5 *0 -%,; /,- -%, $,*/( &+),+. +e can also see this effect by comparing the contribution margins from accepting or not accepting the special order (since fixed costs will be the same across decisions!.
×
(DKF DFC D4C!R O
3ontribution /argin (re=ect special order! @ K,FCC × (DKF DFC D4C! @ D;?K,FCC. 7gain, we see that 7ward >lus0 profit is DK,FCC higher if they re=ect the special order. This problem reinforces that, in the short$term, capacity is fixed and, accordingly, short$term decisions center on the best use of available capacity. 6ftentimes, it is profitable to find uses for excess capacity, as shown in part QbR.
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;$&S
6.5
<]gyoku has two options (! run the special promotion or (&! do not run the special promotion. 3alculating the incremental revenues and costs associated with running the promotion is more difficult than it first appears. -irst, we need to keep in mind that, while the price charge on winter items will decrease to D;, the variable cost per item will not decrease. That is, the variable cost per winter item will equal DS × .4C @ D?.;C. This implies that the incremental contribution margin due to the increased sales volume @ (D;.CC D?.;C! × ,FCC @ D?,;CC. 9econd, we need to consider the lost contribution margin on regular business related to winter items that is, the D4,FCC in regular business means that <]gyoku typically cleans D4,FCCLS @ FCC winter items each month. >resumably, these customers (in the coming month! also will be charged D; for each winter item cleaned, implying that the contribution margin on )regular* winter item business will go down by FCC × (DS D;! @ D,FCC. These two numbers, coupled with the increased advertising expenditure, allow us to calculate the change in profit from running the special promotion
'ncremental contribution margin from increased sales
(;.CC ?.;C! × ,FCC
:ost contribution margin on regular winter item business
FCC × (DS D;!
'ncrementaladvertising
iven
8et change in monthly profit
D?,;CC
(D,FCC!
(D,CCC! D,CC
<]gyoku should run the promotion as her profit in the coming month is expected to *+,/$, ?; "1#1. 6.51
a. 'n this problem, it is important to recognize that all of the common fixed costs allocated to the dry cleaning operations would not disappear if the dry cleaning business were to be closed. 9pecifically, the dry cleaning business currently generates a segment margin of D?CC,CCC (DECC,CCC DFCC,CCC!. This margin would not be available if the dry cleaning business were to close.
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;$?C This effect is perhaps most easily seen (and verified! by constructing an income statement without the dry cleaning business. +e present such an income statement below
2evenue Aariable costs 3ontribution margin "irect fixed costs 3ommon fixed costsZ
:aundry 6nly D?,CCC,CCC D,CCC,CCC D&,CCC,CCC D,CCC,CCC DECC,CCC
P+&0*-
"2#
Z @ D,CCC,CCC D&CC,CCC. 7gain, we see that 9pring-resh0s overall profit ),+,/$,$ ?; "1# -& "2#. 7ssuming the accuracy of the estimate of the reduction in common fixed costs, 9pring-resh should not eliminate its dry cleaning operations. This particular problem underscores that income statements can be misleading in terms of what a particular department or product actually contributes to overall profitability. The key in making this assessment is determining what revenues and costs actually disappear if the department is eliminated. b. 'ncreasing the volume of laundry will increase the contribution margin available to cover fixed costs. Based on the data provided, we find that each D.CC of revenue in laundry provides DC.;K in contribution margin (D&,CCC,CCC in contribution margin divided by D?,CCC,CCC in revenue!. Thus, an increase of CH in laundry sales will increase the laundry contribution margin by CH as well. This implies that the laundry contribution margin will increase to D&,&CC,CCC. 6ur revised income statement with laundry only looks as follows
2evenue Aariablecosts 3ontribution margin "irect fixed costs 3ommon fixed costsZ P+&0*-
:aundry 6nly D?,?CC,CCC D,CC,CCC D&,&CC,CCC D,CCC,CCC DECC,CCC "4#
D?,CCC,CCC × . D,CCC,CCC × . D&,CCC,CCC × . D,CCC,CCC D &CC,CCC
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;$? 'n constructing this income statement, however, notice the assumption that neither the traceable fixed costs nor the common fixed costs would increase if the volume of laundry were to increase by CH. This is a questionable assumption. /anagement =udgment is key in determining whether the increase in the fixed costs, if any, would exceed DCC,CCC, or the expected net increase in the firm0s profit. 6.52
a. oo Nuice0s decision deals with ,,$$ $'(;. The competition has moved in, soaking up some of oo Nuice0s monthly gasoline and merchandise sales. 3onsequently, oo Nuice finds itself in a position with )excess* gasoline and merchandise (i.e., oo Nuice has the supply to accommodate more customers!. 7 short$term promotion is one way to spur additional demand. b. Because the question asks for the change in profit, we employ the incremental approach with the status quo as the benchmark option. That is, we employ controllable cost analysis. The following table calculates the expected change in monthly profit if oo Nuice runs the special promotion I-, 7dditional sales of gasoline 7dditional sales of merchandise $ 3ost of additional gasoline sales $ 3ost of additional merchandise sales $ -ree merchandise sales I+,,-/( +&0*-
D,-/*( T&-/( .CE I DFC,CCC D&,CCC .& I DKF,CCC S,CCC C.KF I D&,CCC (S,CCC! C.FC I DS,CCC (4,FCC! C.C I Q(DFC,CCC (E,CC! O D&,CCC!LDC.&CR <"6=
oo Nuice0s monthly fixed costs are not relevant to running the special promotion because they will be incurred regardless of whether oo Nuice runs the special promotion. 'n short, running the special promotion does not appear to be a good idea because G&G& '*,$ &-%(; +&0*- *$ ,,-,) -& ),+,/$, ?; "6. c. By using a threshold, oo Nuice is trying to give customers the impression that they are receiving DC.C in free merchandise for every DC.&C spent on gasoline (after all, DC.FCLDC.CC @ DC.CF per D.CC, or DC.C per DC.&C!. 'n reality, this is not the case since customers only receive DC.C per DC.&C spent on gasoline if their purchase equals DC, D&C, D?C, etc. (i.e., some whole number multiple of DC!. 6therwise, customers receive strictly less than DC.C per DC.&C spent. -or example, a customer spending DS.SS on gasoline receives DC.CC per DC.&C spent on gasoline in free merchandise and a customer spending D&.FC on gasoline receives DC.FCLD&.FC @ DC.C4 per D.CC, or DC.C per DC.&F in free merchandise. 3onceptually, the scheme converts a variable discount to a step$discount, with DC as the step$size. This change ensures that the actual discount provided will always be lower than DC.C per DC.&C of gasoline sales. Balakrishnan, /anagerial 7ccounting e
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;$?& /anagement of oo Nuice may believe that such a threshold will stimulate the same increase in gas sales as before, thereby increasing monthly gas profit by D?,CCC (@ D&,CCC $ DS,CCC% as shown in part QbR!. 7dditionally, because of the threshold the scheme would reduce the )loss* on free merchandise sales (since customers effectively receive less than DC.C per DC.&C spent on gasoline, there will be less than DE,CC in free sales!. The cost (or risk! is that some savvy customers may not respond to oo Nuice0s promotion and, as a result, demand for both gasoline and merchandise will not increase as expected. N&-,> 6rganizations devote much time and resources to structuring coupons and
promotions that lookfrequently more attractive customers than actually is the -or example, businesses offer to rebates, but require customers to case. fill out detailed paperwork to receive the rebate. The rebate then comes ;$E weeks later in a package that looks like )=unk mail* (the company is hoping that the consumer throws the letter away along with the other =unk mail!. 'n a similar fashion, companies often issue coupons that can only be used later here, the company is hoping the person will lose the coupon, thus lowering the redemption rate. 9imilarly, lottery organizations advertise the total payout in the =ackpot without taking into the present value for money or taxes such accounting would reduce the prize from say, DCC million, to D&F million5 The lesson is that organizations frequently do what they can to increase sales, but minimize the cost of increasing sales. 9pecial promotions and coupons are one way of providing consumers with the )illusion of value.* The amount the firm saves is )breakage,* and could be in the millions of dollars for firms such as Best Buy and
Balakrishnan, /anagerial 7ccounting e
-62 '89T213T62 19# 68:
;$??
6.53
a. Timmy0s overall profit equals all revenues less all costs. 6ne could quickly calculate profit for ?/--,+; -,$-,+$ as (D?F D&E! × &C,CCC @ "14# and profit for $&(,&*) -,$-,+$ as (D&C D&&! × C,CCC @ <"2#=. Thus, &:,+/(( +&0*- @ D4C,CCC O (D&C,CCC! @ "12#. /ore formally, one might depict overall profit and the profit for each product as follows
2evenue -ixed costs /anufacturing /arketing G administrative Aariable costs /anufacturing /arketing G administrative P+&0*-
D?F × &C,CCC% D&C × C,CCC
F/--,+; T,$-,+$ DKCC,CCC
DC × &C,CCC% DC × C,CCC D4 × &C,CCC% D4 × C,CCC
(&CC,CCC!
D& × &C,CCC% D; × C,CCC D& × &C,CCC% D& × C,CCC
(&4C,CCC!
S&(,&*) T,$-,+$
T&-/(
D&CC,CCC
DSCC,CCC
(CC,CCC!
(?CC,CCC!
(4C,CCC!
(&C,CCC!
(;C,CCC!
(?CC,CCC!
(&C,CCC! <"2#=
(;C,CCC! "12#
(EC,CCC!
(4C,CCC! "14#
b. Timmy0s contribution margin equals revenues less all variable costs. Thus, Timmy0s contribution margin on ?/--,+; -,$-,+$ equals QD?F.CC (D& O D&!R × &C,CCC @ "42# and Timmy0s contribution margin on solenoid testers equals QD&C.CC (D; O D&!R × C,CCC @ "12#. Thus, the -&-/( &-+*?'-*& /+* @ D4&C,CCC O D&C,CCC @ "54#. /ore formally, one might show overall contribution margin and contribution margin for each product as (by re$arranging the income statement calculated in part QaR!
Balakrishnan, /anagerial 7ccounting e
-62 '89T213T62 19# 68:
;$?4
2evenue
D?F × &C,CCC% D&C × C,CCC
Aariable costs /anufacturing
D& × &C,CCC% D; × C,CCC D& × &C,CCC%
/arketing G 7dministrative
P+&0*-
D&
S&(,&*) T,$-,+$
T&-/(
D&CC,CCC
DSCC,CCC
(;C,CCC!
(?CC,CCC!
(&4C,CCC! (4C,CCC! (&C,CCC!
×
C&-+*?'-*&M/+* -ixed costs /anufacturing
/arketing G 7dministrative
F/--,+; T,$-,+$ DKCC,CCC
C,CCC
"42#
DC × &C,CCC% (D&CC,CCC! DC × C,CCC (EC,CCC! D4 × &C,CCC% D4 × C,CCC D4C,CCC
(;C,CCC!
"12#
"54#
(DCC,CCC!
(D?CC,CCC!
(4C,CCC!
(&C,CCC!
(D&C,CCC!
D&C,CCC
c. The key here is to realize that, as stipulated in the problem, the overall fixed costs of D4&C,CCC will not decrease if Timmy drops the solenoid testers. Thus, if Timmy stops producing the solenoid testers %*$ +&0*- *(( ),+,/$, ?; "12#, which is the contribution margin from the solenoid testers calculated in part QbR. 'n essence, this question illustrates the value associated with restating income statements using a contribution margin format. The profit effect of dropping solenoid testers also can be verified by constructing an income statement with battery testers. 9uch an income statement is presented below
2evenue AariablecostsZ 3ontribution margin -ixedcosts P+&0*-
F/--,+; T,$-,+$ DKCC,CCC (&EC,CCC! D4&C,CCC (4&C,CCC! "
Z @ D&4C,CCC O D4C,CCC 7gain, we see that Timmy0s overall profit is expected to ),+,/$, ?; "12# -& ".
Balakrishnan, /anagerial 7ccounting e
-62 '89T213T62 19# 68:
;$?F
d. +e see that unitizing fixed costs (expressing them on a per$unit basis! can allow us to quickly calculate overall profitability or the reported profitability of any particular product. That is, we can simply take the price per unit less the cost per unit multiplied by the number of units sold. 1nfortunately, unitizing fixed costs could lead to disastrous effects in terms of decision$ making. This outcome occurs because decision makers can be tempted to multiply the unitized fixed cost by some new level of volume to arrive at total fixed costs. 6ver many ranges of activity, however, fixed costs in total will not change thus, it is important to remember that total fixed costs equal the fixed cost per unit multiplied by the level of volume used to arrive at the fixed cost per unit. By using one volume to calculate the fixed cost per unit and multiplying it by another volume, the decision maker is treating the fixed cost as if it were variable, which it is not. This feature QagainR underscores that fixed costs often are not relevant to short$term decisions. 6.54
a. The incremental cost associated with the show appears to be D&FC, or the variable cost of running the show. The QallocatedR fixed cost per show is not relevant because the total amount of fixed costs for the year will not change as a result of the special screening. -urther, the stated ticket prices are not relevant because the show will take place in the mid$morning hours when the '/7^ is not traditionally open thus, the students will not be displacing any regular customers. Based on the financial data provided, the minimum price quote appears to be "25. b. 7t a minimum, 2andy should consider the following •
"oes the 9cience 9tation have a gift shop andLor cafeteriaP 'f so, many students are likely to buy food andLor gift items, thereby increasing the 9cience 9tation0s contribution margin. 'n turn, this would reduce the minimum price quote in part QaR.
•
+hat is the impact on future revenueP +hat proportion of the students and teachers would have seen the show at the regular priceP (That is, what is the opportunity cost in the form of lost revenueP!. 7lternatively, after seeing the show, many students may return with their parents, thereby increasing future revenue.
•
7re there costs associated with the special showing that are not captured by the D&FC variable cost numberP -or example, will the 9cience 9tation have to pay an overtime premium for a pro=ectionist andLor usherP
Balakrishnan, /anagerial 7ccounting e
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;$?;
c. 2andy probably should consider the educational mission of the 9cience 9tation. 9uch screenings directly contribute to this mission, the station, and, hopefully, the betterment of the students. The special screening may be an excellent way to expose some students to science these students may have never gone through the 9cience 9tation if it were not for the school outing. 6verall, the )best* price to charge is unclear and requires some managerial =udgment as 2andy needs to balance an array of financial and non$financial factors. 6.55
+e can address this problem from both quantitative and qualitative perspectives. -rom a quantitative perspective, the incremental costs and revenues associated with reducing the length of stay from .E days to .F days are as follows I+,,- )', -& +,)'* LOS
8umber of patients 2eductioninaverage:69 "ecrease in number of days (C,CCC × .?C! Aariablecostperday 3ost savings from reducing :69 (?,CCC × &F! 2evenue from increased re$admissions (&CC × FCC! 3ostofincreasedre$admissions T&-/(/))*-*&/($/:*$%/,*+&0*-
C,CCC C.?C ?,CCC D&F D?KF,CCC CC,CCC (FC,CCC! "425#
-rom a financial perspective, uincy0s plan makes sense the analysis suggests that the hospital0s annual profit would increase by "425#. 6ne might also sympathize with uincy0s logic the quest for survival in an era where hospital revenues are fixed and medical costs are increasing have pushed many healthcare administrators into making similar decisions (for example, maternity stays have been reduced dramatically in recent years!. There are, however, other important considerations. 6ne has to consider the effect on patients being discharged )early.* 7t a minimum, numerous patients will experience added discomfort and disruption in their lives. -urther, approximately &CC patients will have to be re$admitted and undergo additional treatment there are both monetary and non$monetary costs that will be borne by these individuals. -inally, some patients may even die as a consequence of being discharged early.
-62 '89T213T62 19# 68:
;$?K
There is no )correct* answer to this problem the problem shows that for many decisions in life it is important to balance quantitative and qualitative considerations. "ecision models invariably incorporate both types of factors, and students QrightfullyR may place different weights or values on the various factors. /oreover, it is important to recognize and think about such tradeoffs hopefully, the lively discussion the problem generates helps demonstrate the value of viewing decision making as an exercise in model building and measurement, and also see that decision models are unique, somewhat like an individual0s fingerprints. 6.56
a. +e first calculate the incremental cost associated with offering the free web$ based tax$filing product, which is 3ost of developing product $' 3ost of maintaining product given Aalue of names obtained &FC,CCC 'ncremental cost
×
C.EC ×D C.CS
D4&C,CCC (E,CCC! D4C&,CCC
8ext, since the unit contribution margin from the personal$finance software is D&F.CC D.CC @ D&4.CC, the increased volume required can be calculated as D4C&,CCCLD&4.CC @ 16#75 software packages. Because &FC,CCC individuals are expected to use the free web$based product, the required proportion is ;,KFCL&FC,CCC @ 6.7. This seems eminently reasonable. b. There are many other factors to consider.tax >erhaps theThat mostis, prominent relates to the cannibalization of the stand$alone product. offering the free$ web$based tax product is likely to eat into the sales of the stand$alone tax product. The lost contribution margin on these sales needs to be factored in as an incremental cost the problem does not, however, provide us with enough information to calculate this opportunity cost. There also are likely to be legal liability issues in offering the free web$based product, Tax>lan needs to be concerned about system breakdown, loss of data, incorrect transmission, and so on. 9hould the system fail for any reason, Tax>lan likely exposes itself to legal action as well as negative publicity. 6ther factors may relate to issues of how long returns need to be stored and how many names will be )new* to the system.
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c. The '29 has a financial interest because the costs (to the '29! associated with receiving paper returns are substantially higher than the costs of receiving electronic returns. 9ome of the incremental costs include having staff to receive and open the paper returns, keying (inputting! the data from the paper returns into the computer, correcting any errors in keying, storing the paper returns, handling any checks, and so on. Thus, the '29 vastly prefers electronic filing5 This aspect of the problem reminds students of the importance in considering externalities in their decision making invariably, the decisions we make affect others. 6.57
a. 3ompared to the status quo of keeping the recently acquired machines, the table below presents the change in profit associated with acquiring the better video poker machines
>roceeds from sale of recently purchased machines >rofit from increased wagering on better machines 3ost of better machines I+,/$,P ) +&0*-
D,CCC × &FC
D&FC,CCC
D?C,CCC × &FC × .C × & years
,FCC,CCC
DF,FCC × &FC
(,?KF,CCC! "375#
The casino would gain D?KF,CCC over the two years by replacing the recently acquired video poker machines with the better model. 8otice that the cost of the recently acquired video poker machines, or D,&FC,CCC, is sunk and not relevant to the analysis. b. 7s shown above, the casino gains D?KF,CCC by replacing the recently acquired video poker machines. The srcinal acquisition cost is sunk and is not relevant for this decision.
Balakrishnan, /anagerial 7ccounting e
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;$?S c. -rom the standpoint of the "iamond Nubilee, the change has no effect the cost is still sunk and the casino would still favor acquiring the better machines as &$year profit increases by D?KF,CCC. 6ne could argue, however, that the potential damage to :ucy0s reputation increases as the magnitude of the price paid for the recently acquired machines increases. The )error* attributed to :ucy would no longer be D,CCC,CCC but, rather, D?KF,CCC (D?KF,CCC @ (D&,FCC D,CCC! × &FC!. That is, from :ucy0s perspective, the cost to acquire the old machines is not sunk because it affects the magnitude of the damage to her reputation. 3ompared to our earlier analysis, :ucy likely will be more inclined to recommend purchasing the better machines. The classification of a cost as sunk is only valid within a decision context and for the specified decision maker (please also see the continuation problem!. This is because a sunk cost can influence the value for relevant items such as reputation. Because different parties may care differently about factors such as personal reputation, a cost that is sunk for one decision maker may be a relevant item for another decision maker. 6.58
a. 7s shown in part QaR to previous problem, the D,&FC,CCC cost of the recently acquired video poker machines does not affect the decision to purchase the better video poker machines. This cost is sunk and it does not lead to differential cash flows across options. /oreover, in a world without taxes it does not matter whether the acquisition cost was D,&FC,CCC or, for that matter, DC,CCC,CCC. b. 'n this case, the acquisition cost, while sunk, does lead to differential cash flows across options. 9uppose the new machines are not purchased. Then, the existing machines will be depreciated over the next two years. The depreciation expense will reduce taxable income, thereby reducing taxes paid. (9pend a few minutes reviewing the difference between a cash outflow and an expense.! iven the data for the "iamond Nubilee, keeping the existing machines produces an overall tax benefit of C.&F I D,&FC,CCC @ "312#5. 8ow, consider the option of buying the new machines. The acquisition cost of the old machines affects taxes paid in this case as well. 'f the better video machines are purchased, the "iamond Nubilee will reap a tax benefit from the loss on selling the )old* machines. This loss and concomitant tax benefit are shown below >urchase >roceedsprice from sale of recently purchased machines (D,CCC × &FC! :oss Balakrishnan, /anagerial 7ccounting e
D,&FC,CCC &FC,CCC D,CCC,CCC -62 '89T213T62 19# 68:
;$4C 2ate Tax T/S/:*$
.&F "25#
The important points to notice are that the tax in either case depends on the purchase price of the old machine and that the tax benefit is different across options. That is, the tax effect is not a wash. K,,* -%, &() /%*,$ ;*,()$ / /))*-*&/( -/ $/:*$ &0 "62#5@ D?&,FCC $ D&FC,CCC. The acquisition cost, while sunk, clearly )matters* in a world with taxes because it leads to differential cash flows between the options. c. 7bove and beyond our calculations in part QbR, there are two other tax effects we need to consider when we compute the profit impact of replacing the old machines (! The taxes on profit from wagering, and (&! the tax shield due to the depreciation on the new machine. >roceeds from sale of recently purchased machines >rofit from increased wagering on better machines Tax on profit from increasedwagering 3ost of better machines Tax benefit due to
D,CCC × &FC
D&FC,CCC
D?C,CCC × &FC × .C × &
,FCC,CCC
>reviousrowIC.&F DF,FCC × &FC
depreciation on new DF,FCCI&FCI&FH machine 8et tax benefit lost if old machinesaresold 3omputedinpartb I+,/$,)P+&0*-
(?KF,CCC! (,?KF,CCC! ?4?,KFC (;&,FCC! "281#25
The casino would gain D&E,&FC over the two years by replacing the recently acquired video poker machines with the better model. The above table presented the incremental approach for buying the new machines, with status quo as the benchmark (i.e., performed controllable cost analysis!. -or completeness, we present the gross approach. -irst, we compute the profit if we keep the old machines. (8ote Because we do not know the wagers over the two years associated with the recently acquired )old* machines, let us call it W. This term )washes* out because it is common to both options.!
Balakrishnan, /anagerial 7ccounting e
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;$4
+agers on old machine Tax on profit from wagers in old machine Tax shield because of depreciation of old machines P+&0*- *0 , ,, &() /%*,$
W
8ot known
I W
(C.&FW!
&FH
D,&FC,CCCIC.&F
?&,FCC "312#5 .75 W
8ext, we compute the profit if the casino purchases the new machines. >roceeds from sale of recently purchased machines Tax shield because of loss due to sale >rofit from wagering on better machines Tax on profit from wagering Tax shield because of depreciation of new machines 3ost of better machines
D,CCC × &FC (DF,CCC$D,CCC! I &FCIC.&F W O (D?C,CCC × &FC × .C × &! >revious row I &FH DF,FCC I &FC I &FH DF,FCC × &FC
P+&0*- *0 , ?'; -%, , /%*,$
D&FC,CCC &FC,CCC
W O D,FCC,CCC (C.&FW O D?KF,CCC! D?4?,KFC
(D,?KF,CCC! .75W "593#75
The difference in profit is D&E,&FC, as calculated before. The incremental method has fewer steps and is less tedious.
Balakrishnan, /anagerial 7ccounting e
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;$4&
6.59
a. The key aspect of this problem is to recognize that the srcinal cost of the existing case (D&C,CCC! is a sunk cost and, therefore, is not relevant for the decision to repair the existing case or buy a new case. 7dditionally, the book value of the existing case also is not relevant. The controllable costs associated with each option follow (8ote rather than deducting the utility costs from the purchase price of the new case, these savings could be added to the costs of repairing and keeping the existing case the net difference is still D4,FCC in favor of repairing the existing case! 3ost of the 8ew 3ase >urchase price 1tility savings 8et 3ost
CC × & × CZ
3ost to 2epair #xisting 3ase 8ew motor and wiring
D&,CCC (&,CCC! "9#
"4#5
Z DCC per month for C years +e see that it is cheaper for ina to fix the existing case than buy the new case. ina saves "4#5 by repairing the existing case. b. This information does not change the analysis in any way. The purchase price of the existing machine and its current book value are simply not relevant for the analysis (given the current setup!. N&-, The current book value could become relevant for the analysis if ina could claim a tax deduction for the loss incurred on the sale of the existing case. Thus, a seemingly sunk cost (the book value of the old case! can become relevant because it influences the value of a relevant cost (the tax loss!. This issue is more fully explored in requirement QdR below.
c. 7bsolutely. The ability to sell the existing case for DF,CCC reduces the cost of buying the new case from DS,CCC to "4# (alternatively, one could view this as an opportunity cost associated with keeping the existing case% here, we would add the DF,CCC to the cost of the existing case!. The cost of repairing the existing case remains unchanged at "4#5. 3onsequently, ina now favors buying the new case by "5.
Balakrishnan, /anagerial 7ccounting e
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;$4?
d. ina0s tax status can affect her decision because taxes will alter ina0s out$of$ pocket costs associated with repairing the existing case versus buying the new case. -or example, if ina sells the existing case then she can claim the loss on the sale as a tax deduction. 7dditionally, ina0s expenses associated with operating the cases will be deductible for tax purposes. That is, each dollar of expense will reduce taxable income by D, thereby saving DC.?C in taxes. The net after$tax cost of a dollar is thus only DC.KC. 9uch savings frequently are referred to as a )tax shield.* The after$tax costs associated with can eachbeoption follow. (7gain, please note controllable that costs such as expenditures on utilities framed as either reducing the cost of buying the new case or increasing the cost of repairing the existing case!% the net difference between the options is what we are after 3ost of the 8ew 3ase >urchase price D&,CCC >roceeds sale of old case not taxed (F,CCC! 1tility savings (&,CCC! DCC × & × C Tax savings from purchase of new (;,?CC! .?C × D&,CCCZZ case Taxes on utility savings ?,;CC .?C × D&,CCC Tax savings loss on sale of old case (?,?CC! .?C × D,CCCZ 8et 3ost <"2#=
3ost to 2epair #xisting 3ase Beforetaxcostformotorandwiring D4,FCC Tax savings of ?CH ZZ (,FCC! .?C × D4,FCC Tax savings from depreciating .?C I D;,CCC (4,ECC! current 3ase 8et 3ost <"1#8= Z :oss @ D;,CCC (book value! DF,CCC (proceeds! @ D,CCC ZZ Both the srcinal book value and the cost of improvements will be depreciated over time, yielding a tax shield.
ina is better off (to the tune of "2! if she buys the new case. 'ndeed, the negative cost of getting the new case suggests that ina should have purchased the new case even if the motor had not burned out perhaps ina should thank her assistant for leaving the case0s door open5 Balakrishnan, /anagerial 7ccounting e
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;$44 N&-, The conclusion about a mistake increasing profit is, of course, tongue in cheek...if the assistant had not made the mistake, no repairs would be necessary. ina would have had a net cost of (D4,ECC! from retaining the old case. +e do not have enough data to say if the new case is preferred in this event. >resumably, the resale price for the old case also would increase from DF,CCC if it were not broken. N&-, This problem features a non$standard treatment of the tax shield on the purchase of the new case. Typically, the new case would be depreciated over time, and the depreciation provides a tax shield. 7bsent a time value for money, however, the net effect is a tax shield on the purchase price.
e. These types of )open$ended* questions are important to address because there are numerous factors that are relevant to any decision but may be difficult to quantify. 9uch measurement difficulties, however, do not relieve us from our obligation to consider certain variables in the decision model. 'n this particular example, ina likely should consider whether the new case would have better climate control and extend the shelf life of her flowers (this could increase sales andLor reduce costs!. The new case also may be more or less attractive, have a larger or smaller storage capacity, and so on. 'n turn, these factors likely affect sales and, as such, can tilt the analysis in favor of buying the new case or repairing the existing case.
6.6
a. -irst, we should determine Bob0s capacity to ensure that the professor0s order will not impose any constraints on Bob0s business. 7t D;KF,CCC in sales, Bob expects to operate at SCH of capacity% thus, calculate capacity as D;KF,CCCL.SC @ DKFC,CCC. 9ince the order is we for can DFC,CCC (withBob0s pre$discount price!, Bob has enough idle capacity to fulfill the order without eating into his regular business. The next key is to realize that fixed costs would not change whether Bob provides the professor with a discount. -urther, Bob will incur DC.4F in variable costs for each pre$discount sales dollar. +e are now in a position to calculate, relative to the status quo of not accepting the order, the incremental costs and benefits of accepting the order as 'ncremental revenue 'ncremental costs N,I-+,/$,*P+&0*-
DFC,CCC × .KF DFC,CCC × .4F
D?K,FCC (D&&,FCC! "15#
Thus, Bob0s profit increases by "15# as a result of providing the professor with the &FH discount. This assumes, of course, that some of Bob0s other customers also will not demand a similar discount, in which case, Bob needs to factor in the lost contribution margin on these orders. Balakrishnan, /anagerial 7ccounting e
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;$4F
b. 'f Bob is operating at S;H of capacity at a sales level of D;KF,CCC we can calculate Bob0s capacity in sales dollars as D;KF,CCCL.S; @ DKC?,&F. 9ince the order is for DFC,CCC, this implies that Bob will have to sacrifice DK&F,CCC (D;&F,CCCODFC,CCC! DKC?,&F @ D&,EKF in regular business. 'f Bob sacrifices D&,EKF in regular business he will lose D&,EKF × .FF @ D&,C?.&F in contribution margin. This amount reduces the increase in profit we arrived at in part QaR, resulting in a net increase in profit of DF,CCC D&,C?.&F @ "2#968.75 by providing the professor with the discount. c. 'n this case, Bob will lose DFC,CCC in regular business, which amounts to DFC,CCC × .FF @ D&K,FCC in lost contribution margin. 'n turn, by providing the professor with the discount Bob0s profit will decrease by DF,CCC D&K,FCC @ "12#5. 8otice that this corresponds perfectly to the amount of the discount, or DFC,CCC × .&F @ "12#5. Barring some unusual circumstances, Bob should not provide the professor with the discount. This problem helps illustrate the opportunity cost of capacity. 'n part QaR capacity was not binding and, as a result, the opportunity cost of capacity was DC. 'n part QbR, acceptance of the special order meant that capacity did bind, resulting in a loss of some regular business.
The incremental revenue to #dmund from accepting the pro=ect @ &C hours × C.FC × DCC per hour @ D,CCC. Based on the information provided, the incremental financial cost appears to be DC as #dmund0s costs are mostly fixed. 7dditionally, because this is the slow season, #dmund likely has enough free time (idle capacity! to do the pro=ect. That is, #dmund probably will not be foregoing another =ob by taking on this pro=ect. Thus, from a purely quantitative standpoint, #dmund increases his profit by D,CCC from accepting the pro=ect. -rom a qualitative standpoint, accepting the pro=ect may curtail #dmund0s recreational activities. Thus, #dmund needs to consider the value he attaches to his )free* time it is quite possible that #dmund values &C hours of free time during the off$peak months at an amount greater than D,CCC. -rom a qualitative standpoint, #dmund also needs to consider whether accepting the pro=ect will lead other clients to demand similar loyalty discounts during the Balakrishnan, /anagerial 7ccounting e
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;$4; slow season surely, this is a position #dmund does not wish to be in. -inally, #dmund needs to assess whether re=ecting the pro=ect will lead to a loss of all future business with this client. Because the increase in profit from accepting the pro=ect is rather small, it is likely that #dmund0s decision will hinge on the qualitative factors.
6.62
a. The first step is to rank$order the products per their contribution margin of the scarce (binding constraint!. -orneed 9ylvester0s, the cold mill (32/!resource is the scarce resource. Thus, we to calculate eachrolling product0s contribution margin per minute of 32/ usage. "oing so yields
A((&;
C&*($
S-,,( F/+$
W*+,
3ontribution margin per pound /inutesperpoundin32/ 3ontribution per minuteZ
D.4C DC.4F DC.SE DC.KF C.C C.C? C.?F C.?C "14. "15. "2.8 "2.5
Z @ (contribution margin per pound!L(minutes per pound in 32/! 6ur analysis reveals that coils are the most profitable product, followed by alloy, steel bars, and then wire. 3oils are most profitable because they make the most efficient (in the sense of contribution to profit! use of the resource that limits 9ylvester0s profit thethat 3old9ylvester0s 2olling /ill. constraints (see partto QbR!, we would recommend use Barring all of itsother available 32/ capacity produce coils. 9ince the 3old 2olling /ill can be operated for &4,CCC minutes per month and coils yield DF.CC per minute, 9ylvester0s total contribution margin for the month @ &4,CCC I DF.CC @ D?;C,CCC. -rom this, we subtract 9ylvester0s monthly fixed costs of D&CC,CCC (@ D&,4CC,CCCL&! to arrive at a &-%(; +&0*- &0 "16#. b. Based on our calculations in part QaR, 9ylvester0s should devote all available capacity to coils.
Balakrishnan, /anagerial 7ccounting e
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;$4K /ore generally, 9ylvester0s would devote as much time as possible to coils until the contribution per minute in the 32/ (due to market constraints! was lower than alloys. 't would then turn its attention to alloys and devote the maximum attention to this product until its contribution margin per minute in the 32/ was =ust lower than steel bars. This process would be repeated until 9ylvester0s )runs out* of 32/ time. 'mplementing this strategy, though, requires that we know the market demand constraints for each of the products. This information is not available in the problem, but clearly is necessary for optimal decision$making. 'n addition to confirming price, we also would want to check the reliability of the variable cost number in the computation of the contribution margin. -or example, 9ylvester0s may classify direct labor cost as being variable.
of products could change. /oreover, this problem encourages students to think critically about what is )fixed* and what is )variable.* 6.63
a. 3rash faces a problem of excess demand.
F I FC square feetLgame & I KF square feetLgame ; I C square feetLgame
&FC square feet FC square feet ;C square feet 4;C square feet
Thus, 3rash has to ration available space among the games. 7s detailed in the text, he could determine the profit$maximizing mix by considering the contribution margin per unit of the scarce resource. 'n our case, the scarce resource is space. The following table shows the contribution margin for each game per square foot.
Balakrishnan, /anagerial 7ccounting e
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;$4E
2evenue per hour (fully occupied! 6ccupancy rate Total hours available per week 2evenue per week (@ revenue per hour I
Aideo ame D&C 4CH CC
occupancy rate I hours available! /aintenance costs per week 3ontribution margin per week 9quare feet occupiedLmachine 3ontribution per square foot
"ance ame D4C ?CH CC
9imple ame DF CH CC
DECC
D,&CC
DFC
DCC
D?CC
DC
DKCC
DSCC
DFC
FC
KF
C
D4
D&
DF
Thus, a simple ranking would show 3rash0s optimal allocation of space to be ;simplegames 4videogames 1nusedspace
;Csquarefeet &CCsquarefeet. 4Csquarefeet.
+ith this solution, we could compute 3rash0s profit as ; simple games I DFCLweek 4 video games I DKCCLweek Total
DSCC per week D&,ECC per week D?,KCCperweek.
b. 6ur solution from part QaR does not use all available capacity because our three choices involve a minimum amount of space that is, they are )lumpy.* +e need C square feet for a simple game, FC square feet for a video game, and KF square feet for a dance game. The left over space of 4C square feet is too small to accommodate a video game or a dance game, and we do not need more space for the simple games. c. Two features of the solution to part QaR are problematic. -irst, the solution does not include any )dance* games and having at least one dance game seems very important from a marketing perspective. 9econd, more than CH of the space is wasted. :et us therefore modify the solution a bit to see if we could do better.
Balakrishnan, /anagerial 7ccounting e
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;$4S -irst, let us consider putting in one dance game and then optimally allocate the remaining space. dancegame KFsquarefeet ;simplegames ;Csquarefeet ?videogames FCsquarefeet. 1nusedspace Fsquarefeet. +ith this allocation, we could compute 3rash0s profit as dance game I DSCCLweek
DSCC per week
; simplegames gamesIIDKCCLweek DFCLweek ? video Totalprofit
DSCC per week D&,CC per week D?,SCCperweek.
7nother possible modification is to only install five simple games (saving C square feet! and installing five video games. +ith this, we have Fsimplegames Fvideogames 1nusedspace
FCsquarefeet &FCsquarefeet. Csquarefeet.
+ith this solution, we could compute 3rash0s profit as F simple games I DFCLweek F video games I DKCCLweek Totalprofit
DKFC per week D?,FCC per week D4,&FCperweek.
d. This problem highlights a hidden assumption in the above$cited rule. 'n particular, the rule implicitly assumes no constraints in how we use capacity for available uses. 'n the context of 3rash0s problem, this means that we could install, for example, &.F4 video machines or .&; dance machines. 'n other words, each of the games must be )smooth* in its use of the scarce resource, space. This assumption is clearly not tenable in some situations.
Balakrishnan, /anagerial 7ccounting e
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;$FC 6.64
a. 9pace is the binding constraint in this problem and, accordingly, Aidya needs to allocate products according to their contribution per unit of space (e.g., cubic foot!. 2eferring to newspaper sales per unit of space as x, we can make this calculation as follows
8ewspapers /agazines 9nackfoods
CM <"1 &0 $/(,$= C.C
S/(,$ ,+ '*- &0 $/,
C.&F C.&C
x Fx C x
CM ,+ '*- &0 $/, DC.Cx
D.&Fx D&.CCx
Thus, the maximum possible space should be devoted to snack food items and the least amount of space should be devoted to newspapers. 9ub=ect to the other constraints identified in the problem, this leaves Aidya with the following allocation of her available space
9nack foods /agazines 8ewspapers
CM ,+ '*- &0 $/, D&.CCx D.&Fx DC.Cx
S/, A((&/-,) CH (limit! 4CH (plug! FCH (minimum!
Thus, Aidya would allocate 3 .5 B 15 '?* 0,,- -& ,$/,+$ 3 .4 B 12 '?* 0,,- -& //*,$# /) 3 .1 B 3 '?* 0,,- -& $/ 0&&)$ b. 7 prudent place to start is with the multi$product 3A> model with a weighted contribution margin ratio (W!R! formulation. 2ecall from 3hapter 4
"rofit @ (W!R × Revenue! #ixed costs. 1nfortunately, we do not know the sales prices of each item. 7s in part QaR, we assume that each cubic foot generates Dx of sales in newspapers. Then, a cubic foot devoted to magazines and candy will generate DFx and DCx of revenue respectively. The following table uses these numbers to calculate the total contribution margin ratio per average sales D
Balakrishnan, /anagerial 7ccounting e
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;$F
I-, 8ewspapers /agazines 9nacks Total
S/, FC cubic foot &Ccubicfeet ?Ccubicfeet
T&-/( S/(,$ B '?* 0,, $/(,$ " ,+ '?* 0&&DFCx (@ FC I Dx! D;CC x (@ &C I DFx! D?CC x (@ ?C I DCx! D,CFCx
CM BCMR ,+ $/(,$ " -&-/( $/(,$ DFx DFCx D;Cx D&&Fx
Thus, Aidya expects to make a total contribution of D&&F x on sales of D,CFCx, where x is the sales in D per cubic foot devoted to newspapers. "ividing, we have
W!R @ D&&FxLD,CFCx @ &.4&E;H Thus, the breakeven revenue @ D&,KCCLC.&4&EF @ D&,;CC. +e can divide the required sales volume (D&,;CC! by the amount of cubic feet available (?CC cubic feet! to get the sales as "42 ,+ '?* 0&&-. N&-,: This problem assumes a continuous stocking model that is, Aidya never runs out of any product.
MINI CASES 6.65
a. 3ody faceswhich excessgroup demand hisoff services% accordingly, 3ody needs to we determine he isfor best booking. To make this assessment, compute the incremental revenues and costs associated with booking each group. +e begin by calculating the increase in 3ody0s business income
'tem -are -uel and oil costsa /aintenance costs
a
"etail iven ;Cmiles × D.?C% 4CCmiles × D.?C ;Cmiles × D.F% 4CCmiles × D.F
C&-+*?'-*&/+*
1pperMeys D?CC D4E
Trip :owerMeys DFCC D&C
D&4 D;C "228
"32
a
7lthough the trip is only one way, 3ody will incur round$trip costs for fuel, oil, and maintenance. Thus, the round$trip costs are relevant. Balakrishnan, /anagerial 7ccounting e
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;$F&
8otice that the cost of the bus, office operating expenses, and advertising costs are all fixed. These costs do not vary with respect to 3ody0s decision and, thus, are not relevant. -or a similar reason, the fixed cost associated with insurance also is excluded. Based on our calculations, 3ody0s business income will increase by D?&C if he books the trip to the :ower Meys and by D&&E if he books the trip to the 1pper Meys. 3ody0s expected also×is.F relevant this decision. Thetip expected tiptoforthe a trip to the :ower Meys @tip DFCC @ DKF,towhile his expected for a trip 1pper Meys @ D?CC × .F @ D4F. Thus, 3ody0s overall (business O personal! income will increase by D?&C O DKF @ "395 *0 %, ?&&$ -%, -+* -& -%, L&,+ K,;$, and D&&E O D4F @ "273 *0 %, ?&&$ -%, -+* -& -%, U,+ K,;$. 'n short, 3ody0s overall income increases by D?SF D&K? @ D&& more by booking the trip to the :ower Meys versus booking the trip to the 1pper Meys. 7bove and beyond the financial benefits, 3ody would need to consider the additional hours it will take to the complete the trip to the :ower Meys. By booking the group going to the :ower Meys, it is likely that 3ody will not return home until late at night. 'f 3ody has plans for the evening (e.g., a family event, playing poker with his buddies, watching the big game with friends!, this could tip the scales in favor of booking the trip to the 1pper Meys. 3ody also likely will consider whether each group has used his services in the past and is likely to do so in the future (i.e., is the relationship ongoing or one time!. b. This piece of information changes the problem in a relatively straightforward way 3ody will now earn a fare on the return trip from the 1pper Meys but (as assumed in part QaR! not on the return trip from the :ower Meys. 7dditionally, 3ody will earn a tip on the return trip from the 1pper Meys. Thus, 3ody will be able to put the excess supply on the return trip from the 1pper Meys to profitable use.
Balakrishnan, /anagerial 7ccounting e
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;$F?
The revised calculations are presented below
'tem -are Tip -uel G oil costs /aintenance costs
"etail D?CC × &% DFCC × D;CC × .F% DFCC × .F ;Cmiles × D.?C% 4CCmiles × D.?C ;Cmiles × D.F% 4CCmiles × D.F
'ncrease in business O personal income
1pperMeys D;CC
Trip :owerMeys DFCC
DSC DKF (D4E! (D&C! (D&4! (D;C! "618
"395
+e now see that 3ody prefers the trip to the 1pper Meys as his overall (business O personal! income increases by D;E, or D;E D?SF @ "223 relative to booking the group traveling to the :ower Meys. The switch in 3ody0s preference relative to part QaR relates to the additional D?CC fee O the D4F tip (@ D?CC I C.F!% in other words, D?CC O D4F D&& @ D&&?.
Balakrishnan, /anagerial 7ccounting e
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;$F4
c. The following table re$classifies 3adillac 3ody0s business and personal income data by when the trip was made peak season or off$peak season.
>eak Trips 2evenuea Tipsb -uel G oil costsc
6ff$>eak Trips
Total
DF&,FCC D&&,EKF (DE,KFC!
D;K,FCC DC,&F (D,&FC!
D&&C,CCC D??,CCC (D?C,CCC!
(DS,?KF! "147#25
(DF,;&F! "6#75
(DF,CCC! D&CE,CCC (D;C,CCC! (DC,CCC! (D4F,CCC! (DF,CCC! "88#
d
/aintenance costs 3ontribution /argin 3ost of buse 'nsurance costse 6ffice operating expensese Brochures G advertising e 6verall 'ncome a
DF&,FCC @ (&KF × D?CC! O (4C × DFCC!% D;K,FCC @ (&F × D?CC! O (;C × DFCC!. D&&,EKF @ DF&,FCC × .F% DC,&F @ D;K,FCC × .F. c DE,KFC @ ;&,FCC × .?C% D,&FC @ ?K,FCC × .?C. d DS,?KF @ ;&,FCC × .F% DF,;&F @ ?K,FCC × .F. e all of these costs are fixed and cannot be traced to the timing of the trip. b
9ince both the peak and the off$peak seasons last for ; months (or roughly &; weeks!, 3ody will lose D4K,&FCL&; @ "5#663 in overall income if he schedules the trip for M/+% and D;C,KFCL&; @ "2#337 in overall income if he schedules the trip for '(;. This information is likely to be very useful to 3ody and his wife in planning their vacation5 2ightfully, this is part of the opportunity cost of going on vacation and should be added to the other vacation costs. 'n essence, we see that it costs 3ody substantially less to vacation during Nuly (3ody0s off$peak business season! than during /arch (3ody0s peak business season! C&); (&$,$ (,$$ *&, ?; $%,)'(* %*$ ://-*& * / ,+*&) &0 ,,$$ $'(;. This part of the problem also shows us the importance of taking aggregate data and breaking it into smaller pieces. 'f 3ody were to use his overall income to guide his vacation decision, he might erroneously conclude that he would lose only DEE,CCCLF& weeks @ D,;S& by going on vacation. This calculation, however, ignores both fixed costs and the timing of the trip. 3ody might do a little better with the overall business contribution margin data, calculating that he would lose D&CE,CCCLF& @ D4,CCC by taking the trip. This number, however, still ignores the seasonal nature of 3ody0s business. 3ody would underestimate the cost of taking a vacation in /arch and
Balakrishnan, /anagerial 7ccounting e
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;$FF overestimate the cost of taking a vacation in Nuly. /oreover, 3ody sacrifices the least amount of income by taking the trip during the non$peak season. d.
7ssuming the friend0s calculations are accurate, we calculate 3ody0s incremental income as follows 6ff$>eak Trips 6ff$>eak Trips (normal fare!
(&FH discount!
D;K,FCC DC,&F (D,&FC! (DF,;&F!
DE,CCC D&,FC (DF,KFC! (DK,EKF!
"6#75
"69#525
a
2evenue Tipsb -uel G oil costs c /aintenance costsd 3ontribution /argin (business and personal income!
a
D;K,FCC @ (&F × D?CC! O (;C × DFCC!% DE,CCC @ Q(&F × .;C! × (D?CC × .KF!R O Q(;C × .;C! × (DFCC × .KF!R. b DC,&F @ D;K,FCC × .F% D&,FC @ DE,CCC × .F. c D,&FC @ ?K,FCC × .?C% DF,KFC @ ?K,FCC × .4C × .?C. d DF,;&F @ ?K,FCC × .F% DK,EKF @ ?K,FCC × .4C × .F. 8otice that the cost of the bus, office operating expenses, and advertising costs are all fixed. 9ince these costs do not vary across 3ody0s decision, they are not relevant. -or a similar reason, the fixed cost associated with insurance also is not relevant. (7bsent information to the contrary, we are assuming that the additional mileage will not decrease the bus0s salvage value. 7ny such decrease would diminish the attractiveness of slashing off$peak fares.! 7ssuming the friend0s numbers are accurate, we see that 3ody0s overall business and personal income will increase to "69#525, which represents a D;S,F&F D;C,KFC @ "8#775 increase in overall income compared to his current pricing strategy. 'n terms of evaluating the advice, we would first need to consider whether 3ody actually would want to be this much busier during the off$peak season perhaps 3ody en=oys the free time and having a more relaxed schedule for half of the year. 7t another level, we see that such differential pricing strategies (also known as peak$load pricing! widely followed. 2eady examples utility specials, firms that offer different ratesare based on time$of$use, airlines offeringare summer hotels offering )deals* for weekend getaways, and golf courses offering reduced rates for winter or mid$week play. The pricing strategy makes sense when fixed Balakrishnan, /anagerial 7ccounting e
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;$F; costs are relatively high, implying that capacity utilization is key for maximizing profit.
Balakrishnan, /anagerial 7ccounting e
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;$FK
+hile this strategy may work well for airlines and hotels, it probably will not work well for 3adillac 3ody. 9tated simply, the strategy works well for airlines, hotels, and golf courses because the size of the overall market changes (it increases! when these organizations cut prices. 'n other words, spurred by a low airfare or a low green fee, more people will travel or play golf. The increase in the market size is the source for the incremental revenue. -or 3adillac 3ody, however, his actions are likely to have minimal impact on market size. 7fter all, people do not plan a vacation, costing thousands of dollars, based on the prices of local transportation5 The number of people traveling to the Meys will be the same regardless of whether keeps his fees prices same ortoslashes them (similarly, relatively small change3ody in shuttle$bus arethe unlikely affect the number of cara rentals!. 'f 3ody were to cut his prices, it also is likely that other shuttle$bus operators will cut their prices. 9ince market size and market share are likely to stay the same, everyone will make a lower profit5 'n other words, the friend0s calculation assumes that all other persons would stay put, which is not a good assumption in the real world. iven this insight and the fact that lowering prices will not affect the overall size of the market, 3ody would be well advised not to lower his off$ peak prices. 6ne may well ask what prevents 3ody (and the other bus operators! from raising prices to exorbitant amounts. 9ome amount of price$gouging no doubt takes place. +e must remember, however, that this is a market with relatively low entry barriers. 'f shuttle$bus operators start making too much money, competition is likely to to occur intensify and exert downward pressure >ricesensitive gougingand is mostly likely in settings where the customer is on notprices. very price non$ market forces prevent competitive entry (e.g., as for a professional or college sports team!.
Balakrishnan, /anagerial 7ccounting e
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;$FE
6.66
a. -or all practical purposes,
6ption 7ccept >iedmont0s business and re=ect 3apelli0s offer. Thus, in total, S& suites (@ ?&C I C.;C% KF to >iedmont and K to individuals! will be booked for each of the three days at the end of -ebruary, with a daily occupancy rate of ;CH, which is close to the usual level.
•
6ption & 7ccept 3apelli0s business and re=ect >iedmont0s offer. Thus, all available suites or ?&C suites (&&F to 3apelli and SF to individuals! will be booked for each of the three days.
Technically, iedmont and 3apelli this is the status quo. iedmont, this is the total number of suites × D?F% D?F @ D&C,CCCL;,CCC% for 3apelli, this cost is the total number of suites × DF&.FC D?F I .FC!, since
Balakrishnan, /anagerial 7ccounting e
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;$FS
A,P*,)&-
A,C/,((*
"ata Totalsuitescorporate Totalsuitesindividual >rice per suite corporate >rice per suite individual
&&F ?F D&C.CC DFC.CC
;KF &EF& D&C.CC DFC.CC
2evenues 9uitescorporate 9uitesindividual 3onventioncenter -ood, telephone, G movies Totalrevenues
D&K,CCC F&,;FC F,CCC 4,4CC? DCS,CFC
DE,CCC 4&,KFC F,CCC &4,CCC D;&,KFC
Aariable 3osts -ood,laundry,supplies,etc. :abor (kitchen help, maids! C&-+*?'-*& /+*
DK,&EC &C,;C 4 DK,;C
D&E,ECC FC,4CC DE?,FFC
7dditional-ixed3osts Build runway P+&?F 0*-@ Q(?&C I ? days! I C.;CR &&F.
D?,CCC "71#61
"8#55
&
&EF @ Q(?&C I ? days! $ ;KFR. ? 4,4CC @ (D&F I S;C! I C.;C. 4 &C,;C @ (D?C I S;C! I C.;C.
-rom a profit$maximizing perspective, we find the 3appelli 6ption to be the most attractive. +e also could verify this using the incremental approach, using either controllable cost analysis or relevant cost analysis. c. The new information would have a substantive effect on
Balakrishnan, /anagerial 7ccounting e
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;$;C
A,P*,)&-
"ata Totalsuitescorporate Totalsuitesindividual >rice per suite corporate >rice per suite individual
2evenues 9uitescorporate 9uitesindividual 3onventioncenter -ood, telephone, G movies Totalrevenues Aariable 3osts -ood, laundry, supplies, etc. :abor(kitchenhelp,maids! C&-+*?'-*& /+*
EC ?F D&C.CC DFC.CC
D&,;CC F&,;FC F,CCC ?,&KF DC&,F&F
DF,S?C E,FEF D;E,CC
7dditional -ixed 3osts Build runway P+&0*-
A,C/,((*
4FC &EF D&C.CC DFC.CC
DF4,CCC 4&,KFC F,CCC E,?KF D?C,&F
D&&,CFC ?E,FEE D;S,4EE
D?,CCC "68#1
"66#488
-rom a profit$maximizing perspective, we find the 3appelli option is no longer as attractive. 'f iedmont option. iedmont0s meeting this year. By turning down >iedmont, a long$time client,
-62 '89T213T62 19# 68:
;$; possibility of uncertain demand reduces the financial attractiveness of 3apelli, although it is likely the better financial option. Thus, even though the profitable short$term decision is to accept 3apelli0s business, iedmont contract forever. 's the immediate incremental benefit of DE,S4C (@ DEC,FFC DK,;C% see part b. above! worth losing a valued clientP 't may be advisable for
b. Brenda0s expected profit is a function of the expected probability of sale, the expected selling price, her commission rate, and the costs she incurs on the open house. -ormally, we have #xpectedprobabilityofsale CH #xpectedsellingprice D&?K,FCC #xpectedcommission DK&.FC Aariable costs of open house D&FC E,-,) +&0*- <,- &*$$*&= "462.5
given .SF × asking price of &FC,CCC CH × ?H × D&?K,FCC
c. Brenda0s expected profit is a function of the expected probability of sale, the expected selling price, and her commission rate (the costs she incurs to show homes are negligible!. -ormally, we have #xpectedsellingprice
D&CS,CCC
C.SF
#xpected commission (other0s listing! #xpected commission (own listing! E,-,) +&0*- <-&-/( &*$$*&=
D&FC.EC D&F.4C "376.2
4H H
×
× ×
D&&C,CCC
?H × D&CS,CCC ;H × D&CS,CCC
d. Based on her expected profit (commission!, Brenda should hold the open house. e. +e know from part QcR that Brenda0s expected profit from showing homes to potential buyers is D?K;.&C. 7dditionally, we can model her profit from the second open house as a function of the likelihood (chance! of selling the home, or #xpected profit from second open house @ (chance of selling × D&?K,FCC × .C?! D&FC. Balakrishnan, /anagerial 7ccounting e
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;$;& +e find the probability that makes Brenda0s indifferent between the two options by setting her expected profit from the second open house equal to D?K;.&C. Thus, we have D?K;.&C @ (chance of selling × D&?K,FCC × .C?! D&FC, or %/, &0 $,((* B . 878. Thus, if the chance of selling the house on the second open house is less than approximately E.KEH then Brenda should not hold the second open house. 7lternatively, if the chance of selling the house on the second open showing is greater than approximately E.KSH then Brenda should hold the second open house. 6.68
a. 'n solving this problem, it probably is best to set$up a profit model for each option. Based on the information provided, we have >rofit (outsource! @ C.&C × whitewater rafting revenue. >rofit (operate internally! @ (.;C × whitewater rafting revenue! D4C,CCC. These models allow us to calculate the profits under each option at the two different revenue levels. Thus, we have
O-*& 6utsource 6perateinternally
#xpected 2evenue "75# "125# DF,CCC D&F,CCC DF,CCC D?F,CCC
I0 +,:,',$ B "75# -%, /+/??*- T+/*($ $%&'() &'-$&'+, /$ -%*$ *+,/$,$ +&0*- ?; "1# & -%, &-%,+ %/)# *0 +,:,',$ B "125# -%, /+/??*- T+/*($ $%&'() &,+/-, -%, %*-,/-,+ +/0-* -&'+$ *-,+/((; /$ -%*$ &-*& (,/)$ -& "1# %*%,+ +&0*- -%/ &'-$&'+*.
b. 9etting the two profit models equal to each other we have .&C × gross whitewater rafting revenue @ (.;C D4C,CCC.
×
gross whitewater rafting revenue!
9olving, we find gross whitewater rafting revenue @ "1#. -urthermore, for revenue \ DCC,CCC, outsourcing is preferred. -or revenue _ DCC,CCC, it is more profitable to provide the service in house. /ore generally, the following graph depicts whitewater rafting profit as a function of whitewater rafting revenue.
Balakrishnan, /anagerial 7ccounting e
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;$;? = " < -* 0 & + PDEC,CCC 2 *1 -0 / D;C,CCC R D4C,CCC
in$house outsource
D&C,CCC DC $D&C,CCC
C
&C,CCC4C,CCC;C,CCCEC,CCCCC,CCC &C,CCC 4C,CCC ;C,CCC &CC,CCC EC,CCC
$D4C,CCC
G+&$$ W%*-,/-,+ R/0-* R,:,',
c. There are numerous other factors that Nackrabbit Trails might take into consideration.
6.69
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Nackrabbit Trails should consider the quality of the service being offered will patrons0 whitewater rafting experience be moreLless en=oyable and safe with Tributary Tours or the in$house serviceP To this end, the reliability and trustworthiness of Tributary Tours needs to be established.
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Nackrabbit Trails should consider the uncertainty in their estimate of gross whitewater rafting revenues. They should also consider other sources of risk such as the liability. By outsourcing, Nackrabbit trails shifts most, if not all of the risk from themselves to Tributary Tours. Thus, increased uncertainty would make contracting out the preferred option if management were averse to risk. (8ote naturally, one could conceive of this risk being priced out in the adventure tour market. That is, the price charged would include a premium for the estimated value of risk in the venture.!
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Nackrabbit Trails needs to consider how offering whitewater rafting will affect their other activities it is quite likely that the revenues on, for example, sailing or canoeing will decrease this opportunity cost would need to be considered before any decision is made.
-rom a purely monetary (quantitative! standpoint, the corporate donor is the better deal. 2obin and the museum net D&,CCC O CH of DF,CCC less the DFCC from the charity by renting the atrium to the corporate donor. This is before counting any
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;$;4 )surprise* donation received from the corporate donor and any future events that the corporate donor might hold. +eighed against this, however, are the qualitative factors. -irst, there is the loss of goodwill associated with moving the charitable event. 't appears that a lot of effort has been vested in the event, and canceling it is likely to trigger much adverse publicity, perhaps with implications for future donations. 6ne could imagine the local newspaper writing an article titled something like )/useum 9tiffs Mids for "ough.* 9econd, there is the clear ethical obligation to the charity after all, they reserved the atrium first5 There also is a legal obligation to the extent 2obin hasthese a contract with charity.is There is effects an implicit long$term value that arises from factors. Thethe problem that the are hard to quantify. /ost managers in this setting probably would call the charity to see if it is possible to move the date andLor the location (with the museum or the corporate donor picking up the cost!. 9ome might even have the corporation call the charity5 'f such a change is not feasible, then the right thing to do is honor the commitment to the children0s charity. 'n addition to the ethical obligation, the potential dilution of the /useum0s mission as well as the possibility of substantial negative publicity are significant. (There also might be a legally binding obligation, even if no written contract exists.! 2obin0s quandary reminds us that both quantitative and qualitative considerations factor into most decisions. The quantitative analysis often is only a start, and it is important to remember that better measurement does not necessarily make the quantitative aspects more relevant than the qualitative aspects (i.e., issues with greater measurement error!. 1ltimately, talent liesconclusion. in the ability to estimate well the qualitative aspects and managerial to reach a reasoned 'n this particular instance, the qualitative considerations are likely to receive the most weight and guide 2obin0s decision.
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