Chapter 19 - Answer

MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 19 RELEVANT COSTS FOR DECISION MAKING I.

Questions 1. Quantitative factors are those which may more easily be reduced in terms of pesos such as projected costs of materials, labor and overhead. Qualitative factors are those whose measurement in pesos is difficult and imprecise; yet a qualitative factor may be easily given more weight than the measurable cost savings. It can be seen that the accountant’s role in making decisions deals with the quantitative factors. 2. Relevant costs are expected future costs that will differ between alternatives. In view of the definition of relevant costs, historical costs are always irrelevant because they are not future costs. They may be helpful in predicting relevant costs but they are always irrelevant costs per se. 3. The differential costs in any given situation is commonly defined as the change in total cost under each alternative. It is not relevant cost, but it is the algebraic difference between the relevant costs for the alternatives under consideration. 4. Analysis: Future costs: New Truck Less: Proceeds from disposal, net

Replace P10,200

Rebuild

1,000 P 9,200

Advantage of rebuilding

P8,500 P700

The original cost of the old truck is irrelevant but its disposal value is relevant. It is recommended that the truck should be rebuilt because it will involve lesser cash outlay. 5. No. Variable costs are relevant costs only if they differ in total between the alternatives under consideration. 6. Only those costs that would be avoided as a result of dropping the product line are relevant in the decision. Costs that will not differ regardless of whether the product line is retained or discontinued are irrelevant. 19-1

Chapter 19 Relevant Costs for Decision Making

7. Not necessarily. An apparent loss may be the result of allocated common costs or of sunk costs that cannot be avoided if the product line is dropped. A product line should be discontinued only if the contribution margin that will be lost as a result of dropping the line is less than the fixed costs that would be avoided. Even in that situation the product line may be retained if its presence promotes the sale of other products. 8. Allocations of common fixed costs can make a product line (or other segment) appear to be unprofitable, whereas in fact it may be profitable. 9. In cost-plus pricing, prices are set by applying a markup percentage to a product’s cost. 10. The price elasticity of demand measures the degree to which a change in price affects unit sales. The unit sales of a product with inelastic demand are relatively insensitive to the price charged for the product. In contrast, the unit sales of a product with elastic demand are sensitive to the price charged for the product. 11. The profit-maximizing price should depend only on the variable (marginal) cost per unit and on the price elasticity of demand. Fixed costs do not enter into the pricing decision at all. Fixed costs are relevant in a decision of whether to offer a product or service, but are not relevant in deciding what to charge for the product or service. Because price affects unit sales, total variable costs are affected by the pricing decision and therefore are relevant. 12. The markup over variable cost depends on the price elasticity of demand. A product whose demand is elastic should have a lower markup over cost than a product whose demand is inelastic. If demand for a product is inelastic, the price can be increased without cutting as drastically into unit sales.

II. Exercises Exercise 1 (Identifying Relevant Costs) Case 1 Item

Relevant 19-2

Not Relevant

Case 2 Relevant

Not Relevant

Relevant Costs for Decision Making Chapter 19 a. b. c. d. e. f. g. h. i. j. k. l.

Sales revenue................................... X Direct materials............................... X Direct labor...................................... X Variable manufacturing overhead.......................................... X Book value – Model E7000 machine........................................... Disposal value – Model E7000 machine........................................... Depreciation – Model E7000 machine........................................... Market value – Model F5000 machine (cost)................................. X Fixed manufacturing overhead.......................................... Variable selling expense.................. X Fixed selling expense...................... X General administrative overhead.......................................... X

X X

X X

X X

X X

X

X X

X

X X X X

Exercise 2 (Identification of Relevant Costs) Requirement 1 Fixed cost per mile (P3,500* ÷ 10,000 miles).......................................................... P0.35 Variable operating cost per mile............................................................................... 0.08 Average cost per mile............................................................................................... P0.43 * Depreciation............................................................................................................ P2,000 Insurance................................................................................................................. 960 Garage rent............................................................................................................. 480 Automobile tax and license..................................................................................... 60 Total........................................................................................................................ P3,500 Requirement 2 The variable operating costs would be relevant in this situation. The depreciation would not be relevant since it relates to a sunk cost. However, any decrease in the resale value of the car due to its use would be relevant. The automobile tax and license costs would be incurred whether Ingrid decides to drive her own car or rent a car for the trip during summer break and are therefore irrelevant. It is unlikely that her insurance costs would increase as a result of the trip, so they are irrelevant as well. The garage rent is relevant only if she could avoid paying part of it if she drives her own car. 19-3


Requirement 3 When figuring the incremental cost of the more expensive car, the relevant costs would be the purchase price of the new car (net of the resale value of the old car) and the increases in the fixed costs of insurance and automobile tax and license. The original purchase price of the old car is a sunk cost and is therefore irrelevant. The variable operating costs would be the same and therefore are irrelevant. (Students are inclined to think that variable costs are always relevant and fixed costs are always irrelevant in decisions. This requirement helps to dispel that notion.) Exercise 3 (Make or Buy a Component) Requirement 1

Cost of purchasing Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead, traceable1

Per Unit Differential Costs 15,000 units Make Buy Make Buy P200 P3,000,000 P 60 P 900,000 80 1,200,000 10 150,000 20

Fixed manufacturing overhead, common Total costs Difference in favor of continuing to make the parts 1

0 P170 P30

300,000 0 0 0 P200 P2,550,000 P3,000,000 P450,000

Only the supervisory salaries can be avoided if the parts are purchased. The remaining book value of the special equipment is a sunk cost; hence, the P3 per unit depreciation expense is not relevant to this decision. Based on these data, the company should reject the offer and should continue to produce the parts internally.

Requirement 2 Make Buy Cost of purchasing (part 1)................................................................................................... P3,000,000 Cost of making (part 1)........................................................................................................ P2,550,000 Opportunity cost—segment margin forgone on a 650,000 19-4

Relevant Costs for Decision Making Chapter 19 potential new product line................................................................................................ Total cost............................................................................................................................... P3,200,000 P3,000,000 Difference in favor of purchasing from the outside supplier.............................................................................................................................. P200,000 Thus, the company should accept the offer and purchase the parts from the outside supplier.

Exercise 4 (Evaluating Special Order) Only the incremental costs and benefits are relevant. In particular, only the variable manufacturing overhead and the cost of the special tool are relevant overhead costs in this situation. The other manufacturing overhead costs are fixed and are not affected by the decision. Per Unit P3,499.50

Total 10 bracelets P34,995.00

Incremental revenue Incremental costs: Variable costs: Direct materials 1,430.00 14,300.00 Direct labor 860.00 8,600.00 Variable manufacturing overhead 70.00 700.00 Special filigree 60.00 600.00 Total variable cost P2,420.00 24,200.00 Fixed costs: Purchase of special tool 4,650.00 Total incremental cost 28.850.00 Incremental net operating income P 6.145.00 Even though the price for the special order is below the company’s regular price for such an item, the special order would add to the company’s net operating income and should be accepted. This conclusion would not necessarily follow if the special order affected the regular selling price of bracelets or if it required the use of a constrained resource. Exercise 5 (Utilization of a Constrained Resource) Requirement 1 X Y Z (1) Contribution margin per unit................................................................................................ P18 P36 P20 (2) Direct labor cost per unit....................................................................................................... P12 P32 P16 19-5

Chapter 19 Relevant Costs for Decision Making (3) Direct labor rate per hour...................................................................................................... 8 8 8 (4) Direct labor-hours required per unit (2) ÷ (3)....................................................................... 1.5 4.0 2.0 Contribution margin per direct labor-hour (1) ÷ (4)............................................................. P12 P 9 P10

Requirement 2 The company should concentrate its labor time on producing product X: X Contribution margin per direct labor-hour Direct labor-hours available Total contribution margin

P12 × 3,000 P36,000

Y P9 × 3,000 P27,000

Z P10 × 3,000 P30,000

Although product X has the lowest contribution margin per unit and the second lowest contribution margin ratio, it has the highest contribution margin per direct labor-hour. Since labor time seems to be the company’s constraint, this measure should guide management in its production decisions. Requirement 3 The amount Jaycee Company should be willing to pay in overtime wages for additional direct labor time depends on how the time would be used. If there are unfilled orders for all of the products, Jaycee would presumably use the additional time to make more of product X. Each hour of direct labor time generates P12 of contribution margin over and above the usual direct labor cost. Therefore, Jaycee should be willing to pay up to P20 per hour (the P8 usual wage plus the contribution margin per hour of P12) for additional labor time, but would of course prefer to pay far less. The upper limit of P20 per direct labor hour signals to managers how valuable additional labor hours are to the company. If all the demand for product X has been satisfied, Jaycee Company would then use any additional direct labor-hours to manufacture product Z. In that case, the company should be willing to pay up to P18 per hour (the P8 usual wage plus the P10 contribution margin per hour for product Z) to manufacture more product Z. Likewise, if all the demand for both products X and Z has been satisfied, additional labor hours would be used to make product Y. In that case, the company should be willing to pay up to P17 per hour to manufacture more product Y.

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Relevant Costs for Decision Making Chapter 19

Exercise 6 (Sell or Process Further) Sales value after further processing Sales value at split-off point Incremental revenue Cost of further processing Incremental profit (loss)

Product A P80,000 50,000 30,000 35,000 P(5,000)

Product B P150,000 90,000 60,000 40,000 20,000

Product C P75,000 60,000 15,000 12,000 3,000

Products B and C should be processed further, but not Product A. Exercise 7 (Identification of Relevant Costs) Requirement 1 The relevant costs of a fishing trip would be: Fuel and upkeep on boat per trip............................. Junk food consumed during trip*............................. Snagged fishing lures............................................... Total........................................................................

P25 8 7 P40

* The junk food consumed during the trip may not be completely relevant. Even if Shin were not going on the trip, he would still have to eat. The amount by which the cost of the junk food exceeds the cost of the food he would otherwise consume would be the relevant amount.

The other costs are sunk at the point at which the decision is made to go on another fishing trip. Requirement 2 If he fishes for the same amount of time as he did on his last trip, all of his costs are likely to be about the same as they were on his last trip. Therefore, it really doesn’t cost him anything to catch the last fish. The costs are really incurred in order to be able to catch fish and would be the same whether one, two, three, or a dozen fish were actually caught. Fishing, not catching fish, costs money. All of the costs are basically fixed with respect to how many fish are actually caught during any one fishing trip, except possibly the cost of snagged lures. Requirement 3 In a decision of whether to give up fishing altogether, nearly all of the costs 19-7


listed by Shin’s wife are relevant. If he did not fish, he would not need to pay for boat moorage, new fishing gear, a fishing license, fuel and upkeep, junk food, or snagged lures. In addition, he would be able to sell his boat, the proceeds of which would be considered relevant in this decision. The original cost of the boat, which is a sunk cost, would not be relevant. These three requirements illustrate the slippery nature of costs. A cost that is relevant in one situation can be irrelevant in the next. None of the costs are relevant when we compute the cost of catching a particular fish; some of them are relevant when we compute the cost of a fishing trip; and nearly all of them are relevant when we consider the cost of not giving up fishing. What is even more confusing is that CG is correct; the average cost of a salmon is P167, even though the cost of actually catching any one fish is essentially zero. It may not make sense from an economic standpoint to have salmon fishing as a hobby, but as long as Shin is out in the boat fishing, he might as well catch as many fish as he can.

Exercise 8 (Dropping or Retaining a Segment) Requirement 1 No, the housekeeping program should not be discontinued. It is actually generating a positive program segment margin and is, of course, providing a valuable service to seniors. Computations to support this conclusion follow: Contribution margin lost if the housekeeping program is dropped............................................................................................ P(80,000) Fixed costs that can be avoided: Liability insurance............................................................................... P15,000 Program administrator’s salary........................................................... 37,000 52,000 Decrease in net operating income for the organization as a whole........................................................................................... P(28,000) Depreciation on the van is a sunk cost and the van has no salvage value since it would be donated to another organization. The general administrative overhead is allocated and none of it would be avoided if the program were dropped; thus it is not relevant to the decision. The same result can be obtained with the alternative analysis below: 19-8


Current Total Revenues...................................................................... P900,000 Variable expenses......................................................... 490,000 Contribution margin.................................................... 410,000 Fixed expenses: Depreciation*.......................................................... 68,000 Liability insurance................................................... 42,000 Program administrators’ salaries............................ 115,000 General administrative overhead............................ 180,000 Total fixed expenses..................................................... 405,000 Net operating income (loss)......................................... P 5,000

Difference: Total If Net Operating HouseIncome keeping Is Increase or Dropped (Decrease) P660,000 P(240,000) 330,000 160,000 330,000 (80,000) 68,000 27,000 78,000 180,000 353,000 P(23,000)

0 15,000 37,000 0 52,000 P (28,000)

*Includes pro-rated loss on disposal of the van if it is donated to a charity.

Requirement 2 To give the administrator of the entire organization a clearer picture of the financial viability of each of the organization’s programs, the general administrative overhead should not be allocated. It is a common cost that should be deducted from the total program segment margin. Following the format for a segmented income statement, a better income statement would be: Total Revenues........................................................ P900,000 Variable expenses.......................................... 490,000 Contribution margin...................................... 410,000 Traceable fixed expenses: Depreciation.............................................. 68,000 Liability insurance.................................... 42,000 Program administrators’ salaries.................................................. 115,000 Total traceable fixed expenses....................... 225,000 Program segment margins............................ 185,000 General administrative overhead.................. 180,000 P 5,000 Net operating income (loss)..........................

Exercise 9 (Special Order) Requirement 1 19-9

Home Nursing P260,000 120,000 140,000

Meals on Wheels P400,000 210,000 190,000

Housekeeping P240,000 160,000 80,000

8,000 20,000

40,000 7,000

20,000 15,000

40,000 68,000 P 72,000

38,000 85,000 P105,000

37,000 72,000 P 8,000


Monthly profits would be increased by P9,000: Total for Per Unit 2,000 Units Incremental revenue......................................................................... P12.00 P24,000 Incremental costs: Variable costs: Direct materials........................................................................ 2.50 5,000 Direct labor.............................................................................. 3.00 6,000 Variable manufacturing overhead............................................. 0.50 1,000 Variable selling and administrative........................................... 1.50 3,000 Total variable cost........................................................................ P 7.50 15,000 Fixed costs: None affected by the special order............................................ 0 Total incremental cost...................................................................... 15,000 Incremental net operating income.....................................................P 9,000 Requirement 2 The relevant cost is P1.50 (the variable selling and administrative costs). All other variable costs are sunk, since the units have already been produced. The fixed costs would not be relevant, since they would not be affected by the sale of leftover units. Exercise 10 (Make or Buy a Component) The costs that are relevant in a make-or-buy decision are those costs that can be avoided as a result of purchasing from the outside. The analysis for this exercise is: Per Unit Differential Costs Make Buy Cost of purchasing....................................................... P23.50 Cost of making: P 4.80 Direct materials....................................................... Direct labor.............................................................. 7.00 Variable manufacturing overhead........................... 3.20 Fixed manufacturing overhead................................ 4.00 * Total cost.................................................................. P19.00 P23.50

20,000 Units Make Buy P470,000 P 96,000 140,000 64,000 80,000 P380,000

P470,000

* The remaining P6 of fixed manufacturing overhead cost would not be relevant, since it will continue regardless of whether the company makes or buys the parts.

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The P150,000 rental value of the space being used to produce part R-3 represents an opportunity cost of continuing to produce the part internally. Thus, the completed analysis would be: Make Buy Total cost, as above.......................................................................................... P380,000 P470,000 Rental value of the space (opportunity cost)................................................... 150,000 Total cost, including opportunity cost............................................................. P530,000 P470,000 Net advantage in favor of buying.................................................................... P60,000

Profits would increase by P60,000 if the outside supplier’s offer is accepted. Exercise 11 (The Economists’ Approach to Pricing) Requirement (1) Cecile makes more money selling the ice cream cones at the lower price, as shown below: P17.90 Price P13.90 Price Unit sales........................................................ 860 1,340 Sales...............................................................P15,394.00 Cost of goods sold @ P4.10............................ 3,526.00 Contribution margin........................................ 11,868.00 Fixed expenses................................................ 425.00 Net operating income...................................... P11,443.00 Requirement (2) The price elasticity of demand is computed as follows:

d

=

In(1 + % change in quantity sold) In(1 + % change in price) In(1 +

1,340 – 860 ) 860

In(1 +

13.90 – 17.90 ) 17.90

=

=

In(1 + 0.55814) In(1 – 0.22346)

=

In(1.55814) In(0.77654)

=

0.44349 –0.25291

19-11

=

–1.75

P18,626.00 5,494.00 13,132.00 425.00 P12,707.00


Requirement (3) The profit-maximizing price can be estimated using the following formulas: Profit-maximizing markup on variable cost

–1 1 + d –1 1 + (–1.75)

= =

Profit-maximizing price

=

1 +

=

1.333

Profit-maximizing markup on variable cost

x

Variable cost per unit

= (1 + 1.3333) x P4.10 = P9.60 This price is much lower than the prices Cecile has been charging in the past. Rather than immediately dropping the price to P9.60, it would be prudent to drop the price a bit and see what happens to unit sales and to profits. The formula assumes that the price elasticity is constant, which may not be the case. Exercise 12 (Target Costing) Sales (50,000 batteries × P65 per battery).....................................P3,250,000 Less desired profit (20% × P2,500,000)........................................ 500,000 Target cost for 50,000 batteries.....................................................P2,750,000 Target cost per battery

= (P2,750,000 ÷ 50,000 batteries) = P55 per battery

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Exercise 13 (Pricing a New Product) The selling price of the new amaretto cappuccino product should at least cover its variable cost and its opportunity cost. The variable cost of the new product is P4.60 and its opportunity cost can be computed by multiplying the opportunity cost of P34 per minute of order filling time by the amount of time required to fill an order for the new product:

Selling price of the new product



Variable cost of the new product

+

Opportunity cost per unit of the x constrained resource

Amounts of the constrained resource required by a unit of the new product




P4.60 + P34 per minute

+




P4.60 + P34 per minute

+ 0.75 minute

45 seconds 60 seconds per minute

Selling price of P30.10 the new product  P4.60 + P25.50 = Hence, the selling price of the new product should at least cover both its variable cost of P4.60 and its opportunity cost of P25.50, for a total of P30.10. III. Problems Problem 1 (Accept or Reject an Order) Selling price per unit Less Variable costs/unit: Materials Labor Factory overhead (25%) Contribution margin/unit Multiplied by number of units to be sold Total contribution margin

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Product A P1.20

Product B P1.40

0.50 0.20 0.10 0.80 P0.40 21,000 units P8,400

0.70 0.24 0.14 1.08 P0.32 30,000 units P9,600


Product B should be accepted because its total contribution margin is higher than that of Product A.

Problem 2 (Eliminate or Retain a Product Line) Requirement 1 No, production and sale of the round trampolines should not be discontinued. Computations to support this answer follow: Contribution margin lost if the round trampolines are discontinued............................................. Less fixed costs that can be avoided: Advertising – traceable.................................. Line supervisors’ salaries............................... Decrease in net operating income for the company as a whole.......................................

P(80,000) P41,000 6,000

47,000 P(33,000)

The depreciation of the special equipment represents a sunk cost, and therefore it is not relevant to the decision. The general factory overhead is allocated and will presumably continue regardless of whether or not the round trampolines are discontinued; thus, it is not relevant. Requirement 2 If management wants a clear picture of the profitability of the segments, the general factory overhead should not be allocated. It is a common cost and therefore should be deducted from the total product-line segment margin. A more useful income statement format would be as follows: Total Sales...................................... P1,000,000 Less variable expenses.......... 410,000 Contribution margin............. 590,000 Less fixed expenses: Advertising – traceable..... 216,000 Depreciation of special equipment...................... 95,000 19-14

Trampoline Round Rectangular P140,000 P500,000 60,000 200,000 80,000 300,000

Octagonal P360,000 150,000 210,000

41,000

110,000

65,000

20,000

40,000

35,000

Relevant Costs for Decision Making Chapter 19 Line supervisors’ salaries........................... Total traceable fixed expenses............................ Product-line segment margin............................... Less common fixed expenses............................ Net operating income (loss).................................. P

19,000

6,000

7,000

6,000

330,000

67,000

157,000

106,000

260,000

P 13,000

P143,000

P104,000

200,000 60,000

Problem 3 (Product Mix) Requirement 1 Selling price per unit Variable cost per unit Contribution margin / unit Divided by no. of hours required for each unit Contribution per hour Product ranking: 1. D 2. B

Product Line B C P25 P10 10 5 P15 P 5

A P30 25 P5 5 hrs. P1

3. C

10 hrs. P1.5

4 hrs. P1.25

D P8 4 P4 1 hr. P4

4. A

Based on the above analysis, first priority should be given to Product D. The company should use 4,000 out of the available 96,000 hrs. to produce 4,000 units of product D. The remaining 92,000 hrs. should be used to produce 9,200 units of Product B. Hence, the best product combination is 4,000 units of Product D and 9,200 units of Product B. Requirement 2 If there were no market limitations on any of the products, the company should use all the available 96,000 hours in producing 96,000 units of product D only. The difference in profit between the two alternatives is computed as follows: Contribution margin of combination (1) Product D (4,000 x P 4.00) Product B (9,200 x P15.00) Total contribution margin of D and B 19-15

P 16,000 138,000 P154,000


Less contribution margin of D only (96,000 x P4) Difference, excess over profit in combination (1) Problem 4 (Accept or Reject a Special Order)

384,000 P230,000

Requirement 1 The company should accept the special order of 4,000 @ P10 each because this selling price is still higher than the additional variable cost to be incurred. Whether or not variable marketing expenses will be incurred, the decision is still to accept the order. Supporting computations: (a) Assume no additional variable marketing cost will be incurred. Selling price per unit Less variable manufacturing costs: Direct materials Direct labor Variable overhead Contribution margin/unit Multiplied by number of units of order Total increase in profit

P10.00 P5.00 3.00 0.75

8.75 P 1.25 4,000 units P5,000

(b) Assume additional variable marketing cost will be incurred. Selling price per unit Less variable costs (P8.75 + P0.25) Contribution margin / unit Multiplied by number of units of order Total increase in contribution margin

P10.00 9.00 P 1.00 4,000 units P4,000

Requirement 2 P8.75, the total variable manufacturing cost. Requirement 3 Direct materials Direct labor Variable factory overhead Total cost of inventory under direct costing

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P5.00 3.00 0.75 P8.75


Requirement 4 Present contribution margin [10,000 units x (P15 - P9)] Less proposed contribution margin [(P14 - P9) x 11,000 units] Decrease in contribution margin

P60,000 55,000 P 5,000

The company should not reduce the selling price from P15 to P14 even if volume will go up because total contribution margin will decrease. Problem 5 (CVP Analysis used for Decision Making) Requirement (a) Units sold per month 4,000 5,000 6,000

No. of months 6 15 9 30

Probability 20% 50% 30% 100%

Requirement (b) 4,000 units P160,000

Production 5,000 units P160,000

6,000 units P160,000

100,000 -

125,000 -

150,000 -

Total Contribution margin

P100,000 P 60,000

P125,000 P 35,000

P150,000 P 10,000

Sales (5,000 x P40) Less variable costs Production cost @ P25 Purchase cost @ P45

P200,000

P200,000

P200,000

100,000 45,000

125,000 -

150,000 -

Total Contribution margin

P145,000 P 55,000

P125,000 P 75,000

P150,000 P 50,000

Sales (4,000 x P40) Less variable costs Production cost @ P25 Purchase cost @ P45

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Sales (6,000 x P40) Less variable costs Production cost @ P25 Purchase cost @ P45 Total Contribution margin

P240,000

P240,000

P240,000

100,000 90,000 P190,000 P 50,000

125,000 45,000 P170,000 P 70,000

150,000 0 P150,000 P 90,000

Requirement (c) Sales Order Contribution Margin 4,000 P35,000 5,000 75,000 6,000 70,000 Average Contribution Margin

Probability 0.20 0.50 0.30

Expected Value P 7,000 37,500 21,000 P65,500

Problem 6 (Pricing) Requirement A:

Sales Less Variable cost Contribution margin Less Fixed cost Net income (loss)

2005 P 100,000 130,000 (P 30,000) 40,000 (P 70,000)

2006 P 400,000 520,000 (P120,000) 40,000 (P160,000)

Operating Result at Full Capacity P 480,000 624,000 (P144,000) 40,000 (P184,000)

The company had been operating at a loss because the product had been selling with a negative contribution margin. Hence, the more units are sold, the higher the loss will be. Requirement B: P60.14 Requirement C: P74.29 Requirement D: P56.58

Problem 7 (Make or Buy) 19-18


Cost of Making Outside purchase Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead* Total cost

Cost of Buying P90,000

P15,000 30,000 10,000 15,000 P70,000

P90,000

* 1/3 x P45,000 = P15,000

Therefore, the annual advantage to make the parts is P20,000. Problem 8 (Close or Retain a Store) Requirement 1 The simplest approach to the solution is: Gross margin lost if the store is closed............................................. Less costs that can be avoided: Direct advertising.......................................................................... P36,000 Sales salaries................................................................................. 45,000 Delivery salaries............................................................................7,000 Store rent....................................................................................... 65,000 Store management salaries (new employee would not be hired to fill vacant position at another store)...................... 15,000 General office salaries...................................................................8,000 Utilities.......................................................................................... 27,200 Insurance on inventories (2/3 × P9,000)......................................6,000 Employment taxes*.......................................................................9,000 Decrease in company net operating income if the Ortigas Store is closed...................................................................

P(228,000)

218,200 P( 9,800)

*Salaries avoided by closing the store: Sales salaries.......................................................................................................... P45,000 Delivery salaries.................................................................................................... 7,000 Store management salaries....................................................................................15,000 General office salaries............................................................................................ 8,000 Total salaries..........................................................................................................75,000 Employment tax rate..............................................................................................× 12% P 9,000 Employment taxes avoided....................................................................................

Requirement 2 The Ortigas Store should not be closed. If the store is closed, overall company 19-19


net operating income will decrease by P9,800 per quarter. Requirement 3 The Ortigas Store should be closed if P200,000 of its sales are picked up by the Makati Store. The net effect of the closure will be an increase in overall company net operating income by P76,200 per quarter: Gross margin lost if the Ortigas Store is closed....................................................................... P(228,000) Gross margin gained at the Makati Store: P200,000 × 43%................................................................................................................... 86,000 Net loss in gross margin............................................................................................................ (142,000) Costs that can be avoided if the Ortigas Store is closed (part 1).............................................. 218,200 Net advantage of closing the Ortigas Store.............................................................................. P 76,200

Problem 9 (Shutting Down or Continuing to Operate a Plant) Requirement 1 Product KK-8 yields a contribution margin of P14 per gallon (P35 – P21 = P14). If the plant closes, this contribution margin will be lost on the 22,000 gallons (11,000 gallons per month × 2 = 22,000 gallons) that could have been sold during the two-month period. However, the company will be able to avoid certain fixed costs as a result of closing down. The analysis is: Contribution margin lost by closing the plant for two months (P14 per gallon × 22,000 gallons).................................................P(308,000) Costs avoided by closing the plant for two months: Fixed manufacturing overhead cost (P60,000 × 2 months = P120,000).......................................................... P120,000 Fixed selling costs (P310,000 × 10% × 2 months)............................................................... 62,000 182,000 Net disadvantage of closing, before start-up costs.......................................... (126,000) Add start-up costs............................................................................................ (14,000) Disadvantage of closing the plant...................................................................P(140,000)

No, the company should not close the plant; it should continue to operate at the reduced level of 11,000 gallons produced and sold each month. Closing will result in a P140,000 greater loss over the two-month period than if the company continues to operate. Additional factors are the potential loss of goodwill among the customers who need the 11,000 gallons of KK-8 each month and the adverse effect on employee morale. By closing down, the needs of customers will not be met (no inventories are on hand), and their business may be permanently lost to another supplier.

19-20


Alternative Solution:

Plant Kept Open Plant Closed Sales (11,000 gallons × P35 per gallon × 2)............................ P 770,000 P 0 Less variable expenses (11,000 gallons × P21 per gallon × 2).............................................. 462,000 0 Contribution margin................................................................. 308,000 0 Less fixed costs: Fixed manufacturing overhead cost (P230,000 × 2; P170,000 × 2)................................................................ 460,000 340,000 Fixed selling cost (P310,000 × 2; P310,000 × 90% × 2)...................................................................... 620,000 558,000 Total fixed cost......................................................................... 1,080,000 898,000 Net operating loss before start-up costs................................... (772,000) (898,000) Start-up costs........................................................................... (14,000) Net operating loss.................................................................... P (772,000) P(912,000)

Difference— Net Operating Income Increase (Decrease) P(770,000) 462,000 (308,000)

120,000 62,000 182,000 (126,000) (14,000) P(140,000)

Requirement 2 Ignoring the additional factors cited in part (1) above, Kristin Company should be indifferent between closing down or continuing to operate if the level of sales drops to 12,000 gallons (6,000 gallons per month) over the two-month period. The computations are: Cost avoided by closing the plant for two months (see above)............................... P182,000 Less start-up costs.................................................................................................... 14,000 Net avoidable costs.................................................................................................. P168,000

Net avoidable costs Contribution margin per gallon

= =

Verification:

P168,000 P14 per gallon 12,000 gallons

Operate at 12,000 Gallons for Two Months Sales (12,000 gallons × P35 per gallon)............................................... P 420,000 Less variable expenses (12,000 gallons × P21 per gallon)................... 252,000 Contribution margin.............................................................................. 168,000 Less fixed expenses: 19-21

Close for Two Months P 0 0 0

Chapter 19 Relevant Costs for Decision Making Manufacturing overhead (P230,000 and P170,000 × 2 months)......................................................................................... 460,000 Selling (P310,000 and P279,000 × 2 months)................................. 620,000 Total fixed expenses.............................................................................. 1,080,000 Start-up costs......................................................................................... 0 Total costs.............................................................................................. 1,080,000 Net operating loss.................................................................................. P (912,000)

340,000 558,000 898,000 14,000 912,000 P(912,000)

Problem 10 (The Economists’ Approach to Pricing) Requirement (1) The postal service makes more money selling the souvenir sheets at the lower price, as shown below: P500 Price P600 Price Unit sales................................................... 50,000 40,000 Sales.......................................................... Cost of goods sold @ P60 per unit............ Contribution margin..................................

P25,000,000 3,000,000 P22,000,000

P24,000,000 2,400,000 P21,600,000

Requirement (2) The price elasticity of demand, as defined in the text, is computed as follows:

d

=

= = = = =

In(1 + % change in quantity sold) In(1 + % change in price) 40,000 – 50,000 In(1 + ) 50,000 600.00 – 500.00 In(1 + ) 500.00 In(1 – 0.2000) In(1 + 0.2000) In(0.8000) In(1.2000) –0.2231 0.1823 –1.2239 19-22


Requirement (3) The profit-maximizing price can be estimated using the following formulas: Profit-maximizing markup on variable cost

= =

Profit-maximizing price

=

–1 1 + d –1 = 1 + (–1.2239) 1 +

4.4663

Profit-maximizing markup on variable cost

x

= (1 + 4.4663) x P60 = P328 This price is much lower than the price the postal service has been charging in the past. Rather than immediately dropping the price to P328, it would be prudent for the postal service to drop the price a bit and observe what happens to unit sales and to profits. The formula assumes that the price elasticity of demand is constant, which may not be true. The critical assumption in the calculation of the profit-maximizing price is that the percentage increase (decrease) in quantity sold is always the same for a given percentage decrease (increase) in price. If this is true, we can estimate the demand schedule for souvenir sheets as follows: Price* Quantity Sold§ P600 40,000 P500 50,000 P417 62,500 P348 78,125 P290 97,656 P242 122,070 P202 152,588 P168 190,735 P140 238,419 P117 298,024 *

The price in each cell in the table is computed by taking 5/6 of the price just above it in the table. For example, P500 is 5/6 of P600 and P417 is 5/6 of P500. §

The quantity sold in each cell of the table is computed by multiplying the quantity sold just above it in the table by 50,000/40,000. For example, 62,500 is computed by multiplying 50,000 by the fraction 50,000/40,000. 19-23

Variable cost per unit


The profit at each price in the above demand schedule can be computed as follows: Price (a) P600 P500 P417 P348 P290 P242 P202 P168 P140 P117

Quantity Sold (b) 40,000 50,000 62,500 78,125 97,656 122,070 152,588 190,735 238,419 298,024

Sales (a) × (b) P24,000,000 P250,00,000 P26,062,500 P27,187,500 P28,320,200 P29,540,900 P30,822,800 P32,043,500 P33,378,700 P34,868,800

19-24

Cost of Sales P60 × (b) P2,400,000 P3,000,000 P3,750,000 P4,687,500 P5,859,400 P7,324,200 P9,155,300 P11,444,100 P14,305,100 P17,881,400

Contribution Margin P21,600,000 P22,000,000 P22,312,500 P22,500,000 P22,460,800 P22,216,700 P21,667,500 P20,599,400 P19,073,600 P16,987,400


The contribution margin is plotted below as a function of the selling price: 23,000,000

Contribution Margin

22,000,000

21,000,000

20,000,000

19,000,000

18,000,000

17,000,000 100.00

200.00

300.00

400.00

500.00

600.00

Selling Price The plot confirms that the profit-maximizing price is about P328. Requirement (4) If the postal service wants to maximize the contribution margin and profit from sales of souvenir sheets, the new price should be: Profit-maximizing price = 5.4663 × P70 = P383 Note that a P100 increase in cost has led to a P55 (P383 – P328) increase in the profit-maximizing price. This is because the profit-maximizing price is computed by multiplying the variable cost by 5.4663. Since the variable cost has increased by P100, the profit-maximizing price has increased by P100 × 5.4663, or P55. Some people may object to such a large increase in price as “unfair” and some 19-25


may even suggest that only the P10 increase in cost should be passed on to the consumer. The enduring popularity of full-cost pricing may be explained to some degree by the notion that prices should be “fair” rather than calculated to maximize profits. Problem 11 (Ranking Alternatives and Managing with a Constraint) Requirement (1) This problem can be solved by first computing the profitability index of each customer and then ranking the customers based on that profitability index: Incremental Profit Customer (A) Lalaine................................ P1,400 Emily................................... 1,240 Anna.................................... 1,600 Catherine............................. 960 Gee Ann............................... 1,900 Lily...................................... 2,880 Lourdes............................... 930 Ma. Cecilia.......................... 1,360 Sheila Raya......................... 2,340 Jane..................................... 2,040

Ji Eun’s Time Required (B) 4 4 5 3 5 8 3 4 6 6

Profitability Index (A) ÷ (B) P350 P310 P320 P320 P380 P360 P310 P340 P390 P340

Cumulative Amount of Ji Eun’s Profitability Ji Eun’s Time Time Customer Index Required Required Sheila Raya...... P390 6 6 Gee Ann........... P380 5 11 Lily.................. P360 8 19 Lalaine............. P350 4 23 Jane.................. P340 6 29 Ma. Cecilia...... P340 4 27 Anna................ P320 5 38 Catherine.......... P320 3 41 Emily............... P310 4 45 Lourdes............ P310 3 48 Given that Ji Eun should not be asked to work more than 33 hours, the four customers below the line in the above table should be told that their reservations have to be cancelled. 19-26


Requirement (2) The total profit on wedding cakes for the weekend after canceling the four reservations would be: Sheila Raya...... Gee Ann............ Lily................... Lalaine.............. Jane.................. Ma. Cecilia....... Total.................

P 2,340 1,900 2,880 1,400 2,040 1,360 P11,920

Notes: ● Both Ji Eun’s time and the cakes would have to be very carefully scheduled to make sure that all cakes are completed on time. We have assumed that the 33 hours of Ji Eun’s time that are available for cake decorating do not include hours that have been set aside as a buffer to provide protection from inevitable disruptions in the schedule. ● If the cumulative amount of Ji Eun’s time required did not exactly consume the total amount of time available, some adjustment might be required in which reservations are cancelled to ensure that the most profitable plan is selected. Requirement (3) To avoid disappointing customers, reservations should probably not be accepted for any particular weekend after 33 hours of Ji Eun’s time have been committed for that weekend’s cakes. To ensure that only the most profitable cake reservations are accepted, a reservation for any cake with a profitability index of less than P340 should probably not be accepted. This was the cutoff point for the cakes in the first weekend in June. This cutoff may need to be adjusted upward or downward over time—the cakes that were reserved for the first weekend in June may not be representative of the cakes that would be reserved for other weekends. If too many reservations are turned down and Ji Eun’s time is not fully utilized, then the cutoff should be adjusted downward. If too few reservations are turned down and Ji Eun’s time is once again overbooked or profitable cake orders are turned away, then the cutoff should be adjusted upward. Requirement (4) 19-27


Ms. Hye Young should consider changing the way prices are set so that they include a charge for Ji Eun’s time. On average, the prices may be the same, but they should be based not only on the size of the cakes, but also on the amount of cake decorating that the customer desires. The charge for Ji Eun’s time should be her hourly rate of pay (including any fringe benefits) plus the opportunity cost of at least P340 per hour. Because Ji Eun will not be working more than 33 hours per week, if another cake reservation is accepted, some other cake reservation will have to be cancelled. Ms. Hye Young would have to give up at least P34 profit per hour to accept another cake reservation. Requirement (5) Making Ji Eun happy involves not asking her to work more than 33 hours per week decorating cakes. Making customers happy involves not canceling their reservations, not raising prices, and providing top quality wedding cakes. Ms. Hye Young can accomplish both of these objectives and increase her profits by clever management of the constraint—Ji Eun’s time. The possibilities include: 

Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on unnecessary tasks. For example, Ji Eun should not be asked to cream butter by hand for frostings if a machine could do the job as well with less labor time.



Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on tasks that can be done by other persons. For example, an assistant can be assigned to prepare frosting and to clean up, relieving Ji Eun of those tasks. As long as the cost of the assistant’s time is less than P34 per hour, the result will be higher profits and more pleased customers.



Ms. Hye Young should consider assigning an apprentice to Ji Eun. The apprentice could relieve Ji Eun of some of her workload while learning the skills to eventually expand the company’s cake decorating capacity.



Ms. Hye Young might consider subcontracting some of the less demanding cake decorating to another baker. This would be profitable as long as the charge is less than P340 per hour.

IV. Multiple Choice Questions 1. 2. 3. 4. 5.

C C B B A

11. 12. 13. 14. 15.

D A D A D

21. 22. 23. 24. 25. 19-28

D A D E B

31. 32. 33. 34. 35.

A D C A C


6. 7. 8. 9. 10.

B C B A B

16. 17. 18. 19. 20.

C A C B C

26. 27. 28. 29. 30.

D D C A A

Supporting computations for nos. 16 - 29: 16. Sales [(100,000 x 90%) x (P5.00 x 120%)] Less: Variable costs (P300,000 x 90%) Contribution margin Less: Fixed costs Operating income

P540,000 270,000 P270,000 150,000 P120,000

17. Direct materials Direct labor Overhead Selling cost Minimum selling price per unit

P 4 5 2 3 P14

18. Relevant cost to make (10,000 x P24) Purchase cost Less: Savings in manufacturing cost Avoidable fixed overhead Net purchase price Difference in favor of “buy” alternative

P240,000 P300,000 P45,000 50,000

95,000 P205,000 P 35,000

19. Increase in sales (60,000 x P3) P180,000 Less: Increase in variable cost (60,000 x P2.50) 150,000 Net increase in income P 30,000 20. R S T Sales (10,000 x P20) P200,000 P200,000 P200,000 Less: Variable costs R (P12 x 10,000) 120,000 S (P 8 x 10,000) 80,000 T (P 4 x 10,000) 40,000 Contribution margin

P 80,000

P120,000

P160,000

Sales (P16 x 15,000)

R P240,000

S P240,000

T P240,000

21.

19-29


Less: Variable costs R (P12 x 15,000) S (P 8 x 15,000) T (P 4 x 15,000)

180,000 120,000 60,000

Contribution margin Less: Fixed costs Operating income

P 60,000 40,000 P 20,000

P120,000 80,000 P 40,000

22. Old operating income: Contribution margin Less: Fixed cost

P180,000 120,000 P 60,000 P80,000 40,000 P40,000 20,000 P20,000

New operating income Difference - decrease 23. Sales Less: Variable costs Direct materials Direct labor Factory overhead Marketing expenses Administrative expenses Contribution margin Less: Fixed costs Factory overhead Marketing expenses Administrative expenses Increase in fixed costs Profit 24. Sales Less: Variable costs Direct materials Direct labor Factory overhead Marketing expenses Administrative expenses Contribution margin Less: Fixed costs Factory overhead Marketing expenses 19-30

P1,200,000 P300,000 400,000 80,000 70,000 50,000 P 50,000 30,000 20,000 10,000

900,000 P 300,000

110,000 P 190,000 P1,200,000

P275,000 375,000 80,000 70,000 50,000 P 50,000 30,000

850,000 P 350,000


Profit

Administrative expenses Decrease in fixed costs (P25,000  4)

20,000 (6,250)

25. Direct materials (P2 x 5,000) Direct labor (P8 x 5,000) Variable overhead (P4 x 5,000) Total variable costs Add: Avoidable fixed overhead Total 26. Avoidable fixed overhead Direct materials Direct labor Variable overhead Total Multiplied by: Number of units to be produced Total relevant costs to make the part 27. Purchase cost (P1.25 x 10,000) Variable costs to make Savings of making the blade 28. Selling price per unit Less: Variable costs of goods sold per unit ([P320,000 - P80,000]  20,000 units) Contribution margin per unit Multiplied by units to be sold under Special Order Increase in operating income 29. Budgeted operating income: Contribution margin (P2,000,000 x 30%) Less fixed costs Net operating income Operating income under the proposal: Sales P2,000,000 Less Variable costs ([70% x P2,000,000] x 80%) 1,120,000 Contribution margin P 880,000 Less fixed costs 520,000 Increase in budgeted operating profit

19-31

93,750 P 256,250 P10,000 40,000 20,000 P70,000 10,000 P80,000 P 4 4 16 18 P42 20,000 P840,000 P12,500 10,000 P 2,500 P17 12 P 5 2,000 P10,000 P600,000 400,000 P200,000

360,000 P160,000

Chapter 19 - Answer

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