How Are Relevant Revenues and Costs Used to Make

Decisions?
Bob Lee is president of Best Boards, Inc., a manufacturer of wakeboards. In the face of stiff

competition, Best Boards’ profits have declined steadily over the past few years. Bob is concerned

about the decline in profits and has instructed Jim Muller, the vice president of operations, to do

whatever it takes to reduce costs. In fact, Bob offered to pay Jim a bonus equal to 25 percent of

any production cost savings the company achieves during the coming year.

Jim Muller thinks he has a way to cut costs and earn his bonus, and he approaches Bob Lee and

Amy Eckstrom, the company’s accountant, to discuss his plan:

Bob and Amy, I hope you’ve had a chance to review my proposal to outsource production. I
Jim:
think it could save the company thousands of dollars this coming year.
Bob: I did review your proposal. Give me a quick summary of what you have in mind.
Our staff accountants tell me that the average unit product cost for our wakeboards is about
Jim:
$110, and we make 10,000 wakeboards each year.
Amy: Sounds about right.
My thought is that we could save substantial amounts of money by having an outside supplier
Jim: make our wakeboards rather than doing it ourselves. I contacted one reputable wakeboard
manufacturer interested in producing the boards for us.
Bob: What did you find?
They told me the wakeboards could be purchased from them for $70 a board. This amounts
Jim: to $40 in savings per unit, and $400,000 in total savings! Even after my 25 percent bonus of
$100,000, Best Boards would save $300,000.
Jim has an interesting idea, but there are some issues that should be considered. Jim, you
are correct in stating the average unit product cost for our wakeboards is $110 given
production of 10,000 units per year. However, it is not accurate to assume we will eliminate
$1,100,000, which is $110 per unit cost times 10,000 units, in total production costs by
Amy: outsourcing production. The average unit cost includes factory equipment lease payments,
along with supervisors’ salaries, and factory rent. These costs don’t go away quickly if we
stop production. The equipment lease is for several years, we are locked into a long-term
lease for the factory building, and we would have to look at our supervisors’ contracts before
letting them go.
Can we get a better idea of which costs would be eliminated by outsourcing production, and
Bob:
which costs would remain?
Amy: Sure. I’ll get a team working on this right away.
Best Boards is facing a decision common to many organizations: whether to build its own

product or to have another company build the product. We will come back to this scenario after

describing how companies facing such decisions can use differential analysis to make wise

business decisions.

7.1 Using Differential Analysis to Make Decisions

LEARNING OBJECTIVE

1. Describe the format used for differential analysis.

Differential revenues and costs (also called relevant revenues and costs or incremental revenues

and costs) represent the difference in revenues and costs among alternative courses of action.

Analyzing this difference is called differential analysis (or incremental analysis). We begin with a

relatively simple example to establish the format used to perform differential analysis and

present more complicated examples later in the chapter. As you work through this example,

notice that we also use the contribution margin income statement format presented in Chapter 5

"How Do Organizations Identify Cost Behavior Patterns?" and Chapter 6 "How Is Cost-Volume-

Profit Analysis Used for Decision Making?".

Question: Assume Phillips Accountancy provides bookkeeping, tax, and audit services to its

clients. Management believes Phillips Accountancy has several unprofitable customers and

would like to perform differential analysis to find out how profits would change if Phillips

dropped these customers. Alternative 1 includes the annual revenues, costs, and resulting profit

if the company keeps all existing customers. Alternative 2 includes the annual revenues, costs,

and resulting profit if the company drops what it believes are unprofitable customers. How

should management decide whether to keep all existing customers or drop certain customers?

Answer: Figure 7.1 "Differential Analysis for Phillips Accountancy" presents the format used by

management to perform differential analysis. In this case, differential analysis is used to evaluate

whether Phillips Accounting should keep all customers or drop unprofitable customers. The

information in Figure 7.1 "Differential Analysis for Phillips Accountancy" confirms that Phillips
Accountancy would be better off dropping the unprofitable customers (Alternative 2), because

company profits would increase by $20,000. The general rule is to select the alternative with the

highest differential profit. Take a close look at Figure 7.1 "Differential Analysis for Phillips

Accountancy" before reading the description of this information that follows.

Figure 7.1 Differential Analysis for Phillips Accountancy

Notice that in Figure 7.1 "Differential Analysis for Phillips Accountancy" the columns

labeled Alternative 1 and Alternative 2 show revenues, costs, and profit for each alternative. The

third column, labeled Differential Amount, presents the differential revenues and costs and

resulting differential profit. Positive amounts appearing in this column indicate Alternative 1 is

higher than Alternative 2. Negative amounts appearing in the Differential Amount column

indicate Alternative 1 is lower than Alternative 2. The fourth column shows whether Alternative 1

is higher or lower than Alternative 2 for each line item.

For example, the differential amount of $1,000,000 for revenue indicates Alternative 1 produces

$1,000,000 more in revenue than Alternative 2. The differential amount of $750,000 for variable

costs indicates variable costs are $750,000 higher for Alternative 1 than for Alternative 2. Move

to the bottom of Figure 7.1 "Differential Analysis for Phillips Accountancy". Notice that the

differential amount for profit is negative ($20,000). This indicates that Alternative 1 results in

profits that are $20,000 lower than Alternative 2. Thus Alternative 2 (dropping unprofitable

customers) is the desirable course of action.

Notice that the columns labeled Alternative 1 and Alternative 2 show information in summary

form (i.e., no detail is provided for revenues, variable costs, or fixed costs). Some managers may

want only this type of summary information, whereas others may prefer more detailed
information. It is important to be flexible with the format, to best meet the needs of managers.

We will build upon the differential analysis format shown in Figure 7.1 "Differential Analysis for

Phillips Accountancy"throughout this chapter, and show how more detail can easily be provided

using the same format.

Next, this chapter focuses on how we use differential analysis to assist in making the following

types of decisions:

 Make or buy products

 Keep or drop product lines

 Keep or drop customers

 Accept or reject special customer orders

KEY TAKEAWAY

 Differential revenues and costs represent the difference in revenues and costs among alternative

courses of action. Analyzing this difference is called differential analysis. Differential analysis is

useful in making managerial decisions related to making or buying products, keeping or dropping

product lines, keeping or dropping customers, and accepting or rejecting special customer orders.

REVIEW PROBLEM 7.1

Coffee Express is a small coffee shop looking to expand its product offerings beyond coffee. The

company is evaluating two alternatives—sandwiches and cookies. Annual projections for sales of

sandwiches are as follows: sales, $18,000; variable costs, $13,000; and fixed costs, $500. Annual

projections for sales of cookies are as follows: sales, $10,000; variable costs, $3,000; and no

additional fixed costs.

Using the format in Figure 7.1 "Differential Analysis for Phillips Accountancy", perform differential

analysis to determine which alternative is more profitable, and by how much. Assume adding

sandwiches is Alternative 1 and adding cookies is Alternative 2.

Solution to Review Problem 7.1

 As shown in the differential analysis given, selling cookies is the most profitable alternative.

Selling cookies results in profits of $7,000 for the year, which is $2,500 higher than the sandwich

alternative.

7.2 Make-or-Buy Decisions

LEARNING OBJECTIVE

1. Use differential analysis for make-or-buy decisions.

Question: With the differential analysis format in hand, we can now go back to Best Boards,

Inc., introduced at the beginning of the chapter. Recall that Best Boards produces each

wakeboard for $110, and Jim Muller, vice president of operations, received a bid for $70 per

board from an outside manufacturer. Best Boards’ president asked the company’s accountant,

Amy Eckstrom, to investigate whether it makes sense for Best Boards to hire an outside

company to produce the wakeboards. What information should Amy provide that will help

management make this decision?

Answer: Table 7.1 "Make-or-Buy Decision" presents the costs that the vice president of

operations at Best Boards must evaluate in deciding whether to make the wakeboards or buy

them from an outside company. This is called a make-or-buy decision because the company must

decide whether to make the product internally or buy the product from an outside firm (often

called outsourcing).

Table 7.1 Make-or-Buy Decision

 Costs to Make Wakeboard Costs to Buy Wakeboard
Direct materials Wakeboards from supplier
Variable production costs Direct labor
Manufacturing overhead
Factory equipment lease Factory equipment lease
Fixed production costs Factory building rent Factory building rent
Supervisor salaries Supervisor salaries

Determining Differential Product Costs

Question: What information did Amy find to help Best Boards with the decision whether to

make their own wakeboards or buy them from an outside supplier?

Answer: After further research, Amy identified the following product costs associated with

wakeboard production at Best Boards:

Since Best Boards produces 10,000 wakeboards each year, the product cost per unit is $110 (=

$1,100,000 ÷ 10,000 units). However, Amy must identify which of the costs listed previously

are differential costs if the company acquires the wakeboards from an outside producer. That is,

Amy must determine which costs will change and which will remain the same. Here’s what she

found:
  All variable production costs will be eliminated if Best Boards buys the wakeboards rather

than making them. These are differential costs.

 The factory equipment lease will continue for several years whether Best Boards makes or

buys the wakeboards. This is not a differential cost.

 The factory building lease covers several years, so this cost will continue whether Best

Boards makes or buys the wakeboards. This is not a differential cost.

 One of Best Boards’ two production supervisors was hired recently, is paid $50,000 per

year, and can be let go if needed. This is a differential cost.

 The other of Best Boards’ two production supervisors has been with the company for

several years, is paid $90,000 per year, and has five years remaining on her contract.

This is not a differential cost.

Question: Amy must now prepare a differential analysis to determine which alternative is best

for the company. Her analysis appears in Figure 7.2 "Make-or-Buy Differential Analysis for

Best Boards, Inc.". Because the focus of make-or-buy decisions is on product costs, and because

sales revenue is not differential to this decision, it is not necessary to include sales revenue in

the analysis. This in turn eliminates the need to show the contribution margin or net income.

(Even if sales revenue were included, the outcome would remain the same.) What does Amy’s

analysis tell us?

Figure 7.2 Make-or-Buy Differential Analysis for Best Boards, Inc.

a $700,000 = $70 per unit × 10,000 units.

b One supervisor must be paid $90,000 per year even if the company buys the product. The other

supervisor, who is paid $50,000 per year, can be let go if the company buys the product.

Answer: Realizing that the information shown in Figure 7.2 "Make-or-Buy Differential Analysis

for Best Boards, Inc." does not provide the savings initially hoped for, Amy presents the

unfavorable analysis to Jim Muller and the company’s president, Bob Lee. Refer to Figure 7.2

"Make-or-Buy Differential Analysis for Best Boards, Inc." as you follow Amy’s comments to Bob

and Jim about her analysis.

Bob: Hi, Amy, what have you got for us?

As you can see from my analysis, outsourcing the production of our wakeboards does not
Amy:
reduce overall production costs.
How can that be? I got a bid from an outside supplier for $70 per board, and our cost to
Jim:
produce the very same board is $110.
As I mentioned before, the $110 includes costs that do not go away if we outsource
production. Let’s look at my analysis. Alternative 1 represents the production costs we incur
Amy:
to make the board ourselves, and Alternative 2 represents the costs we incur if we buy the
board from an outside supplier using Jim’s quote of $70 each.
Well, this certainly explains where the $110 product cost per board comes from if we
Jim: produce the boards ourselves. I see the total cost of $1,100,000. Divide this by 10,000 units
produced annually, and the resulting cost per unit is $110.
Exactly! Now let’s look at Alternative 2 more carefully. Although we eliminate all variable
product costs such as direct materials and direct labor by outsourcing production, several
fixed product costs remain. We still must lease the factory equipment at a rate of $110,000
per year, and the factory building lease of $290,000 per year is in effect for several more
Amy: years. Also, one of our factory supervisors has a long-term contract for $90,000 per year and
cannot be let go any time soon. None of these costs can be eliminated if we outsource
production. Add these costs to the $700,000 cost incurred to purchase the boards from a
supplier, and the total cost of $1,190,000 is $90,000 higher than if we produce the boards
ourselves.
Perhaps we should consider outsourcing in a few years as these long-term commitments
Bob: expire. Jim, I commend you for your creative approach to reducing costs, but the numbers
don’t make it feasible for us to discontinue production and buy the products elsewhere.

Using a Summary Format for Differential Analysis

Question: The Differential Amount column presented in Figure 7.2 "Make-or-Buy Differential

Analysis for Best Boards, Inc." indicates Best Boards would be better off producing wakeboards
internally. However, management may want a more concise explanation of why production

costs are $90,000 higher when outsourcing production. How can we present this information

in a more concise format?

Answer: We show a more concise presentation in Figure 7.3 "Summary of Differential Analysis

for Best Boards, Inc.", which includes the Differential Amount column shown in Figure 7.2

"Make-or-Buy Differential Analysis for Best Boards, Inc." along with a brief description for each

item. Look closely at Figure 7.2 "Make-or-Buy Differential Analysis for Best Boards, Inc." to

confirm that the Differential Amount column matches Figure 7.3 "Summary of Differential

Analysis for Best Boards, Inc.", and review the explanation of the difference for each line item. As

you compare these two figures, notice that only differential costs are presented in Figure 7.3

"Summary of Differential Analysis for Best Boards, Inc.", and therefore costs for the factory

equipment lease, factory building rent, and a portion of supervisor salaries are excluded

from Figure 7.3 "Summary of Differential Analysis for Best Boards, Inc.". That is, costs that

do not differ from one alternative to another are excluded from the summary differential analysis

since this information is irrelevant to the decision. The amounts in parentheses in Figure 7.3

"Summary of Differential Analysis for Best Boards, Inc." indicate a negative impact on profit, and

amounts without parentheses indicate a positive impact on profit.

Figure 7.3 Summary of Differential Analysis for Best Boards, Inc.

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without

parentheses indicate a positive impact on profit.

The analysis shown in Figure 7.3 "Summary of Differential Analysis for Best Boards, Inc." is

particularly useful if all costs are not easily identified, and differential costs can be determined.

After all, the goal of differential analysis is to analyze the costs that differ from one alternative to

the next.

We often use the term avoidable cost to describe a cost that can be avoided, or eliminated, if one

alternative is chosen over another. If Best Boards chooses to buy the product from an outside

producer, the company avoids such costs as direct materials, direct labor, manufacturing

overhead, and the salary of one supervisor. In this context, avoidable cost is the same

as differential cost.

Business in Action 7.1

Source: Photo courtesy of C.G.P. Grey, http://www.cgpgrey.com/.

Outsourcing Construction

Salt Lake City, Utah, recently built a $65 million library. The library’s façade was assembled from

precast concrete panels that a company called Pretecsa produced in a plant near Mexico City.

Trucks hauled 140 truckloads of these panels—each truckload averaging 10 tons—2,350 miles

from Mexico City to Salt Lake City. In all, four million pounds of concrete were shipped. As the

director of Pretecsa noted, “The idea of manufacturing a building a couple of thousand miles

away and then exporting it, well it was considered crazy.”

The manager in charge of the library construction had tried to obtain the concrete panels from

sources in the United States. He stated, “We contacted precast contractors in Phoenix, Denver,

and Las Vegas, but they didn’t feel they could do it cheaply enough, once you factored in their

shipping costs. Pretecsa’s low-cost labor made up for the higher shipping costs, and they came

in the cheapest.”

Pretecsa disclosed that it took 163,000 labor hours to produce the concrete panels and charged

$2.5 million for all its services, including materials. Labor costs alone in the United States would

have been $3 million.

Source: Joel Millman, “Blueprint for Outsourcing,” The Wall Street Journal, March 3, 2004.

KEY TAKEAWAY

 Differential analysis requires the identification of all revenues and costs that differ from one

alternative to another. In general, managers select the alternative with the highest profit. If the

only differences between the alternatives are with costs (as in the make-or-buy decision for Best

Boards), decision makers would select the alternative with the lowest cost.

REVIEW PROBLEM 7.2

Quality Bikes, Inc., currently produces racing bikes. Management is interested in outsourcing

production of these bikes to a reputable manufacturing company that can supply the bikes for

$600 per unit. Quality Bikes incurs the following annual production costs to produce 2,000 racing

bikes internally:
 Outsourcing production eliminates all variable production costs, the production supervisor’s

salary, and factory insurance costs. Factory building and equipment lease costs will remain the

same regardless of the decision to outsource or to produce internally.

1. Perform differential analysis using the format presented in Figure 7.2 "Make-or-Buy Differential

Analysis for Best Boards, Inc.". Assume making the bike internally is Alternative 1, and buying the

bike from an outside manufacturer is Alternative 2.

2. Which alternative is best? Explain.

3. Summarize the result of outsourcing production using the format presented in Figure 7.3

"Summary of Differential Analysis for Best Boards, Inc.".

Solution to Review Problem 7.2

1.
 *$1,200,000 = $600 per unit × 2,000 units.

2. Buying the bikes from an outside supplier is the best alternative. This alternative results in total

costs of $1,380,000, providing $30,000 in savings compared to the $1,410,000 cost of producing

bikes internally.

3.

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses

indicate a positive impact on profit.

7.3 Product Line Decisions

LEARNING OBJECTIVE

1. Use differential analysis for product line decisions.

Question: As competitors enter the market and as products go through life cycles, managers

often must decide whether to keep or drop product lines. A product line is a group of related

products. The Home Depot, Inc., has many different product lines such as appliances, flooring,

and paint products. Ford Motor Co. produces a variety of products such as compact cars,

trucks, and tractors. Companies must continually assess whether they should add new product

lines, and whether they should discontinue current product lines. Differential analysis provides
a format for these types of decisions. How would differential analysis be used to make a

product line decision?

Answer: Let’s look at an example of a product line decision. Assume Barbeque Company has

three product lines: gas barbecues, charcoal barbecues, and barbecue accessories. Charcoal

barbecue sales have declined in recent years, leading management to question whether this

product line is worth keeping. Barbeque Company would like to consider two alternatives.

Alternative 1 is to retain all three product lines, and Alternative 2 is to eliminate the charcoal

barbecues product line. Figure 7.4 "Product Line Decision" shows the decision facing the

manager at Barbeque Company: whether to eliminate or keep the charcoal barbecue product line.

Figure 7.4 Product Line Decision

Figure 7.5 "Income Statement for Barbeque Company" presents the income statement for the

past year, separated by product line (this is often referred to as a segmented income statement).

Carefully examine Figure 7.5 "Income Statement for Barbeque Company". Notice that the

charcoal barbecues product line shows a loss of $8,000 for the year. This is the reason

management would like to consider dropping this product line.

Figure 7.5 Income Statement for Barbeque Company

*Includes cost of goods sold and other variable costs.

The variable costs in Figure 7.5 "Income Statement for Barbeque Company" are related directly

to each product line, and thus are eliminated if the product line is eliminated. That is, all variable

costs are differential costs for the two alternatives facing Barbeque Company.

Question: Notice that two lines appear for fixed costs: direct fixed costs and allocated fixed

costs. What is the difference between direct fixed costs and allocated fixed costs?

Answer: Direct fixed costs are fixed costs that can be traced directly to a product line. Direct fixed

costs are often differential costs. For example, the salary of the manager responsible for charcoal

barbecues is easily traced to the charcoal barbecues product line. If this product line is

eliminated, the product line manager’s salary is also eliminated (unless the product line manager

has a long-term employment contract).

Allocated fixed costs (also called common fixed costs) are fixed costs that cannot be traced

directly to a product line, and therefore are assigned to product lines using an allocation process.

Allocated fixed costs are typically not differential costs. For example, rent paid for Barbeque
Company’s retail store is allocated to all three product lines because it is not easily traced to each

product line. However, the retail store rent likely will not decrease if the charcoal barbecues

product line is eliminated (unless the company chooses to move to a smaller, less costly store).

The charcoal barbecues’ allocation for rent would simply be reallocated to the other two

products. Thus rent for the retail store is an example of an allocated fixed cost that is not a

differential cost for the two alternatives facing Barbeque Company.

Question: How are Barbeque Company’s allocated fixed costs assigned to individual product

lines?

Answer: Barbeque Company’s total allocated fixed costs of $120,000 are allocated based on sales.

Sales revenue for gas barbecues totals $450,000, which is 75 percent of total company sales (=

$450,000 ÷ $600,000). Thus 75 percent of all allocated fixed costs are assigned to the gas

barbecues product line. This amounts to $90,000 (= $120,000 × 0.75).

Question: Will dropping the charcoal barbecues product line result in higher company profit?

Answer: The differential analysis presented in Figure 7.6 "Product Line Differential Analysis for

Barbeque Company" provides the answer. Panel A shows the income statement for Alternative 1:

keeping all three product lines. Panel B shows the income statement for Alternative 2: dropping

the charcoal barbecues product line. And panel C presents the differential analysis for the two

alternatives. The differential analysis in panel C shows that overall profit will decrease by

$10,000 if the charcoal barbecue product line is dropped.

Figure 7.6 Product Line Differential Analysis for Barbeque Company

a $105,882 = ($450,000 ÷ $510,000) × $120,000.

b $14,118 = ($60,000 ÷ $510,000) × $120,000.

The Differential Amount column in panel C of Figure 7.6 "Product Line Differential Analysis for

Barbeque Company" indicates the company would be better off continuing with all three product

lines. However, management may want a more concise explanation of why profit is $10,000

higher when all three product lines are maintained. We provide such an explanation in Figure 7.7

"Summary of Differential Analysis for Barbeque Company", which presents the Differential

Amount column shown in panel C of Figure 7.6 "Product Line Differential Analysis for Barbeque
Company" along with a brief description for each item. Take a close look at panel C of Figure 7.6

"Product Line Differential Analysis for Barbeque Company", confirm that the Differential

Amount column matches Figure 7.7 "Summary of Differential Analysis for Barbeque Company",

and review the explanation of the difference.

Figure 7.7 Summary of Differential Analysis for Barbeque Company

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without

parentheses indicate a positive impact on profit.

Figure 7.7 "Summary of Differential Analysis for Barbeque Company" shows that Barbeque

Company will lose sales revenue of $90,000 if it drops the charcoal barbecues product line.

However, it saves variable costs of $40,000 and direct fixed costs of $40,000 if it drops the

charcoal barbecues product line. Because the $80,000 in cost savings is not enough to make up

for the $90,000 loss in sales revenue, profit will decline by $10,000 (= $80,000 − $90,000).

Misleading Allocation of Fixed Costs

Question: How can the charcoal barbecues product line show a loss of $8,000 in Figure 7.6

"Product Line Differential Analysis for Barbeque Company", while the company as a whole is

better off keeping this product line?

Answer: The answer lies within allocated fixed costs. Even though total allocated fixed costs of

$120,000 cannot easily be traced to each product line, company management wants each

product line manager to be aware of these costs. As a result, it uses an allocation process to assign

the costs to product lines. Thus the charcoal barbecues product line is assigned $18,000 in

allocated fixed costs even though these costs cannot be controlled by the product line. If the

charcoal barbecues product line is eliminated, $18,000 in allocated fixed costs is not eliminated.

Instead, $18,000 in costs is assigned to the other two product lines.

In many situations, this increased allocation to other product lines may cause other product lines

to appear unprofitable. The message here is to be careful when analyzing segmented information

containing cost allocations. Allocated costs are typically not differential costs, and therefore are

typically not relevant to the decision.

An alternative view of the decision facing Barbeque Company—whether to keep or drop the

charcoal barbecues product line—is simply to calculate profitability of this product

line before deducting allocated fixed costs. Figure 7.6 "Product Line Differential Analysis for

Barbeque Company" shows a contribution margin of $50,000 for charcoal barbecues. Deduct

direct fixed costs of $40,000 and this product line has a remaining profit of $10,000. This

explains why Barbeque Company’s overall profit would be $10,000 lower if the charcoal

barbecues product line were eliminated. (As discussed previously, the allocated fixed costs are

irrelevant to this decision.)

Including Opportunity Costs in Differential Analysis

Managers must often consider the impact of opportunity costs when making decisions.

An opportunity cost is the benefit foregone when one alternative is selected over another. For

example, assume you have the choice between going to school and working. The opportunity cost

of attending school is the lost wages from working.

Question: In the case of Barbeque Company, assume the company can lease the space currently

being used by the charcoal barbecues product line for $25,000 per year. Thus the opportunity

cost (benefit foregone) of keeping the charcoal barbecues is $25,000. How does this affect

Barbeque Company’s decision to keep or drop charcoal barbecues?

Answer: Figure 7.8 "Differential Analysis with Opportunity Cost for Barbeque

Company" provides the answer by simply adding one item to Figure 7.7 "Summary of Differential

Analysis for Barbeque Company". Barbeque Company would increase profits $15,000 by

dropping the charcoal barbecues.

Figure 7.8 Differential Analysis with Opportunity Cost for Barbeque Company

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without

parentheses indicate a positive impact on profit.

Opportunity costs can also be included in the differential analysis format presented in Figure 7.6

"Product Line Differential Analysis for Barbeque Company". Panel C of Figure 7.6 "Product Line

Differential Analysis for Barbeque Company" is simply modified to reflect the opportunity cost,

as shown.
Sunk Costs and Differential Analysis

Question: What is a sunk cost, and how do sunk costs affect differential analysis?

Answer: A sunk cost is a cost incurred in the past that cannot be changed by future decisions. For

example, suppose Barbeque Company must dispose of store equipment related to the charcoal

barbecues product line if charcoal barbecues are eliminated. The original cost of this store

equipment is a sunk cost and should have no bearing on the decision whether to eliminate

charcoal barbecues. As a general rule, sunk costs are not differential costs.

Business in Action 7.2

Source: Photo courtesy of Paul Sableman, http://www.flickr.com/photos/pasa/5583935536/.

Kmart Sells Stores

The management of Kmart Corp., a mass merchandising company with more than 1,500 stores

throughout the United States, agreed to sell 24 stores to Home Depot for $365 million in cash.

Julian Day, Kmart’s president and chief executive officer, stated, “We will take advantage of

opportunities to create value that include the sale of existing stores.”

In deciding whether to sell the stores, management likely considered the differential revenues

and costs associated with keeping the stores versus selling them. Perhaps the stores were not

profitable enough to exceed the $365 million in cash that Kmart received from the sale. Large

retail companies with many widely dispersed stores commonly review their unprofitable stores

on a regular basis and consider closing or selling stores that cannot turn a profit in the near

future.

Source: Kmart Corp. press release, June 4, 2004 (http://www.kmartcorp.com).

 KEY TAKEAWAY

 Managers often use differential analysis to determine whether to keep or drop a product line.

Direct fixed costs are typically eliminated if a product line is eliminated, and are considered

differential costs. Allocated fixed costs are typically not eliminated if a product line is eliminated,

and are not differential costs. Managers compare sales revenue and costs for each alternative

(keep or drop), and select the alternative with the highest profit.

REVIEW PROBLEM 7.3

The following annual income statement is for Austin Appliances, Inc., a maker of electrical

appliances:

Austin Appliances is concerned about the losses associated with the blenders product line and is

considering dropping this product line. Allocated fixed costs are assigned to product lines based

on sales. For example, $56,250 in allocated fixed costs is allocated to the blenders product line

based on the blenders product line sales as a percent of total sales [$56,250 = $150,000 ×

($750,000 ÷ $2,000,000)]. If Austin Appliances eliminates a product line, total allocated fixed

costs are assigned to the remaining product lines. All variable costs and direct fixed costs are

differential costs.

1. Using the differential analysis format presented in Figure 7.6 "Product Line Differential Analysis

for Barbeque Company", determine whether Austin Appliances would be better off dropping the

blenders product line or keeping the product line. Support your conclusion.
2. Assume Austin Appliances can lease the warehouse space currently being used by the blenders

product line for $15,000 per year. How does this affect the company’s decision to keep or drop

the blenders product line?

3. Summarize the result of dropping the blenders product line and leasing the warehouse space

using the format presented in Figure 7.8 "Differential Analysis with Opportunity Cost for

Barbeque Company".

Solution to Review Problem 7.3

1. As shown in the differential analysis given here, Austin Appliances would be better off

keeping the blenders product line. Dropping this product line would result in a drop in

total profit of $40,000.

 a $120,000 = ($1,000,000 ÷ $1,250,000) × $150,000.

b $30,000 = ($250,000 ÷ $1,250,000) × $150,000.

2. The $15,000 opportunity cost of keeping all three product lines would not affect the

company’s decision to keep the blenders product line. If the blenders are dropped, total

profit will decrease by $40,000. Lease revenue of $15,000 is not enough to offset the

$40,000 decrease in profit. In this scenario, total profit would decrease by $25,000 (=

$40,000 − $15,000). This result is presented formally, as follows:

 3.

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses

indicate a positive impact on profit.

7.4 Customer Decisions

LEARNING OBJECTIVE

1. Use differential analysis to decide whether to keep or drop customers.

Question: Much like product line decisions, managers often use profitability as a determining

factor to decide whether to keep or drop customers. This is an issue for all types of

organizations, including manufacturers, retailers, and service companies. How does the

differential analysis format differ for customer decisions compared to product line decisions?
Answer: Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we

track this information by customer. Fixed costs that cannot be traced directly to customers are

allocated to customers. Let’s look at an example for a company called Colony Landscape

Maintenance to identify the similarities and differences between the two formats.

Evaluating Customer Information

Question: Colony Landscape Maintenance provides services to three large customers:

Brumfield, Hodges, and Orth. The segmented income statement in Figure 7.9 "Income

Statement for Colony Landscape Maintenance" provides annual revenue and cost information

by customer. Notice that this information is formatted similarly to the product line information

in Figure 7.8 "Differential Analysis with Opportunity Cost for Barbeque Company". However,

instead of tracking information by product line, here we track information by customer.

Examine Figure 7.9 "Income Statement for Colony Landscape Maintenance" carefully and

notice that the Brumfield account shows a loss for the year of $15,000. Should Colony

Landscape Maintenance drop the Brumfield account?

Answer: To answer this question we must take a closer look at the information in Figure 7.9

"Income Statement for Colony Landscape Maintenance". The variable costs and direct fixed costs

are related directly to each customer, and thus are eliminated if Colony eliminates the Brumfield

account. That is, all variable costs and direct fixed costs are differential costs for the two

alternatives facing Colony. Colony assigns the allocated fixed costs of $20,000 to Brumfield

based on sales revenue, and those costs will continue regardless of Colony’s decision. Thus

allocated fixed costs are not differential costs.

Figure 7.9 Income Statement for Colony Landscape Maintenance

Management of Colony Landscape Maintenance would like to know if dropping the Brumfield

account would increase overall company profit. The differential analysis presented in Figure 7.10

"Customer Differential Analysis for Colony Landscape Maintenance" provides the answer. Panel

A shows the income statement for Alternative 1: keeping all three customers. Panel B shows the

income statement for Alternative 2: dropping the Brumfield account. And panel C presents the

differential analysis for both alternatives. The differential analysis presented in panel C shows

that overall profit will decrease by $5,000 if Colony drops the Brumfield account.

Figure 7.10 Customer Differential Analysis for Colony Landscape Maintenance

a $62,500 = ($500,000 ÷ $800,000) × $100,000.

b $37,500 = ($300,000 ÷ $800,000) × $100,000.

Figure 7.11 "Keep or Drop Customer" provides a bar chart summarizing how total profit will

decrease if the Brumfield account is dropped. This information comes from the bottom of panels

A and B in Figure 7.10 "Customer Differential Analysis for Colony Landscape Maintenance".

Figure 7.11 Keep or Drop Customer

We show a more concise explanation in Figure 7.12 "Summary of Differential Analysis for Colony

Landscape Maintenance", which presents the Differential Amount column shown in panel C

of Figure 7.10 "Customer Differential Analysis for Colony Landscape Maintenance" along with a

brief description of each item.

Figure 7.12 Summary of Differential Analysis for Colony Landscape Maintenance

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without

parentheses indicate a positive impact on profit.

An alternative way of handling the decision facing Colony Landscape Maintenance is simply to

calculate profitability of the Brumfield account before deducting allocated fixed costs. Figure 7.12

"Summary of Differential Analysis for Colony Landscape Maintenance" shows a contribution

margin of $30,000 for the Brumfield account. Deduct direct fixed costs of $25,000 and the

customer has a remaining profit of $5,000. This explains why Colony’s overall profit would be

$5,000 lower if it eliminated the Brumfield account.

Business in Action 7.3

Engineering Firm Fires Its Biggest Customer

The president of ABCO Automation, Inc., a 120-person engineering firm in North Carolina,

decided it was time to fire the firm’s biggest client. Although the client provided close to 60

percent of the firm’s annual revenue, ABCO decided that firing this client was necessary. The

president of ABCO stated, “We cannot be a great place to work without employees, and this

client was bullying my employees. Its demands for turnaround were impossible to meet even

with people working seven days a week. No client is worth losing my valued employees.”

The initial impact on revenues was significant. However, ABCO was able to cut costs and obtain

new customers to fill the void. In addition, the fired client later gave ABCO two new projects on

more equitable terms.

The lesson from this is that dropping customers is not always a financial decision. ABCO’s client

was profitable, but in the long run, the firm was at risk of losing valuable employees. This was a

risk ABCO was not willing to take.

Source: Roger Herman and Joyce Gioia, “Herman Trend Alert,” Strategic Business Futurists

2004 (http://www.hermangroup.com).

Using Activity-Based Costing to Assess Customer Profitability

Question: Activity-based costing, which we discussed in Chapter 3 "How Does an Organization

Use Activity-Based Costing to Allocate Overhead Costs?", is a refined approach to allocating

costs to products or customers. Activity-based costing first assigns costs to activities and then to

products or customers based on their use of the activities. The cost information provided by

activity-based costing is generally regarded as more accurate than most traditional costing

methods. How can using activity-based costing information with differential analysis lead to

better decisions in areas such as product lines and customer profitability?

Answer: Let’s look at a brief example of how activity-based costing can help with customer

profitability. When assessing customer profitability, costs can be assigned to customers based on

each customer’s use of activities. Consultants from PricewaterhouseCoopers suggest that

customer costs are measurable across four categories of activities:Joseph A. Ness, Michael J.

Schroeck, Rick A. Letendre, and Willmar J. Douglas, “The Role of ABM in Measuring Customer

Value—Part 2,” Strategic Finance(April 2001): 44–49.

 Cost to acquire customers: Consists of activities such as advertising and promotional

materials.

 Cost to provide goods and services: Consists of activities such as processing customer

orders and delivering goods.

 Cost to serve customers: Consists of activities such as technical support and processing

customer payments.
  Cost to retain customers: Consists of activities such as offering discounts and building

relationships.

With the help of activity-based costing, costs can be assigned to activities within each category.

These costs are then allocated to customers based on each customer’s use of activities. A

significant advantage of using activity-based costing is having accurate data for decision-making

purposes, particularly in the area of differential analysis.

KEY TAKEAWAY

 Managers use differential analysis to determine whether to keep or drop a customer. The format

is similar to the differential analysis format used for making product line decisions. However,

sales revenue, variable costs, and fixed costs are traced directly to customers rather than to

product lines.

REVIEW PROBLEM 7.4

The following annual income statement is for Tatum & Associates, a firm that provides legal

services to its customers.

Tatum & Associates is concerned about the losses associated with the Elko Corporation account

and is considering dropping this customer. Allocated fixed costs are assigned to customers based

on sales. For example, $105,000 in allocated fixed costs is assigned to Elko based on this

customer’s sales as a percent of total sales [$105,000 = $300,000 × ($1,050,000 ÷ $3,000,000)]. If

a customer is dropped, total allocated fixed costs are assigned to the remaining customers. All

variable costs and direct fixed costs are differential costs.

1. Using the differential analysis format presented in Figure 7.10 "Customer Differential Analysis for

Colony Landscape Maintenance", determine whether Tatum & Associates would be better off

dropping the Elko Corporation account or keeping the account. Explain your conclusion.

2. Summarize the result of dropping the Elko Corporation account using the differential analysis

format presented in Figure 7.12 "Summary of Differential Analysis for Colony Landscape

Maintenance".

Solution to Review Problem 7.4

1. As shown in the differential analysis provided, Tatum & Associates would be better off

dropping the Elko Corporation account. Profit is $5,000 lower if the Elko account is

retained.
 a $184,615 rounded = ($1,200,000 ÷ $1,950,000) × $300,000.

b $115,385 rounded = ($750,000 ÷ $1,950,000) × $300,000.

2.
 Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses

indicate a positive impact on profit.

7.5 Review of Cost Terms Used in Differential Analysis

LEARNING OBJECTIVE

1. Understand cost terms used in differential analysis.

Question: We’ve introduced many new terms in this chapter. What are these important terms,

and how do they relate to differential analysis?

Answer: The important terms introduced in this chapter are outlined here:

Differential analysis requires that we consider all differential revenues and costs—costs that

differ from one alternative to another—when deciding between alternative courses of

action. Avoidable costs—costs that can be avoided by selecting a particular course of action—are

always differential costs and must be considered when deciding between alternative courses of

action.

Opportunity costs—the benefits foregone when one alternative is selected over another—are

differential costs, and must be included when performing differential analysis. Sunk costs—costs
incurred in the past that cannot be changed by future decisions—are not differential costs

because they cannot be changed by future decisions.

Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are

differential costs and therefore pertinent to making decisions. However, we must review these

costs on a case-by-case basis because some direct fixed costs may not be considered differential

in spite of being traced directly to a product line. For example, a five-year lease on a warehouse

used solely for one product line is a direct fixed cost but not a differential cost because the costs

will continue even if the product line is eliminated.

Allocated fixed costs—fixed costs that cannot be traced directly to a product—are

typically notdifferential costs. For example, if a product line is eliminated, these costs are simply

allocated to the remaining product lines.

KEY TAKEAWAY

 When deciding between alternatives, only those revenues and costs that differ from one

alternative course of action to another are relevant. Avoidable costs, opportunity costs, and

direct fixed costs typically fall into this category. Revenues and costs that do not differ from one

alternative course of action to another are irrelevant to the decision.

REVIEW PROBLEM 7.5

Match each of the following terms with the appropriate definition in the list given.

1. Differential analysis

2. Differential revenues and costs

3. Avoidable costs

4. Sunk costs

5. Direct fixed costs

6. Allocated fixed costs

7. Opportunity costs

a. The benefits forgone when one alternative is selected over another.

b. Fixed costs that can be traced directly to a product line.

c. Revenues and costs that differ from one alternative to another.

d. Costs incurred in the past that cannot be changed by future decisions.

e. Costs that can be avoided by selecting a particular course of action.

f. Fixed costs that cannot be traced directly to a product line.

g. Analyzing the difference in revenues and costs from one alternative course of action to another.

Solution to Review Problem 7.5

1. g

2. c

3. e

4. d

5. b

6. f

7. a

7.6 Special Order Decisions

LEARNING OBJECTIVE

1. Use differential analysis for special order decisions.

Question: We have already learned that managers use differential analysis for make-or-buy

decisions, product line decisions, and customer decisions. Differential analysis also provides a

format that helps managers decide whether to accept special orders made by customers. What

is a special order, and how can differential analysis be used to make a special order decision?

Answer: A special order is a unique one-time order made by a customer. Differential analysis

provides a format that helps managers decide whether to accept or reject special orders, as shown

in the example that follows.

Special Order Considerations

Assume Tony’s T-shirts makes shirts for local soccer, baseball, basketball, and other sports

teams. The owner, Tony, purchases the shirts and prints graphics on the shirts for each team. The

graphics were designed several years ago, so design costs are no longer incurred. On average,

Tony sells 1,000 shirts each month. Typical monthly financial data follow:

The monthly information provided relates to the company’s routine monthly operations. A

representative of the local high school recently approached Tony to ask about a one-time special

order. The high school will be hosting a statewide track and field event and is willing to pay

Tony’s T-shirts $17 per shirt to make 200 custom T-shirts for the event. Because enough idle

capacity exists to handle this order, it will not affect other sales. That is, Tony has the factory

space and machinery available to produce more T-shirts.

Tony incurs the same variable costs of $13 per unit to produce the special order, and he will pay a

firm $600 to design the graphics that will be printed on the shirts. This special order will have no

other effect on Tony’s monthly fixed costs.

Question: Should Tony accept the special order?

Answer: Let’s use differential analysis to answer this question. As shown in Figure 7.13 "Special

Order Differential Analysis for Tony’s T-Shirts", Alternative 1 assumes Tony rejects the special
order, and Alternative 2 assumes he accepts the special order. The differential analysis in Figure

7.13 "Special Order Differential Analysis for Tony’s T-Shirts" shows that Tony’s would be better

off accepting the special order, as profit increases $200.

Figure 7.13 Special Order Differential Analysis for Tony’s T-Shirts

a $23,400 = $20,000 + ($17 per shirt × 200 shirts).

b $15,600 = $13,000 + ($13 × 200 shirts).

c $4,600 = $4,000 + $600 cost for special order design.

Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts" provides an alternative

presentation of differential analysis for Tony’s T-shirts. As discussed earlier in the chapter, this

presentation summarizes the differential revenues and costs.

Figure 7.14 Summary of Differential Analysis for Tony’s T-Shirts

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without

parentheses indicate a positive impact on profit.

Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts" shows the differential

revenues and costs for the special order being considered. If Tony’s T-shirts accepts the special

order, sales revenue will increase $3,400 with a corresponding increase in variable costs of

$2,600. Fixed costs will increase by $600 because design work is required for the special order.

Thus profit will increase by $200 (= $3,400 − $2,600 − $600).

Special Order Assumptions

Question: What assumptions were made with the differential analysis performed for Tony’s T-

shirts?

Answer: We made two important assumptions in the Tony’s T-shirts special order example. The

first assumption is that Tony’s has enough idle capacity to handle the order without disrupting

regular customer orders. Suppose Tony’s T-shirts is operating at capacity and cannot produce

any more T-shirts. Tony must turn away regular customers to make room for the special order. In

this scenario, the opportunity cost of turning away existing customers must be considered in the

differential analysis.

The second assumption is that this is a one-time order, and therefore represents a short-run

pricing decision. If Tony’s T-shirts expects future orders from the high school at the $17 per shirt

price, the company must consider the impact this might have on long-run pricing with other

customers. That is, regular customers may hear of this special price and demand the same price,

particularly those customers who have been loyal to Tony’s T-shirts for many years. Tony’s might

be forced to lower prices for regular customers, thereby eroding the company’s profits over time.

The key point is that companies evaluating special orders can drop prices in the short run to

cover differential variable and fixed costs. But in the long run, prices must cover all variable and

fixed costs.

Computer Application
Using Excel to Perform Differential Analysis

Managers often perform differential analysis with the help of computer software for several

reasons:

 Once the format is established, the template can be used repeatedly for different

scenarios.

 Formulas underlie all calculations, thereby minimizing the potential for math errors and

speeding up the process.

 Changes can be made easily without having to redo the entire analysis.

An example of how to use Excel to perform differential analysis for the special order scenario

presented in Figure 7.13 "Special Order Differential Analysis for Tony’s T-Shirts" is shown here.

Although many accounting courses do not require the use of computer spreadsheets, you are

encouraged to use spreadsheet software like Excel when preparing homework or working review

problems.

KEY TAKEAWAY

 Managers often use differential analysis to decide whether to accept a special one-time order

made by a customer. Managers compare sales revenue and costs for each alternative (accept or

reject the special order), and select the alternative with the highest profit. Organizations must be

careful to consider the long-run implications of reducing prices for special orders.

REVIEW PROBLEM 7.6

The following monthly financial data are for Quicko’s, a company that makes photocopies for its

customers. On average, Quicko’s makes 100,000 copies each month.

 Quicko’s is approached by a local restaurant that would like to have 20,000 flyers copied. The

restaurant asks Quicko’s to produce the flyers for 7 cents a copy rather than the standard price of

8 cents. Quicko’s can produce up to 130,000 copies a month, so the special order will not affect

regular customer sales. Variable costs per copy will remain at 5 cents, but production of the

restaurant flyers will require a special copy machine part that costs $250. This special order will

have no other effect on monthly fixed costs.

1. Using the differential analysis format presented in Figure 7.13 "Special Order Differential Analysis

for Tony’s T-Shirts", determine whether Quicko’s would be better off accepting or rejecting the

special order.

2. Summarize the result of accepting the special order using the format presented in Figure 7.14

"Summary of Differential Analysis for Tony’s T-Shirts".

3. Assume Quicko’s can only produce 100,000 copies per month, and that regular customer sales

would decrease as a result of the special order. Using the differential analysis format presented

in Figure 7.13 "Special Order Differential Analysis for Tony’s T-Shirts", determine whether

Quicko’s would be better off accepting or rejecting the special order.

Solution to Review Problem 7.6

1.
 a $9,400 = $8,000 + ($0.07 per copy × 20,000 copies);or alternative approach: ($0.08 per copy × 100,000 copies)

+ ($0.07 per copy × 20,000 copies).

b $6,000 = $5,000 + ($0.05 per copy × 20,000 copies); or alternative approach: $0.05 × 120,000 copies.

c $2,250 = $2,000 + $250 cost for copy machine part.

This analysis shows that Quicko’s would be better off accepting the special order because

profit is $150 higher for Alternative 2.

2.

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses

indicate a positive impact on profit.

3. Assuming Quicko’s has a capacity of 100,000 copies per month, the analysis shows the

company would be better off rejecting the special order because profit is $450 higher for

this alternative.
 a $7,800 = ($0.08 × 80,000 regular customer copies) + ($0.07 × 20,000 special order copies).

b $2,250 = $2,000 + $250 cost for copy machine part.

7.7 Cost-Plus Pricing and Target Costing

LEARNING OBJECTIVE

1. Understand how to use cost-plus pricing and target costing to establish prices.

The previous section focuses on using differential analysis to assess pricing for special orders.

Organizations also use other approaches to establish prices, such as cost-plus pricing and target

costing. We cover these two approaches next.

Cost-Plus Pricing

Questions: Companies that produce custom products, such as homes or landscaping for

commercial buildings, often have a difficult time determining a reasonable market price. Prices

for these products can be determined using cost-plus pricing. How is cost-plus pricing used to

arrive at a reasonable price?

Answer: Cost-plus pricing starts with an estimate of the costs incurred to build a product or

provide a service, and a certain profit percentage is added to establish the price. For example, a

defense contractor working with the government assumes the cost to build a new fighter jet is

$60 million. As there is no open market price for this product, the contractor must come up with

an approach to establishing the price that does not rely on market pricing. Based on industry-

wide standards and negotiations with the government, the contractor requests a 10 percent

markup on cost. If the government accepts this proposal, the contractor will receive $66 million

for each plane delivered [$66 million = $60 million + ($60 million × 10 percent)].

The concept of cost-plus pricing sounds simple. However, the difficulty is in determining which

costs should be included. Are only variable product costs included? Should fixed manufacturing

overhead be included? What about selling costs? The answers to these questions depend on the
negotiations between buyer and seller, and should be clearly defined in the agreement. When

using cost-plus pricing, it is important to establish in advance which costs are to be included for

pricing purposes.

Target Costing

Question: Organizations are constantly trying to find ways to become more efficient and

reduce costs. However, once manufacturing firms design a product and begin production, it is

difficult to make significant changes that will reduce costs. How can target costing help with

this issue?

Answer: Target costing is an approach that mitigates cost efficiency problems associated with

introducing new products by integrating the product design, desired price, desired profit, and

desired cost into one process beginning at the product development stage. Target costing has four

steps:

Step 1. Design a product that provides the features and price demanded by

customers.

Step 2. Determine the company’s desired profit.

Step 3. Derive the target cost by subtracting the desired profit (from step 2) from

the desired price (from step 1).

Step 4. Engineer the product to achieve the target cost (from step 3). If the desired

target cost cannot be achieved, the company must go back to step 1 and reevaluate

the features and price.

For example, suppose Hewlett-Packard designs a laser printer with features that customers

have requested and wants to sell it for $240; this is Step 1. Management requires a profit equal to

40 percent of the selling price, or $96 (= $240 × 40 percent); this is Step 2. The target cost is

$144 (= $240 − $96); this is Step 3. The product engineers must now design this product in

detail to achieve or beat the target cost of $144; this is Step 4.

KEY TAKEAWAY

 Cost-plus pricing starts with an estimate of the costs incurred to build a product, and a certain

profit percentage is added to establish the price. Companies often use this method when it is

difficult to determine a reasonable market price. Target costing integrates the product design,

desired price, desired profit, and desired cost into one process beginning at the product

development stage.

REVIEW PROBLEM 7.7

Suppose Nike, Inc., has developed a new shoe that can be sold for $140 a pair. Management

requires a profit equal to 60 percent of the selling price. Determine the target cost of this

product.

Solution to Review Problem 7.7

The target cost of $56 is found by subtracting the target profit from the target selling price. This

calculation is as follows.

7.8 Identifying and Managing Bottlenecks

LEARNING OBJECTIVE

1. Understand the theory of constraints.

Question: As we noted in Chapter 6 "How Is Cost-Volume-Profit Analysis Used for Decision

Making?", many companies have limited resources in such areas as labor hours, machine

hours, facilities, and materials. These constraints will likely affect a company’s ability to
produce goods or provide services. Companies facing constraints often use a variation of

differential analysis to optimize the use of constrained resources called the theory of

constraints. What are constrained resources, and how does the theory of constraints help

managers make better use of these resources?

Answer: Constrained resources are often referred to as bottlenecks. A bottleneck is a process in

which the work to be performed exceeds available capacity. The theory of constraints is a recently

developed approach to managing bottlenecks.

We will look at an example to help explain how the theory of constraints works. Assume

Computers, Inc., produces desktop computers using six departments as shown in Figure 7.15

"Production Process at Computers, Inc.". Computers are assembled in departments 1, 2, and 3

and are then sent to department 4 for quality testing. Once testing is complete, products are

packaged in department 5. Department 6 is responsible for shipping the products.

Question: The theory of constraints provides five steps to help managers make efficient use of

constrained resources. What are these five steps, and how will they help Computers, Inc.?

Answer: The five steps are described here, with a narrative indicating how Computers, Inc.,

would utilize each step.

Step 1. Find the constrained resource (bottleneck).

In this step, the process that limits production is identified. The management at Computers, Inc.,

has identified department 4, quality testing, as the bottleneck because assembled computers are

backing up at department 4. Quality testing cannot be performed fast enough to keep up with the
inflow of computers coming from departments 1, 2, and 3. A limitation of labor hours available to

perform testing is causing this backlog.

Step 2. Optimize the use of the constrained resource.

The constrained resource has been identified as the number of labor hours available to perform

testing. At this point, Computers, Inc., would like to optimize the labor hours used for quality

testing. To assist in this goal, we will calculate the contribution margin per unit of constraint (the

unit of constraint is labor hour in this example). Production will then focus on products with the

highest contribution margin per labor hour. Figure 7.16 "Contribution Margin per Unit of

Constrained Resource for Computers, Inc." provides this information for each product. (We first

introduced the concept of calculating a contribution margin per unit of constraint in Chapter 6

"How Is Cost-Volume-Profit Analysis Used for Decision Making?".)

Figure 7.16 Contribution Margin per Unit of Constrained Resource for Computers, Inc.

Based on the information presented in Figure 7.16 "Contribution Margin per Unit of Constrained

Resource for Computers, Inc.", and given that labor hours in department 4 is the constraint,

Computers, Inc., would optimize the use of labor hours by producing the S150 model because it

provides a contribution margin of $800 per labor hour versus $500 for the A100 model, and

$625 for the P120 model.

Step 3. Subordinate all nonbottleneck resources to the bottleneck.

The goal in this step is to shift nonbottleneck resources to the bottleneck in department 4. At this

point, improving efficiencies in other departments does little to alleviate the bottleneck in

department 4. Thus Computers, Inc., must try to move resources from other areas to department

4 to reduce the backlog of computers to be tested.

Step 4. Increase bottleneck efficiency and capacity.

Management’s goal is to loosen the constraint by providing more labor hours to department 4.

For example, management may decide to move employees from departments 1, 2, and 3 to the

quality testing department. Another option is to authorize overtime for the workers in

department 4. Perhaps management will consider hiring additional workers for department 4.

Step 5. Repeat steps 1 through 4 for the new bottleneck.

Once the bottleneck in department 4 is relieved, a new bottleneck will likely arise elsewhere.

Going back to step 1 requires management to identify the new bottleneck and follow steps 2

through 4 to alleviate the bottleneck.

KEY TAKEAWAY

 Most companies have limited resources in areas such as labor hours, machine hours, facilities,

and materials. The theory of constraints is an approach that enables companies to optimize the

use of limited resources. Five steps are involved. First, find the constrained resource (or

bottleneck). Second, optimize the use of the constrained resource. Third, subordinate all

nonbottleneck resources to the bottleneck. Fourth, increase bottleneck efficiency and capacity.

Fifth, repeat the first four steps for the new bottleneck.

REVIEW PROBLEM 7.8

Southside Company produces three types of baseball gloves: child, teen, and adult. The gloves

are produced in separate departments and sent to the quality testing department before being

packaged and shipped. A machine-hour bottleneck has been identified in the quality testing
 department. Southside would like to optimize its use of machine hours (step 2) by producing the

two most profitable gloves. The machine hours required for each glove follow:
Child glove 0.25 machine hours
Teen glove 0.40 machine hours
Adult glove 0.50 machine hours

Price and variable cost information is as follows:

Price Variable Cost
Child glove $15 $5
Teen glove 20 8
Adult glove 35 22

1. Calculate the contribution margin per unit of constrained resource for each glove.

2. Which two gloves would Southside prefer to produce and sell to optimize the use of machine

hours in the quality testing department?

Solution to Review Problem 7.8

1.

2. The company would prefer to produce and sell the child and teen gloves, since these products

have the highest contribution margin per machine hour.

7.9 Be Aware of Qualitative Factors

LEARNING OBJECTIVE

1. Evaluate qualitative factors when using differential analysis.

Question: This chapter has focused on using relevant revenue and cost information to perform

differential analysis. Using these quantitative factors to make decisions allows managers to

support

decisions with measurable data. For example, the idea of outsourcing production of

wakeboards at Best Boards, Inc., presented at the beginning of the chapter, was rejected

because it was more costly to outsource production of the boards than to produce them

internally. Although using quantitative factors for decision making is important, management

must also consider qualitative factors. How might the consideration of qualitative factors

improve decisions made by managers?

Answer: Qualitative factors may outweigh the quantitative factors in making a decision. For

example, assume management at Best Boards, Inc., believes there will be a decline in the market

for wakeboards after next year. Outsourcing production makes it easier to quickly reduce costs in

the face of a downturn by simply ordering fewer wakeboards from the supplier. Continuing to

build the boards internally takes away this flexibility. The significant fixed costs often associated

with manufacturing firms are difficult to reduce in the short run if production declines. Thus the

qualitative factor of being able to reduce manufacturing costs quickly by outsourcing production

may outweigh the quantitative factors shown in Figure 7.3 "Summary of Differential Analysis for

Best Boards, Inc." and Figure 7.4 "Product Line Decision".

Question: What if the quantitative differential analysis for Best Boards had a different result, in

that it showed the company should outsource? What qualitative factors should management

consider before implementing this decision?

Answer: Management must consider whether product quality would remain the same. Financial

stability of the producer must be considered as well. It does no good to outsource production and

eliminate production facilities and employees if the producer being used suddenly shuts down.
Also, employee morale tends to slide if employees in one segment of a company are fired. This

can lead to an unhappy and inefficient workforce in other areas of the company, causing costs to

rise. These are just a few of the qualitative factors that must be weighed against quantitative

factors when performing differential analysis.

KEY TAKEAWAY

 Although accountants are responsible for providing relevant and objective financial information

to help managers make decisions, qualitative factors also play a significant role in the decision-

making process.

REVIEW PROBLEM 7.9

What qualitative factors should management consider when deciding whether to outsource

production or keep production within the company?

Solution to Review Problem 7.9

The qualitative factors that management should consider when deciding whether to outsource

production include the following:

 Will the quality of the products remain the same?

 Will shutting down the manufacturing facility have a negative impact on the morale of remaining

employees?

 Is the producer that will be making the product financially stable and reliable?

7.10 Appendix: Making Decisions Involving Joint Costs

LEARNING OBJECTIVE

1. Analyze the impact that joint costs have on decision making.

Question: When two or more products are produced from a single input, these products are

called joint products. The cost of this single input and the related manufacturing process costs

are called joint costs. For example, lumber companies often must deal with joint products

(different types of lumber) resulting from one input (a log). How do the concepts of joint

products and joint costs help a lumber company establish a cost for each of its products?
Answer: Suppose Oregon Lumber Company takes a log (the single input) and mills it into two

types of products: high quality Grade A lumber, and lower quality Grade B lumber. Grade A

lumber and Grade B lumber are examples of joint products, and the cost of the logs and related

manufacturing process costs are examples of joint costs.

Figure 7.17 "Joint Costs and Joint Product Flows at Oregon Lumber Company" presents the

information for Oregon Lumber for the month of June. Joint costs for the month total $250,000.

Notice that the split-off point is the point at which identifiable products emerge from the

production process. The issue is how to allocate joint costs—the $250,000 in production costs

incurred prior to the split-off point—to the resulting joint products.

Two methods are commonly used to allocate these joint costs to the joint products: the physical

quantities method and the sales value method. We discuss each of these methods next.

The Physical Quantities Method

Question: The physical quantities method allocates joint costs based on a physical measure of

output. Assume Oregon Lumber produces 600,000 board feet of Grade A lumber and 200,000

board feet of Grade B lumber during June. How would Oregon Lumber use this information to

allocate $250,000 in joint production costs to each grade of lumber?

Answer: Oregon Lumber would allocate 75 percent of the joint costs to Grade A lumber (75

percent = 600,000 Grade A board feet ÷ 800,000 total board feet), and 25 percent of the joint

costs to Grade B lumber.

Grade A allocation:

$187,500 allocation = $250,000 joint costs × (600,000 Grade A board feet ÷ 800,000 total
board feet)

Grade B allocation:
$62,500 allocation = $250,000 joint costs × (200,000 Grade B board feet ÷ 800,000 total
board feet)

Figure 7.18 "Joint Product Profitability for Oregon Lumber Company: Physical Quantities

Method"presents the profitability of each joint product for the month using the physical

quantities method assuming Grade A lumber sells for $0.40 per board foot and Grade B lumber

sells for $0.30 per board foot.

Figure 7.18 Joint Product Profitability for Oregon Lumber Company: Physical Quantities Method

a $240,000 = $0.40 per board foot × 600,000 Grade A board feet.

b $60,000 = $0.30 per board foot × 200,000 Grade B board feet.

c $187,500 = $250,000 joint costs × (600,000 Grade A board feet ÷ 800,000 total board feet).

d $62,500 = $250,000 joint costs × (200,000 Grade B board feet ÷ 800,000 total board feet).

Although Grade B lumber appears to be unprofitable, elimination of Grade B lumber sales

would notincrease overall profit for Oregon Lumber. Grade B lumber contributes $60,000 to

covering joint costs. Thus elimination of Grade B lumber sales would result in a decrease in

overall profit of $60,000. The $62,500 in joint cost allocated to Grade B lumber would simply be

reallocated to Grade A lumber.

The Sales Value Method

Question: A different approach to allocating joint costs to joint products is the sales value

method, which allocates joint costs based on the relative sales value of each product at the split-

off point. How would Oregon Lumber allocate joint production costs using this method?
Answer: Because sales revenue totals $240,000 for Grade A lumber and $60,000 for Grade B

lumber, 80 percent of the joint costs are allocated to Grade A lumber (80 percent = $240,000

Grade A revenue ÷ $300,000 total revenue), and 20 percent of the joint costs are allocated to

Grade B lumber:

Grade A allocation:

$200,000 allocation = $250,000 joint costs × ($240,000 Grade A sales value ÷ $300,000 total
sales value)

Grade B allocation:

$50,000 allocation = $250,000 joint costs × ($60,000 Grade B sales value ÷ $300,000 total
sales value)

Figure 7.19 "Joint Product Profitability for Oregon Lumber Company: Sales" presents the

profitability of each joint product for the month using the sales value method, again assuming

Grade A lumber sells for $0.40 per board foot, and Grade B lumber sells for $0.30 per board

foot.

Figure 7.19 Joint Product Profitability for Oregon Lumber Company: Sales

a $240,000 = $0.40 per board foot × 600,000 Grade A board feet.

b $60,000 = $0.30 per board foot × 200,000 Grade B board feet.

c $200,000 = $250,000 joint costs × ($240,000 Grade A sales value ÷ $300,000 total sales value).

d $50,000 = $250,000 joint costs × ($60,000 Grade B sales value ÷ $300,000 total sales value).

The sales value method assumes that profit as a percent of sales will remain the same across all

products. For example, Figure 7.19 "Joint Product Profitability for Oregon Lumber Company:

Sales"shows that Grade A lumber has a profit margin ratio of 16.67 percent (= $40,000 profit ÷
$240,000 sales), as does Grade B lumber (= $10,000 profit ÷ $60,000 sales). This method also

ensures that joint costs allocated to each product will not exceed sales revenue for each product

(unless total joint costs are higher than total revenue).

As you review Figure 7.18 "Joint Product Profitability for Oregon Lumber Company: Physical

Quantities Method" and Figure 7.19 "Joint Product Profitability for Oregon Lumber Company:

Sales", notice that the total column for both methods of joint cost allocation is the same. The

issue is not with the overall results. The issue is how to allocate joint costs to each joint product.

Deciding Whether to Process Further

Question: Assume Oregon Lumber Company has the option of processing Grade B lumber

further into a finished product by sanding the lumber and painting it with primer. This option

is presented in Figure 7.20 "Further Processing of Oregon Lumber Company’s Grade B

Lumber". The sanded and painted Grade B lumber sells for $0.45 per board foot rather than

$0.30 for the unfinished Grade B lumber. The additional cost to sand and paint the Grade B

lumber is $0.05 per board foot. Should Oregon Lumber process Grade B lumber further into

finished lumber?

Answer: The answer depends on whether the additional revenue exceeds the additional cost of

processing Grade B lumber further. Since the additional revenue of $0.15 per board foot (= $0.45

finished price − $0.30 unfinished price) is greater than the additional $0.05 per board foot

processing cost, Oregon Lumber should process the Grade B lumber further into finished lumber.

Profit increases $0.10 per board foot as a result of processing further (= $0.15 additional revenue

− $0.05 additional cost).

Oregon Lumber will decide whether or not to process Grade B lumber further regardless of how

joint costs are allocated to Grade A and Grade B lumber. In a sense, joint costs are sunk costs

with respect to this decision, and will not influence future processing decisions. Thus joint costs

incurred prior to the split-off point are irrelevant to the decision whether to process

further after the split-off point.

 KEY TAKEAWAY

 Two or more products made from a single input are called joint products. The costs of the single

input and related manufacturing process costs must be allocated to each of the joint products.

The physical quantities method allocates joint costs based on a physical measure of output (e.g.,

pounds or yards of material). The sales value method allocates joint costs based on the relative

sales value for each of the joint products. Regardless of the allocation method used, total joint

costs and total profit remain the same. Companies must often decide whether to process a joint

product further. If as a result of processing the product further, additional sales revenue exceeds

additional costs, the wise decision is to process further.

REVIEW PROBLEM 7.10.

Fresh Veggies, Inc., purchased 10,000 pounds of fresh apples from a local grower for $4,000. The

apples were separated into high-quality Grade A apples (3,000 pounds) and lower-quality Grade

B apples (7,000 pounds). Fresh Veggies sells Grade A apples for $0.80 per pound and Grade B

apples for $0.50 per pound.

1. Allocate joint costs to each product using the physical quantities method (pounds), and calculate

the profit or loss for each product.

2. Allocate joint costs to each product using the relative sales value method, and calculate the profit

or loss for each product.

3. Assume Grade B apples can be processed further into dried apple slices for an additional $0.20

per pound. Customers are willing to pay $0.65 per pound for dried apple slices. Should Fresh

Veggies, Inc., process the Grade B apples further?

Solution to Review Problem 7.10.

1.

a $2,400 = $0.80 per pound × 3,000 pounds of Grade A apples.

 b $3,500 = $0.50 per pound × 7,000 pounds of Grade B apples.

c $1,200 = $4,000 joint costs × (3,000 pounds of Grade A apples ÷ 10,000 total pounds).

d $2,800 = $4,000 joint costs × (7,000 pounds of Grade B apples ÷ 10,000 total pounds).

2.

a $2,400 = $0.80 per pound × 3,000 pounds of Grade A apples.

b $3,500 = $0.50 per pound × 7,000 pounds of Grade B apples.

c $1,627 (rounded) = $4,000 joint costs × ($2,400 Grade A sales value ÷ $5,900 total sales value).

d $2,373 (rounded) = $4,000 joint costs × ($3,500 Grade B sales value ÷ $5,900 total sales value).

3. Because the additional revenue of $0.15 per pound (= $0.65 price with further processing − $0.50

without further processing) is less than the additional $0.20 per pound processing cost, Fresh

Veggies should not process the Grade B apples further into dried apples. Profit decreases $0.05

per pound (= $0.20 additional cost − $0.15 additional revenue) as a result of processing further.

END-OF-CHAPTER EXERCISES

Questions

1. What are differential revenues and costs?

2. What is differential analysis?

3. Define what is meant by a “make-or-buy” decision. Describe how differential analysis can be used

to assist in making this type of decision.

4. Figure 7.2 "Make-or-Buy Differential Analysis for Best Boards, Inc." and Figure 7.3 "Summary of

Differential Analysis for Best Boards, Inc." provide two different formats for presenting the same

analysis. Describe the similarities and differences in these two formats.

5. What is an avoidable cost?

6. Review Note 7.8 "Business in Action 7.1" Why did Salt Lake City choose to outsource the concrete

panels to a company in Mexico City even though the library was being constructed in Salt Lake

City?

7. How is differential analysis used in deciding whether to keep or drop product lines?

8. Why are direct fixed costs typically differential costs?

9. Why are allocated fixed costs typically not differential costs?

10. What is an opportunity cost? Why is an opportunity cost a differential cost?

11. Review Note 7.17 "Business in Action 7.2" What did Kmart do with 24 of its stores? Why

might Kmart have taken this action?

12. How is differential analysis similar for customer decisions and product line decisions?

13. Review Note 7.21 "Business in Action 7.3" Why did ABCO Automation, Inc., fire its biggest client

even though the client provided close to 60 percent of ABCO’s annual revenue?

14. What two important assumptions must be considered when evaluating special order scenarios?

15. What is cost-plus pricing?

16. Describe the four steps of target costing.

17. Describe the five steps used to manage constraints according to the theory of constraints.

18. What is a qualitative advantage of keeping unprofitable customers?

19. What are joint products and joint costs?

20. Describe the two methods of allocating joint costs.

Brief Exercises

21. Cutting Costs at Best Boards, Inc. Refer to the dialogue at Best Boards, Inc., presented at the

beginning of the chapter. How does the vice president of operations, Jim Muller, expect to

reduce costs and earn his bonus? What was the flaw in his plan?

22. Make-or-Buy Decision. Coffee Mugs, Inc., currently manufactures ceramic coffee mugs.

Management is interested in outsourcing production to a reputable manufacturing

company that can supply the cups for $2 per unit. Coffee Mugs produces 100,000 mugs

each year. Variable production costs are $0.80 and annual fixed costs are $150,000. If

production is outsourced, all variable costs and 40 percent of annual fixed costs will be

eliminated.
 Perform differential analysis using the format presented in Figure 7.2 "Make-or-Buy

Differential Analysis for Best Boards, Inc." and explain which alternative is best,

Alternative 1 (producing internally) or Alternative 2 (outsourcing).

23. Product Line Decision. The following segmented annual income statement is for Flash

Drive, Inc.:

For items A, B, and C, assign allocated fixed costs to each product line based on sales

revenue for each product line as a proportion of total sales revenue. For example, the 1

Gig product will be assigned 10 percent of allocated fixed costs (= $1,000,000 in 1 Gig

sales revenue ÷ $10,000,000 total sales revenue), or $110,000 (=$1,100,000 total

allocated fixed costs × 10 percent). For items D, E, and F, calculate the profit or loss for

each product line.

24. Customer Decision. Consulting Group LLC has two customers. Customer One generates

$150,000 in income after direct fixed costs are deducted, and Customer Two generates

$200,000 in income after direct fixed costs are deducted. Allocatedfixed costs total

$300,000 and are assigned 30 percent to Customer One and 70 percent to Customer Two

based on several different cost drivers. Total allocated fixed costs remain the same

regardless of how these costs are assigned to customers.

Calculate the amount of allocated fixed costs to be assigned to each customer, and

determine the profit or loss for each customer. Should Consulting Group drop Customer

Two? Explain.
25. Special Order Decision: Operating with Idle Capacity. Jerseys, Inc., currently produces 10,000

jerseys a year for its regular customers and charges $10 per jersey. Jerseys, Inc., has capacity to

produce an additional 5,000 jerseys if sales grow in the future. Variable costs total $6 per jersey

and annual fixed costs total $15,000. The city of Rockville recently approached the company and

proposed a one-time purchase of 3,000 jerseys for $8 each. Should Jerseys, Inc., accept the

proposal? Explain.

26. Cost-Plus Pricing. KJ Home Builders is bidding on a custom home for a potential customer. The

company typically charges 15 percent above cost and estimates the home will cost $500,000 to

build. Calculate the price bid by KJ Home Builders.

27. Constrained Resources. Deal, Inc., produces two types of computers: Vortex and Zoom.

The computers are produced in separate departments and sent to the quality testing

department before being packaged and shipped. A labor-hour bottleneck has been

identified in the quality testing department due to the high skill requirements of the job.

Deal, Inc., would like to optimize its use of labor hours by producing the most profitable

computer. Based on the information shown, calculate the contribution margin per quality

testing labor hour for each product:

Quality Testing Labor Hours Contribution Margin
Vortex 0.50 $600
Zoom 0.40 500

28. Evaluating Qualitative Factors. Assume your company is considering whether to outsource

production. What qualitative factors should be considered before making this decision?

29. Allocating Joint Costs (Appendix). Charlotte Company produces two joint chemical products,

product A and B. Prior to the split-off point, the company incurred $100,000 in joint costs.

Production totaled 12,000 gallons for product A and 8,000 gallons for product B. Allocate joint

costs to each product using the physical quantities method (gallons).

Exercises: Set A

30. Make-or-Buy Decision. Wheels, Inc., currently manufactures its own custom rims for

automobiles. Management is interested in outsourcing production of these rims to a

 reputable manufacturing company that can supply the rims for $80 per unit. Wheels, Inc.,

incurs the following annual production costs to produce 10,000 rims internally.

If production is outsourced, all variable production costs, factory building and equipment

lease costs, and factory insurance costs will be eliminated. The production supervisor’s

salary cost will remain regardless of the decision to outsource or to produce internally

because the supervisor recently signed a long-term contract with Wheels, Inc.

Required:

a. Perform differential analysis using the format presented in Figure 7.2 "Make-or-Buy

Differential Analysis for Best Boards, Inc.". Assume making the rims internally is

Alternative 1, and buying the rims from an outside manufacturer is Alternative 2.

b. Which alternative is best? Explain.

c. Summarize the result of outsourcing production using the format presented in Figure 7.3

"Summary of Differential Analysis for Best Boards, Inc.".

d. Compare the format used in requirement a with that of requirement c.

31. Product Line Decision. The following monthly segmented income statement is for

Durango Company.
 Management is concerned about the losses associated with product line A and is

considering dropping this product line. Allocated fixed costs are assigned to product lines

based on sales. If product line A is eliminated, total allocated fixed costs are assigned to

the remaining product lines, and all variable and direct fixed costs for product line A will

be eliminated.

Required:

. Perform differential analysis using the format presented in Figure 7.6 "Product Line

Differential Analysis for Barbeque Company". Assume keeping all product lines is Alternative 1,

and dropping product line A is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping product line A using the format presented in Figure

7.7 "Summary of Differential Analysis for Barbeque Company".

c. Explain why the loss shown for product line A in the segmented income statement

might be misleading to management.

32. Customer Decision. The following customer segmented quarterly income statement is for

Accounting Associates.
 Management is concerned about the significant losses associated with the Nguyen

account and would like to drop this customer. Allocated fixed costs are assigned to

customers based on sales revenue. If Nguyen is dropped, total allocated fixed costs are

assigned to the remaining customers, and all variable and direct fixed costs for the

Nguyen account will be eliminated.

Required:

. Perform differential analysis using the format presented in Figure 7.10 "Customer

Differential Analysis for Colony Landscape Maintenance". Assume keeping all customers is

Alternative 1, and dropping the Nguyen account is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping the Nguyen account using the format presented

in Figure 7.12 "Summary of Differential Analysis for Colony Landscape Maintenance".

c. Explain what happened to the profitability of the other two customers as a result of

dropping the Nguyen account.

33. Special Order Decision: Operating with Idle Capacity. The following monthly financial

data are for RadioCom, Inc., a maker of handheld VHF radios. RadioCom produces and

sells 5,000 radios each month to regular customers.

 RadioCom received an offer from the Coast Guard Auxiliary to purchase 1,000 radios next

month for $75 per unit. RadioCom can produce up to 7,000 radios a month, so the special

order would not affect regular customer sales. Variable costs per radio will remain at $60.

This special order will have no effect on monthly fixed costs.

Required:

. Using the differential analysis format presented in Figure 7.13 "Special Order

Differential Analysis for Tony’s T-Shirts", determine whether RadioCom would be better off

rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).

a. Summarize the result of accepting the special order using the format presented

in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

34. Special Order Decision: Operating at Full Capacity. The following monthly financial data

are for RadioCom, Inc., a maker of handheld VHF radios. RadioCom produces and sells

5,000 radios each month to regular customers.

RadioCom received an offer from the Coast Guard Auxiliary to purchase 1,000 radios next

month for $75 per unit. RadioCom can only produce up to 5,000 radios a month, so the
 special order would result in reduced sales to regular customers. Variable costs per radio

will remain at $60. This special order will have no effect on monthly fixed costs.

Required:

. Using the differential analysis format presented in Figure 7.13 "Special Order

Differential Analysis for Tony’s T-Shirts", determine whether RadioCom would be better

off rejecting (Alternative 1) or accepting (Alternative 2) the offer received from the Coast

Guard Auxiliary.

a. Summarize the result of accepting the special order using the format presented

in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

35. Target Costing. Quality Sounds, Inc., makes speakers and headphones for high-end sound

systems. The marketing department has identified a market for a specific type of

headphones that Quality Sounds does not currently produce, and expects to be able to

sell each pair for $150. Management requires a profit of 45 percent of the selling price.

Required:

Determine the highest cost (target cost) management would be willing to accept to

produce this product.

36. Constrained Resources. Cycle, Inc., produces three types of bicycles: racer, cruiser, and

climber. The bikes are produced in separate departments and sent to the quality testing

department before being packaged and shipped. A labor-hour bottleneck has been

identified in the quality testing department due to the high skill requirements of the job.

Cycle, Inc., would like to optimize its use of labor hours by producing the two most

profitable bikes. Information for each bike follows.

Quality Testing Labor Hours Price Variable Cost
Racer 1.25 $1,000 $400
Cruiser 1.00 500 300
Climber 1.00 800 450

37. Required:

. Calculate the contribution margin per unit of constrained resource for each product.
a. Which two products would Cycle, Inc., prefer to produce and sell to optimize the use of

labor hours in the quality testing department?

38. Qualitative Factors. For each of the following independent scenarios, identify at least

one qualitative factor that should be considered before making the decision.

. A company sells three types of computers (laptops, desktops, and palmtops), all of

which are profitable. The company faces a machine-hour bottleneck and plans to eliminate the

palmtop product because it has the lowest contribution margin per machine hour.

a. A company plans to drop an unprofitable customer.

b. A maker of high-end stereo equipment would like to shut down its manufacturing

facility and outsource production.

39. Allocating Joint Costs (Appendix). Clemson Products produces two joint products,

product Y and Z. Prior to the split-off point, the company incurred $60,000 in joint costs.

Clemson Products produced 10,000 yards of product Y and 30,000 yards of product Z

produced. Product Y sells for $4 per yard and product Z sells for $2 per yard.

Required:

. Allocate joint costs to each product using the physical quantities method (yards), and

calculate the profit or loss for each product.

a. Allocate joint costs to each product using the relative sales value method, and calculate

the profit or loss for each product.

Exercises: Set B

39. Make-or-Buy Decision. Quality Glass currently manufactures windshields for

automobiles. Management is interested in outsourcing production of these windshields

to a reputable manufacturing company that can supply the windshields for $45 per unit.

Quality Glass incurs the following annual production costs to produce 15,000 windshields

internally.
 If production is outsourced, all variable production costs will be eliminated, and 80

percent of fixed production costs will be eliminated. Regardless of the decision to

outsource or to produce internally, 20 percent of fixed production costs will remain .

Required:

a. Perform differential analysis using the format presented in Figure 7.2 "Make-or-Buy

Differential Analysis for Best Boards, Inc.". Assume making windshields internally is Alternative 1,

and buying windshields from an outside manufacturer is Alternative 2.

b. Which alternative is best? Explain.

c. Summarize the result of outsourcing production using the format presented in Figure

7.3 "Summary of Differential Analysis for Best Boards, Inc.".

d. Why might some managers prefer the format presented in requirement c?

40. Product Line Decision. The following segmented annual income statement is for Office

Express.
 Management is concerned about the significant losses associated with the computers

product line and would like to drop this product line. Allocated fixed costs are assigned to

product lines based on sales. If the computers product line is eliminated, total allocated

fixed costs are assigned to the remaining product lines, and all variable and direct fixed

costs for the computers product line will be eliminated.

Required:

. Perform differential analysis using the format presented in Figure 7.6 "Product Line

Differential Analysis for Barbeque Company". Assume keeping all product lines is Alternative 1,

and dropping the computers product line is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping the computer product line using the format presented

in Figure 7.7 "Summary of Differential Analysis for Barbeque Company".

c. Explain what happened to the profitability of the furniture product line as a result of

dropping the computers product line.

41. Customer Decision. The following customer segmented annual income statement is for

Management Consulting, Inc.

Management is concerned about the losses associated with the Apple LLP account and

would like to drop this customer. Allocated fixed costs are assigned to customers based

on sales revenue. If Apple LLP is dropped, total allocated fixed costs are assigned to the

remaining customers, and all variable and direct fixed costs for the Apple LLP account will

be eliminated.
 Required:

. Perform differential analysis using the format presented in Figure 7.10 "Customer

Differential Analysis for Colony Landscape Maintenance". Assume keeping all customers is

Alternative 1, and dropping the Apple LLP account is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping the Apple LLP account using the format presented

in Figure 7.12 "Summary of Differential Analysis for Colony Landscape Maintenance".

c. Explain why the loss shown for the Apple LLP account in the segmented income

statement might be misleading to management.

42. Special Order Decision: Operating with Idle Capacity. The following monthly financial

data are for Sport Socks, Inc., a maker of socks for runners. Sport Socks makes and sells

40,000 pairs each month to regular customers.

Sport Socks received an offer from a large sporting goods store to purchase 15,000 socks

next month for $0.90 per pair. Sport Socks can produce up to 60,000 pairs of socks a

month, so the special order would not affect regular customer sales. Variable costs per

pair will remain at $0.70. This special order will cause fixed costs to increase by $6,000 for

next month.

Required:

. Using the differential analysis format presented in Figure 7.13 "Special Order

Differential Analysis for Tony’s T-Shirts", determine whether Sport Socks would be better off

rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).
a. Summarize the result of accepting the special order using the format presented

in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

43. Special Order Decision: Operating at Full Capacity. The following monthly financial data

are for Sport Socks, Inc., a maker of socks for runners. Sport Socks makes and sells 40,000

pairs each month to regular customers.

Sport Socks received an offer from a large sporting goods store to purchase 15,000 socks

next month for $0.90 per pair. Assume Sport Socks can only produce up to 40,000 pairs of

socks each month. Thus any special orders would result in reduced sales to regular

customers. However, fixed costs will not change as a result of the special order.

Required:

. Using the differential analysis format presented in Figure 7.13 "Special Order

Differential Analysis for Tony’s T-Shirts", determine whether Sport Socks would be better off

rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).

a. Summarize the result of accepting the special order using the format presented

in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

44. Target Costing. Nature Wood, Inc., makes wood tables for commercial use. The

marketing department has identified a market for a specific table that the company does

not currently produce, and it expects that each table could be sold for $1,000.

Management requires a profit of 30 percent of the selling price.

Required:

Determine the highest cost (target cost) management would be willing to accept to

produce this product.

 45. Constrained Resources. Ratcliff Enterprises produces three types of computers; laptop,

desktop, and palmtop. A machine-hour bottleneck has been identified in the production

department. Ratcliff would like to optimize its use of machine hours by producing the two

most profitable computers. Information for each computer follows.

Production Machine Hours Price Variable Cost
Laptop 2.00 $1,200 $900
Desktop 1.00 800 700
Palmtop 1.25 300 180

46. Required:

. Calculate the contribution margin per unit of constrained resource for each product.

a. Which two products would Ratcliff Enterprises prefer to produce and sell to optimize

the use of machine hours in the production department?

47. Qualitative Factors. For each of the following independent scenarios, identify at least

one qualitative factor that should be considered before making the decision.

. A company sells three types of chainsaws (light duty, medium duty, and heavy duty), all

of which are profitable. The company faces a labor-hour bottleneck and plans to eliminate the

light duty product because it has the lowest contribution margin per labor hour.

a. A company plans to drop an unprofitable customer.

b. A maker of farm equipment would like to shut down its manufacturing facility and

outsource production.

48. Allocating Joint Costs and Evaluating Overall Company Profit (Appendix).Elexor, Inc.,

produces two joint products, product A and product B. Prior to the split-off point, the

company incurred $10,000 in joint costs. Production of product A totaled 400 pounds,

and product B totaled 600 pounds. Product A sells for $60 per pound and product B sells

for $10 per pound.

Required:

. Allocate joint costs to each product using the physical quantities method (pounds), and

calculate the profit or loss for each product.

 a. Allocate joint costs to each product using the relative sales value method, and

calculate the profit or loss for each product.

b. Using your answer to requirement a, describe what will happen to overall

company profit if the least profitable product is eliminated.

Problems

48. Make-or-Buy Decision. Vail Door Company currently manufactures doors used in the

production of custom homes. Management is interested in outsourcing production of the

doors to a reputable manufacturing company that can supply the doors for $90 per unit.

Vail incurs the following annual production costs to produce 3,000 doors internally.

If production is outsourced, all variable production costs, equipment lease costs, and

factory insurance costs will be eliminated. The production supervisor’s salary cost will

remain regardless of the decision to outsource or to produce internally because the

supervisor recently signed a long-term contract with the company. The factory lease has

five years remaining and cannot be terminated before then.

Required:

a. Perform differential analysis using the format presented in Figure 7.2 "Make-or-

Buy Differential Analysis for Best Boards, Inc.". Assume making the product internally is

Alternative 1, and buying the product from an outside manufacturer is Alternative 2.

b. Which alternative is best? Explain.

 c. Summarize the result of outsourcing production using the format presented

in Figure 7.3 "Summary of Differential Analysis for Best Boards, Inc.".

d. Assume Vail Door Company can lease the space it currently uses to produce

doors for $30,000 per year if production of doors is outsourced. Because the company

subleasing this space would also pay for insurance, Vail would not be required to pay for

factory insurance. Use the format presented in Figure 7.3 "Summary of Differential

Analysis for Best Boards, Inc." to determine if Vail would be better off outsourcing

production. (Hint: $30,000 will appear in the analysis as an opportunity cost similar

to Figure 7.8 "Differential Analysis with Opportunity Cost for Barbeque Company".)

49. Make-or-Buy Decision and Qualitative Factors. Soda Bottling, Inc., currently bottles its

own soda drinks. Management is interested in outsourcing the production of bottles to a

reputable manufacturing company that can supply the bottles for $0.04 each. Soda

Bottling incurs the following monthly production costs to produce 1,000,000 bottles

internally.

If production is outsourced, all variable production costs and 70 percent of fixed

production costs will be eliminated.

Required:

. Perform differential analysis using the format presented in Figure 7.2 "Make-or-Buy

Differential Analysis for Best Boards, Inc.". Assume making the product internally is Alternative 1,

and buying the product from an outside manufacturer is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of outsourcing production using the format presented in Figure

7.3 "Summary of Differential Analysis for Best Boards, Inc.".

c. Assume all the facts of this problem remain the same. However, management of Soda

Bottling has an opportunity to lease the space it currently uses to produce bottles for $6,000 per

month if production of bottles is outsourced. Use the format presented in Figure 7.3 "Summary

of Differential Analysis for Best Boards, Inc." to determine if Soda Bottling would be better off

outsourcing production. (Hint: $6,000 will appear in the analysis as an opportunity cost similar

to Figure 7.8 "Differential Analysis with Opportunity Cost for Barbeque Company".)

d. Identify at least one qualitative factor that should be considered before management

decides to outsource production.

50. Product Line Decision. The following monthly segmented income statement is for Hal’s

Hardware.

Management is concerned about the low profit associated with the tools product line and

is considering dropping this product line. Allocated fixed costs are assigned to product

lines based on floor space used by each product line (measured in square feet), resulting

in the following percentages for garden supplies, tools, and paint, respectively: 20

percent, 50 percent, and 30 percent. If the tools product line is eliminated, total allocated

fixed costs will be assigned as follows: 62.5 percent to garden supplies, and 37.5 percent

to paint. All variable and direct fixed costs for the tools product line will be eliminated.

Required:

. Perform differential analysis using the format presented in Figure 7.6 "Product Line

Differential Analysis for Barbeque Company". Assume keeping all product lines is Alternative 1,

and dropping the tools product line is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping the tools product line using the format presented

in Figure 7.7 "Summary of Differential Analysis for Barbeque Company".

c. Assume the space available from dropping the tools product line can be used by the

paint product line, resulting in increased revenues for paint of $12,000 and increased variable

costs for paint of $4,000. No additional direct fixed costs would be incurred, and 80 percent of

allocated fixed costs would be assigned to paint and 20 percent assigned to garden supplies.

Should Hal’s Hardware drop the tools product line and use the freed-up space to expand the

paint product line? (Hint: Prepare a differential analysis using the format presented in Figure 7.6

"Product Line Differential Analysis for Barbeque Company" to find the answer. Alternative 1

assumes all product lines are kept, and Alternative 2 assumes the tools product line is dropped

with a corresponding expansion of the paint product line.)

51. Product Line Decision and Qualitative Factors. The following annual segmented income

statement is for Wax, Inc., a maker of wax for cars, boats, and floors.

Management is concerned about the loss associated with the floors product line and is

considering dropping this product line. Allocated fixed costs are assigned to product lines

based on direct labor hours associated with each product line, resulting in the following

percentages for cars, boats, and floors, respectively: 30 percent, 25 percent, and 45

percent. If the floors product line is eliminated, total allocated fixed costs will be assigned

to the remaining products as follows: 55 percent to cars, and 45 percent to boats. All

variable and direct fixed costs for the floors product line will be eliminated.

Required:
. Perform differential analysis using the format presented in Figure 7.6 "Product Line

Differential Analysis for Barbeque Company". Assume keeping all product lines is Alternative 1,

and dropping the floors product line is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping the floors product line using the format presented

in Figure 7.7 "Summary of Differential Analysis for Barbeque Company".

c. Assume the space available from dropping the floors product line can be used by the

boats product line, resulting in increased revenues for boats of $200,000 and increased variable

costs for boats of $110,000. An additional $10,000 in direct fixed costs would be incurred for the

boats product line. Allocated fixed costs would be assigned as follows: 40 percent to cars, and 60

percent to boats. Should Wax, Inc., drop the floors product line and use the freed-up space to

expand the boats product line? (Hint: Prepare a differential analysis using the format presented

in Figure 7.6 "Product Line Differential Analysis for Barbeque Company" to find the answer.

Alternative 1 assumes all product lines are kept, and Alternative 2 assumes the floors product

line is dropped with a corresponding expansion of the boats product line.)

d. Identify at least one qualitative factor that should be considered before management

decides to drop a product line.

52. Customer Decision. The following customer segmented quarterly income statement is for

Ciena and Associates, a firm that performs legal services.

Management is concerned about the significant losses associated with the Davis account

and would like to drop this customer. Allocated fixed costs are assigned to customers

based on sales revenue. If Davis is dropped, total allocated fixed costs are assigned to the
 remaining customers, and all variable and direct fixed costs for the Davis account will be

eliminated.

Required:

. Perform differential analysis using the format presented in Figure 7.10 "Customer

Differential Analysis for Colony Landscape Maintenance". Assume keeping all customers is

Alternative 1, and dropping the Davis account is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping the Davis account using the format presented

in Figure 7.12 "Summary of Differential Analysis for Colony Landscape Maintenance".

c. Explain what happened to the profitability of the other two customers as a result of

dropping the Davis account.

d. Assume all the facts of this problem remain the same with one exception. As a result of

dropping the Davis account, Ciena and Associates is only able to reduce the direct fixed costs

associated with the Davis account by 90 percent. The remaining 10 percent will not be

eliminated for several more years. Does this change Ciena’s decision as to whether to drop the

Davis customer? Explain. (Hint: Modify one line item in your answer to requirement c.)

53. Customer Decision and Qualitative Factors. The following customer segmented monthly

income statement is for Quality Web, Inc., a firm that provides Web site maintenance

services.

Management is concerned about the losses associated with the Murray account and

would like to drop this customer. Allocated fixed costs are assigned to customers based
 on sales revenue. If Murray is dropped, total allocated fixed costs are assigned to the

remaining customers, and all variable and direct fixed costs for the Murray account will

be eliminated.

Required:

. Perform differential analysis using the format presented in Figure 7.10 "Customer

Differential Analysis for Colony Landscape Maintenance". Assume keeping all customers is

Alternative 1, and dropping the Murray account is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of dropping the Murray account using the format presented

in Figure 7.12 "Summary of Differential Analysis for Colony Landscape Maintenance".

c. Explain what happened to the profitability of the other two customers as a result of

dropping the Murray account.

d. Assume all the facts of this problem remain the same with one exception. As a result of

dropping the Murray account, Quality Web, Inc., is able to reduce total allocated fixed costs by

20 percent. The remaining 80 percent will be allocated to the other two products based on sales

revenue. Does this change Quality Web’s decision as to whether to drop the Murray customer?

Explain. (Hint: Add one line item in the requirement c analysis to reflect allocated fixed cost

savings.)

e. Identify at least one qualitative factor that should be considered before deciding

whether to drop the Murray account.

54. Special Order Decision with Idle Capacity and at Full Capacity. The following quarterly

financial data are for Pneumatic, Inc., a maker of compressors. On average, Pneumatic

makes 20,000 compressors each quarter.

 Pneumatic received an offer from a one-time customer to purchase 5,000 compressors

this coming quarter for $275 per unit. Pneumatic can produce up to 30,000 units a

quarter, so the special order would not affect regular customer sales. Variable costs per

unit will remain at $100. This special order will have no effect on fixed costs.

Required:

. Using the differential analysis format presented in Figure 7.13 "Special Order

Differential Analysis for Tony’s T-Shirts", determine whether Pneumatic would be better off

rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).

a. Summarize the result of accepting the special order using the format presented

in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

b. Assume Pneumatic is approached with the same special offer, but has limited capacity,

and can only produce up to 20,000 units per quarter. Thus any special orders will result in

reduced sales to regular customers. Using the differential analysis format presented in Figure

7.13 "Special Order Differential Analysis for Tony’s T-Shirts", determine whether Pneumatic

would be better off rejecting (Alternative 1) or accepting (Alternative 2) the special order.

c. Summarize the result of accepting the special order in requirement c using the format

presented in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

55. Special Order Decision at Full Capacity. The following monthly financial data are for

Green Mowers, Inc., a maker of electric lawn mowers. On average, Green Mowers makes

5,000 mowers each month.

Green Mowers received an offer from a one-time customer to purchase 1,000 mowers

this coming month for $180 per unit. Green Mowers can produce up to 5,000 units a
 month, so the special order would reduce regular customer sales. Variable costs per unit

will remain at $150. This special order will have no effect on fixed costs.

Required:

. Using the differential analysis format presented in Figure 7.13 "Special Order

Differential Analysis for Tony’s T-Shirts", determine whether Green Mowers would be better off

rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).

a. Summarize the result of accepting the special order using the format presented

in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

b. Assume Green Mowers can increase capacity to accommodate the special order by

paying an additional $20 in variable costs per unit (for overtime pay) for the additional 1,000

units. With this increased capacity, the special order would not affect regular customer sales.

Using the differential analysis format presented in Figure 7.13 "Special Order Differential

Analysis for Tony’s T-Shirts", determine whether Green Mowers would be better off rejecting

(Alternative 1) or accepting (Alternative 2) the special order.

c. Summarize the result of accepting the special order in requirement c using the format

presented in Figure 7.14 "Summary of Differential Analysis for Tony’s T-Shirts".

56. Target Costing. Toolmakers, Inc., produces table saws. The marketing department has

identified a market for a specific type of table saw that Toolmakers does not currently

produce, and expects to be able to sell each saw for $800. Management requires a profit

of 60 percent of the selling price.

Required:

. Determine the highest cost (target cost) management would be willing to accept to

produce this product.

a. Describe the four steps of target costing, and identify what Toolmakers would do next if

it cannot make the product at or below the target cost.

57. Constrained Resources. Instrumental Strings, Inc., produces three types of string

instruments: violin, cello, and bass. The instruments are produced in separate

departments and sent to the quality testing department before being packaged and

shipped. A labor-hour bottleneck has been identified in the quality testing department
 due to the high skill requirements of the job. Instrumental Strings would like to optimize

its use of labor hours by producing the two most profitable instruments. Information for

each product follows.

Required:

. Calculate the contribution margin per unit of constrained resource for each product.

a. Which two products would Instrumental Strings prefer to produce and sell to optimize

the use of labor hours in the quality testing department?

b. Assume additional employees are hired and trained for the quality testing

department thereby alleviating this constraint. A labor-hour bottleneck has now been

identified in the packaging department, which is recognized by management as a crucial

department given the fine craftsmanship of each instrument. Of the three instruments

produced by the company, identify which two products Instrumental Strings would prefer to

produce and sell to optimize the use of labor hours in the packaging department. Assume

the following labor hours are required to package each instrument:

Violin: 4.00 hours
Cello: 4.00 hours
Bass: 6.00 hours

58. Allocating Joint Costs and Product Profitability (Appendix). Fresh Catch, Inc., has a fleet

of fishing boats. The most recent outing cost $90,000 and yielded 24,000 pounds of

salmon and 8,000 pounds of halibut. Fresh Catch can sell salmon for $3 per pound and

halibut for $6 per pound.

Required:

. Allocate joint costs to each product using the physical quantities method, and calculate

the profit or loss for each product.

a. Allocate joint costs to each product using the relative sales value method, and calculate

the profit or loss for each product.

b. Explain what happened to the profitability of each product as the allocation method was

changed from requirement a to requirement b. Why might management make bad decisions

using the information from requirement a?

c. Assume salmon can be processed further into smoked salmon for an additional $2.50

per pound. Customers are willing to pay $7 per pound for smoked salmon. Should Fresh Catch

process the salmon further? Explain.

59. Allocating Joint Costs (Appendix). Fruit Tree Nursery (FTN) grows peach and apple trees

in containers for its customers. This past year, FTN grew 3,000 peach trees and 7,000

apple trees at a cost of $100,000. FTN can sell peach trees for $20 each and apple trees

for $11 each.

Required:

. Allocate joint costs to each product using the physical quantities method, and calculate

the profit or loss for each product.

a. Allocate joint costs to each product using the relative sales value method, and calculate

the profit or loss for each product.

b. Assume peach trees can be processed further by allowing them to grow for another few

months. The additional processing cost is $4 per tree, and customers are willing to pay $23 for

the larger trees. Should FTN process the peach trees further? Explain.

One Step Further: Skill-Building Cases

60. Outsourcing Building Materials. Review Note 7.8 "Business in Action 7.1" What qualitative

factors did the manager of the library’s construction likely consider in deciding to

have Pretecsa produce the concrete panels?

61. Internet Project: Outsourcing. Accenture LLP is a global management consulting, technology

services, and outsourcing company with more than $17 billion in annual revenues. Go to

Accenture’s Web site (http://www.accenture.com) and select outsourcing, or type outsourcing in

Accenture’s search feature. Review the information provided about outsourcing, select a specific

outsourcing topic, and write a one-page report summarizing your findings.

62. Sale of Stores at Kmart. Refer to Note 7.17 "Business in Action 7.2" What qualitative factors were

likely considered by the company’s management in considering whether to keep the stores?

63. Group Activity: Qualitative Factors. Each of the following scenarios is being considered at

three separate companies.

1. A company sells three types of bicycles (racers, cruisers, and climbers), all of which are

profitable. The company faces a labor-hour bottleneck and plans to eliminate the cruiser

product because it has the lowest contribution margin per labor hour.

2. A company plans to accept a special order at a reduced price from a one-time customer.

3. A maker of car batteries plans to eliminate one of its unprofitable product lines.

Required:

Form groups of two to four students and assign one of the three independent scenarios

listed previously to each group. Each group must perform the following requirements:

d. Identify at least two qualitative factors that should be considered before making the

decision.

e. Discuss each option, based on the findings of your group, with the class.

64. Special Order Decision Using Excel. The following monthly financial data are for Green

Mowers, Inc., a maker of electric lawn mowers. Green Mowers makes and sells 5,000

mowers each month.

Green Mowers received an offer from a one-time customer to purchase 1,000 mowers

this coming month for $180 per unit. Green Mowers can only produce up to 5,000 units a

month, so the special order would reduce regular customer sales. Variable costs per unit

will remain at $150. This special order will have no effect on fixed costs.
 Required:

Prepare an Excel spreadsheet, similar to the one shown in the Computer Applicationbox,

to determine whether Green Mowers would be better off rejecting the special order

(Alternative 1) or accepting the special order (Alternative 2). Make a recommendation as

to which alternative should be accepted and explain the reasoning for your

recommendation.

65. Ethics: Cost-Plus Pricing. JR Engineering recently negotiated a cost-plus contract with

Pineville City to provide engineering services at a rate equal to direct labor costs plus 30

percent. On a separate note, the partners at JR Engineering discovered that one of its

customers filed for bankruptcy last month and will not be able to pay the $200,000 owed

to the firm.

The two partners at JR Engineering, Julie and Ron, decided to include some of the direct

labor costs incurred working on the bankrupt company with the direct labor costs

associated with Pineville City. As Ron stated, “After all, customers fail from time to time,

and it’s only fair that our other customers shoulder some of the burden. This enables us

to provide the high-quality service we know is so important to our customers.”

Are JR Engineering’s actions ethical? What are the long-term implications of JR’s actions?

Explain.

Comprehensive Cases

66. Make-or-Buy Decision. Keyboard, Inc., a manufacturer of pianos, typically sells each of its

pianos for $1,480. The cost of manufacturing and marketing one piano at the company’s

usual monthly volume of 6,000 units is shown.

 Required:

a. Keyboard, Inc., received a proposal from an independent piano manufacturer that

will produce and ship 2,000 pianos each month directly to Keyboard’s customers as

requested by Keyboard’s salespeople, at a cost of $900 each. This will have the effect of

reducing total fixed marketing and administrative costs by 5 percent. As a result of reducing

production capacity, Keyboard’s total fixed manufacturing costs will decrease 30 percent.

Total variable manufacturing costs will decrease since only 4,000 pianos will be produced

rather than 6,000. Total variable marketing and administrative costs will remain unchanged.

Perform differential analysis using the format presented in Figure 7.2 "Make-or-

Buy Differential Analysis for Best Boards, Inc." to determine if Keyboard should

accept the proposal from the outside supplier. Assume making all 6,000 pianos

internally is Alternative 1, and outsourcing the production of 2,000 pianos and

producing 4,000 pianos internally is Alternative 2. Explain which alternative is

best.

b. Assume the same facts as in requirement a, with one additional point. If production

of 2,000 pianos is outsourced and 4,000 pianos are produced internally, Keyboard can use

the idle capacity to produce an additional 1,400 beginner pianos that can be sold for $1,100

each. Fixed marketing and administrative costs would be unchanged (the 5 percent

reduction described in requirement a no longer applies). Fixed manufacturing costs would

decrease by 10 percent (rather than the 30 percent described in requirement a). Per unit

variable cost information for the beginner pianos would be as follows:

 Variable manufacturing costs $400
Variable marketing and administrative costs $ 80

c. Perform differential analysis using the format presented in Figure 7.2 "Make-or-Buy

Differential Analysis for Best Boards, Inc." to determine if Keyboard should accept the

proposal from the independent supplier. Assume making all 6,000 pianos internally is

Alternative 1. Alternative 2 consists of outsourcing the production of 2,000 pianos and

producing 5,400 pianos internally (= 4,000 regular pianos + 1,400 beginner pianos). Explain

which alternative is best. (Hint: Include a line item for sales revenue in your analysis to

determine the best alternative.)

67. Product Line Decision. The following monthly segmented income statement is for Thirst

Quench, a maker of soda, sports drink, and lemonade.

Management is concerned about the losses associated with the sports drink and

lemonade product lines and is considering dropping all product lines except soda.

Allocated fixed costs are assigned to product lines based on direct labor hours associated

with each product line resulting in the following percentages for soda, sports drink, and

lemonade, respectively: 25 percent, 20 percent, and 55 percent. If the sports drink and

lemonade product lines are eliminated, total allocated fixed costs will decrease by

$40,000, and variable costs and direct fixed costs for these two product lines will be

eliminated. (No allocated fixed cost savings occur if only one product line is dropped.)

Required:
. Perform differential analysis using the format presented in Figure 7.6 "Product Line

Differential Analysis for Barbeque Company". Assume keeping all product lines is Alternative 1,

and keeping only the soda product line is Alternative 2.

a. Which alternative is best? Explain.

b. Summarize the result of keeping only the soda product line using the format presented

in Figure 7.7 "Summary of Differential Analysis for Barbeque Company".

c. Management has asked you to look at the numbers for each product line and make a

recommendation on how to increase overall company profit. What course of action would you

recommend? Based on your recommendation, describe the qualitative factors that should be

considered.