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MA / Decision Making Andretti Q&A

DECISION MAKING CASES

PROBLEM Relevant Cost Analysis in a Variety of Situations

CHECK FIGURE
(1) $91,200 incremental net operating income
(2) $21.30 break-even price
Andretti Company has a single product called Daks. The company normally produces and
sells 72,000 Daks each year at a selling price of $28.00 per unit. The company’s unit costs at
this level of activity are given below:

Direct materials ........................................... $12.00

Direct labor ................................................. 2.50
Variable manufacturing overhead............... 1.80
Fixed manufacturing overhead ................... 3.20 ($230,400 total)
Variable selling expense ............................. 1.20
Fixed selling expense.................................. 3.00 ($216,000 total)
Total cost per unit ....................................... $23.70

A number of questions relating to the production and sale of Daks follow. Each question is
independent.

Required:

1. Assume that Andretti Company has sufficient capacity to produce 90,000 Daks each year
without any increase in fixed manufacturing overhead costs. The company could increase
its sales by 20% above the present 72,000 units each year if it were willing to increase the
fixed selling expenses by $60,000. Would the increase fixed expenses be justified?
2. Assume again that Andretti Company has sufficient capacity to produce 90,000 Daks
each year. A customer in a foreign market wants to purchase 15,000 Daks. Import duties
on the Daks would be $1.40 per unit, and costs for permits and licenses would be
$15,000. The only selling costs that would be associated with the order would be $2.60
per unit shipping cost. You have been asked by the president to compute the per unit
break-even price on this order.
3. The company has 800 Daks on hand that have some irregularities and are therefore
considered to be “seconds.” Due to the irregularities, it will be impossible to sell these
units at the normal price through regular distribution channels. What unit cost figure is
relevant for setting a minimum selling price?
4. Due to a strike in its supplier’s plant, Andretti Company is unable to purchase more
material for the production of Daks. The strike is expected to last for 2 months. Andretti
Company has enough material on hand to continue to operate at 40% of normal levels for
the two-month period. As an alternative, Andretti Company could close its plant down
entirely for the two months. If the plant were closed, fixed overhead costs would continue
at 50% of their normal level during the two-month period; the fixed selling costs would
be reduced by 25% while the plant was closed. What would be the dollar advantage or
disadvantage of closing the plant for the two-month period?
5. An outside manufacturer has offered to produce Daks for Andretti Company and to ship
them directly to Andretti Company customers. If Andretti Company accepts this offer, the
facilities that it uses to produce Daks would be idle; however, fixed overhead costs would
be reduced by 80%. Since the outside manufacturer would pay for all the costs of
shipping, the variable selling costs would be only 2/3 of their present amount. Compute

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MA / Decision Making Andretti Q&A

the unit cost that is relevant for comparison to whatever quoted price is received from the
outside manufacturer.

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MA / Decision Making Andretti Q&A

SOLUTION

PROBLEM Relevant Cost Analysis in a Variety of Situations

Solution Andretti Company

1. Selling price per unit ........................................... $28.00

Less variable expense per unit ............................ 17.50 *
Contribution margin per unit ............................... $10.50
*$12.00 + $2.50 + $1.80 + $1.20 = $17.50
Increased sales in units (72,000 units × 20%) ................................... 14,400
Contribution margin per unit ............................................................. × $10.50
Incremental contribution margin ....................................................... $151,200
Less added fixed selling expenses ..................................................... 60,000
Incremental net operating income ..................................................... $ 91,200
Yes, the increase in fixed selling expense would be justified.

2. Variable manufacturing cost per unit ................................................ $16.30 *

Import duties per unit ........................................................................ 1.40
Permits and licenses ($15,000 ÷ 15,000 units).................................. 1.00
Shipping cost per unit ........................................................................ 2.60
Break-even price per unit .................................................................. $21.30
*$12.00 + $2.50 + $1.80 = $16.30.

3. The relevant cost is the variable selling expense of $1.20 per unit. Since the irregular
units have already been produced, all production costs (including the variable production
costs) are sunk. The fixed selling expenses are not relevant since they will not change
regardless of whether or not the irregular units are sold. Depending on how the irregular
units are sold, the variable expense of $1.20 per unit may not even be relevant. For
example, the units may be disposed of through a liquidator without incurring the normal
variable selling expense.

4. If the plant operates at 40% of normal levels, then only 4,800 units will be produced and
sold during the two-month period:
72,000 units per year × 2/12 = 12,000 units per month;
12,000 units per month × 40% = 4,800 units produced and sold per month

Given this information, the simplest approach to the solution is:

Contribution margin lost if the plant is closed (4,800 units ×
$10.50 per unit*) ........................................................................ $(50,400)
Fixed costs that can be avoided if the plant is closed:

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MA / Decision Making Andretti Q&A

Fixed manufacturing overhead ($230,400 × 2/12 = $38,400;

$38,400 × 50%) ...................................................................... $19,200
Fixed selling expense ($216,000 × 2/12 = $36,000; $36,000 ×
25%) ....................................................................................... 9,000 28,200
Net disadvantage of closing the plant ............................................ $(22,200)
*$28.00 – ($12.00 + $2.50 + $1.80 + $1.20) = $10.50

Alternative approach:
Continue to Close the
Operate Plant
Sales (4,800 units × $28.00 per unit) ..................................... $134,400 $ 0
Less variable expenses
(4,800 units × $17.50 per unit) ........................................... 84,000 0
Contribution margin .............................................................. 50,400 0
Less fixed expenses:
Fixed manufacturing overhead:
$230,400 × 2/12 ............................................................. 38,400
$230,400 × 2/12 × 50% ................................................. 19,200
Fixed selling expense:
$216,000 × 2/12 ............................................................. 36,000
$216,000 × 2/12 × 75% ................................................. 27,000
Total fixed expenses .............................................................. 74,400 46,200
Net operating income (loss)................................................... $(24,000) $(46,200)

5. The relevant costs are those that can be avoided by purchasing from the outside
manufacturer. These costs are:
Variable manufacturing costs ..................................................................... $16.30
Fixed manufacturing overhead ($230,400 × 80% = $184,320; $184,320
÷ 72,000 units) ........................................................................................ 2.56
Variable selling expense ($1.20 × 1/3) ....................................................... 0.40
Total costs avoided ..................................................................................... $19.26
To be acceptable, the outside manufacturer’s quotation must be less than $19.26 per unit.

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Decision Making Q&A

QUESTION B1
When Mr. Ding L. Berry, president and chief executive of Berry, Inc., first saw the
segmented income statement below, he flew into his usual rage: "When will we ever
start showing a real profit? I'm starting immediate steps to eliminate those two
unprofitable lines!"

*These traceable expenses could be eliminated if the product lines to which they are
traced were discontinued.

Required: Show detailed supportive workings

a) Recommend which segments, if any, should be eliminated. Prepare a report in good

form to support your answer. (6 marks)
b) Briefly discuss 4 non financial factors involved in this decision.(4 marks)

(Total 10 marks)

ANSWER B1
A segmented income report, without the allocation of common fixed expenses, will provide
the basis for deciding which segments to drop.

The only segment that possibly should be eliminated is segment W, which shows a negative
segment margin of $2,000.

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DECISION MAKING Q & A

Decision Making - Broadway

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DECISION MAKING Q & A

6-61

1. On Broadway Off Broadway

Attendance 400 400
Revenue $192,000 $128,000
Expenses 252,000* 102,000
Net profit (loss) $ (60,000) $ 26,000
*$102,000 + $150,000 = $252,000

2. On Broadway Off Broadway

Attendance 750 375
Revenue $360,000 $120,000
Expenses 252,000 102,000
Net profit $108,000 $ 18,000

3. a. $252,000 ÷ $60 = 4,200 weekly attendance

4,200 ÷ 8 = 525 per show attendance
b. $102,000 ÷ $40 = 2,550 weekly attendance
2,550 ÷ 8 = 319 per show attendance

4. On Broadway Off Broadway

Attendance 600 400
Revenue $288,000 $128,000
Expenses 252,000 102,000
Net profit $ 36,000 $ 26,000

Total profit for a 26-week run:

On Broadway: ($36,000 × 26) - $1,295,000 = $(359,000)
Off Broadway: ($26,000 × 26) - $440,000 = $236,000

5. Total profit for a 100-week run:

On Broadway: ($36,000 × 100) - $1,295,000 = $2,305,000
Off Broadway: ($26,000 × 100) - $440,000 = $2,160,000

6. a. $1,295,000 ÷ $36,000 = 36weeks

b. $ 440,000 ÷ $26,000 = 17 weeks

7. Let X be the length of run in weeks at which on-Broadway profit equals off-
Broadway profit:
$36,000 X - $1,295,000 = $26,000 X - $440,000
$10,000 X = $855,000
X = 85.5 weeks
8. Mr. Simon’s decision depends on his predictions of attendance on Broadway versus
off Broadway and his attitude toward risk. The on-Broadway production has more
risk because of its bigger up-front investment. If the attendance figures in
requirements 4 and 5 are accurate, the off-Broadway alternative is better for any runs
less than 85.5 weeks. If this may not be a long run, it appears that the off-Broadway
alternative might be best. However, if attendance on Broadway exceeds 600 per
show, especially if it is almost 1,000 per show, the Broadway alternative is better.

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DECISION MAKING Q & A

There is a trend for non-musical plays to be produced off Broadway because of the
large investment required on Broadway. Many plays do not last beyond a few
weeks, and even filling a theater to capacity would require almost a 5-week run just
to recoup the initial investment. Weekly profit would be ($60 × 1,000 × 8) -
$252,000 = $228,000, so it would take $1,295,000 ÷ $228,000 = 5.7 weeks to break
even. There is less risk off Broadway, especially because it takes many fewer
theatergoers to reach the break-even point. For example, at capacity operations it
takes 5.7 × 8 × 1,000 = 45,600 attendees to break even on Broadway. Off Broadway
it requires only two-thirds of that number:
($40 × 500 × 8) - $102,000 = $58,000 weekly profit
$440,000 ÷ $58,000 = 7.6 weeks to break even
7.6 × 8 × 500 = 30,400 attendees to break even.

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Decision Making Q&A

DECISION MAKING .

For many years, Condor Company has produced a small part that it uses in the production of its
standard line of equipment. The company's cost of producing one part, based on a production level of
50,000 parts per year, is:

Cost
Per Part
Direct materials $ 8.00
Direct labor 5.00
Variable overhead 10.00
Fixed overhead 12.00
Total $35.00

An outside supplier has offered to supply the part to Condor for $29 per part. Condor has determined
that 40% of the fixed overhead represents salaries and other costs which can be eliminated if the parts
are purchased.

Required:

Prepare an analysis to determine whether Condor should accept the supplier's offer.

14. ANS:

CONDOR COMPANY
Relevant Costs for the Make or Buy Decision

To Make To Buy

Expected annual requirement (units) 50,000 50,000

Relevant costs:
Direct materials $ 400,000 $ 0
Direct labor 250,000 0
Variable overhead 500,000 0
Avoidable fixed overhead 240,000 0
Component purchase cost $1,450,000
Total relevant costs $1,390,000 $1,450,000

Relevant costs per unit $27.80 $29.00

Therefore, continue to make the part. The annual cost savings will be $60,000 ($1.20 × 50,000 parts)
or ($1,450,000 - $1,390,000)

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Decision Making Q&A

Question B1
The management of Drummer Corporation is considering dropping product D84L.
Data from the company's accounting system appear below:

All fixed expenses of the company are fully allocated to products in the company's
accounting system. Further investigation has revealed that $201,000 of the fixed
manufacturing expenses and $156,000 of the fixed selling and administrative
expenses are avoidable if product D84L is discontinued.

Required: Show detailed supportive workings

a) What would be the effect on the company's overall net operating income if product
D84L were dropped? Should the product be dropped? Show your work! (6 marks)
b) Briefly discuss 4 non financial factors involved in this decision.(4 marks)
(Total 10 marks)

Answer B1

Net operating income would decline by $3,000 if product D84L were dropped. Therefore, the
product should not be dropped.

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Decision Making Q&A

2a) Foto Company makes 50,000 units per year of a part it uses in the products it
manufactures. The unit product cost of this part is computed as follows:

Direct materials $ 12.00

Direct labor 10.10
Variable manufacturing overhead 2.00
Fixed manufacturing overhead 14.10
Unit product cost $ 38.20

An outside supplier has offered to sell the company all of these parts it needs for $37.30 a
unit. If the company accepts this offer, the facilities now being used to make the part could be
used to make more units of a product that is in high demand. The additional contribution
margin on this other product would be $310,000 per year.

If the part were purchased from the outside supplier, all of the direct labor cost of the part
would be avoided. However, $9.70 of the fixed manufacturing overhead cost being applied to
the part would continue even if the part were purchased from the outside supplier. This fixed
manufacturing overhead cost would be applied to the company's remaining products.

Required:
a. How much of the unit product cost of $38.20 is relevant in the decision of whether to make
or buy the part?
b. What is the financial advantage (disadvantage) of purchasing the part rather than making
it?
c. What is the maximum amount the company should be willing to pay an outside supplier
per unit for the part if the supplier commits to supplying all 50,000 units required each year?

Answer:
a. Relevant cost per unit:

Direct materials $ 12.00

Direct labor 10.10
Variable manufacturing overhead 2.00
Fixed manufacturing overhead 4.40
Relevant manufacturing cost $ 28.50

b. Net advantage (disadvantage):

Manufacturing cost savings $ 1,425,000

Additional contribution margin 310,000
Cost of purchasing the part (1,865,000)
Net advantage (disadvantage) $ (130,000)

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Decision Making Q&A

c. Maximum acceptable purchase price:

Manufacturing cost savings $ 1,425,000

Additional contribution margin 310,000
Total benefit $ 1,735,000
Number of units 50,000
Benefit per unit $ 34.70

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MA / Decision Making Garage Q&A

DECISION MAKING CASES

PROBLEM Relevant Cost Analysis

A garage has an old car that it bought several months ago for £3,000. The car needs a replacement
engine before it can be sold. It is possible to buy a reconditioned engine for £300. This would
take seven (7) hours to fit by a mechanic who is paid monthly wages of £1280 for 160 hours of
work i.e. allocated cost of £8 an hour. At present the garage is short of work / has unused capacity,
but the owners are reluctant to lay off / fire any mechanics or even to cut down their basic working
week because skilled labour is difficult to find and an upturn / increase in repair work is expected
soon.
Without the engine, the car could be sold on ‘as is’ basis for an estimated £3,500.

Question 1: What is the minimum price at which the garage should sell the car, with a
reconditioned engine fitted?

Assume exactly the same circumstances as previously, except that the garage is quite busy at the
moment. If a mechanic is to be put on the engine replacement job, it will mean that other work
that the mechanic could have done during the seven hours, all of which could be charged to a
customer, will not be undertaken. The garage’s labour charge is £20 an hour, though the
mechanic is only paid £8 an hour.

Question 2: What is the minimum price at which the garage should sell the car, with a
reconditioned engine fitted, under these altered circumstances?

Question 3: Apart from whether the car could be sold for more than the relevant cost of doing
this, are there any other factors that should be taken into account in making a decision as to
whether or not to do the work?

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MA / Decision Making Garage Q&A

SOLUTION

Question 1: What is the minimum price at which the garage should sell the car, with a
reconditioned engine fitted?

The minimum price is the amount required to cover the relevant costs of the job. At this
price, the business will make neither a profit nor a loss. Any price lower than this amount
will mean that the wealth of the business is reduced. Thus, the minimum price is:
£
Opportunity cost of the car 3,500
Cost of the reconditioned engine 300
Total 3800

The original cost of the car is irrelevant for reasons as it is a sunk cost: whatever decision
is taken, this cost has already been recorded and will not change.
It’s the opportunity cost of the car that concerns us: the potential benefit that the garage
lets go if they decide to change the engine. The cost of the new engine is relevant
because, if the work is done, the garage will have to pay £300 for the engine; but will pay
nothing if the job is not done. The £300 is an example of a relevant future cost.
The labour cost is irrelevant because the same cost will be incurred whether the mechanic
undertakes the work or not. This is because the mechanic is being paid to do nothing if
this job is not undertaken; thus the additional labour cost arising from this job is zero.
This is an example of a future cost that will not change if one alternative is selected over
the other.
It should be emphasised that the garage will not seek to sell the car with its reconditioned
engine for £3,800; it will attempt to charge as much as possible for it. However, any price
above the £3,800 will make the garage better off financially than not undertaking the
engine replacement.

Question 2: What is the minimum price at which the garage should sell the car, with a
reconditioned engine fitted, under these altered circumstances?
The minimum price is:
£
Opportunity cost of the car 3,500
Cost of the reconditioned engine 300
Labour opportunity cost (7 x £20) 140
Total 3940
We can see that the opportunity cost of the car and the cost of the engine is the same as in
question 1 but now a charge for labour has been added to obtain the minimum price. The

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MA / Decision Making Garage Q&A

relevant labour cost here is that which the garage will have to sacrifice in making the time
available to undertake the engine replacement job. While the mechanic is working on this
job, the garage is losing the opportunity to do work for which a customer would pay
£140. Note that the £8 an hour mechanic’s wage is still not relevant. This is because the
mechanic will be paid £8 an hour irrespective of whether it’s the engine-replacement
work or some other job that is undertaken.

Question 3: Apart from whether the car could be sold for more than the relevant cost of doing
this, are there any other factors that should be taken into account in making a decision as to
whether or not to do the work?

We can think of three points:

• Turning away another job in order to do the engine replacement may lead to customer
dissatisfaction.
• On the other hand, having the car available for sale may be useful commercially for the
garage, beyond the profit that can be earned from that particular car sale. For example,
having a good stock of second-hand cars may attract potential customers.
• There is also a more immediate economic point. It has been assumed that the only labour
opportunity cost is the charge-out rate for the seven hours concerned. In practice, most car
repairs involve the use of some materials and spare parts. These are usually charged to
customers at a profit to the garage. Any such profit from a job turned away would be lost to
the garage, and this lost profit would be an opportunity cost of the engine replacement and
should, therefore, be included in the calculation of the minimum price to be charged for the
sale of the car.
You may have thought of additional points.

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Decision Making Q&A

190) Juliani Company produces a single product. The cost of producing and selling a single
unit of this product at the company's normal activity level of 50,000 units per month is as
follows:

Direct materials $ 32.50

Direct labor $ 7.20
Variable manufacturing overhead $ 1.30
Fixed manufacturing overhead $ 20.90
Variable selling & administrative expense $ 1.90
Fixed selling & administrative expense $ 7.30

The normal selling price of the product is $75.00 per unit.

An order has been received from an overseas customer for 3,000 units to be delivered this
month at a special discounted price. This order would have no effect on the company's
normal sales and would not change the total amount of the company's fixed costs. The
variable selling and administrative expense would be $0.30 less per unit on this order than on
normal sales.

Direct labor is a variable cost in this company.

Required:
a. Suppose there is ample idle capacity to produce the units required by the overseas customer
and the special discounted price on the special order is $65.60 per unit. What is the financial
advantage (disadvantage) for the company next month if it accepts the special order?

b. Suppose the company is already operating at capacity when the special order is received
from the overseas customer. What would be the opportunity cost of each unit delivered to the
overseas customer?

c. Suppose there is not enough idle capacity to produce all of the units for the overseas
customer and accepting the special order would require cutting back on production of 1,000
units for regular customers. What would be the minimum acceptable price per unit for the
special order?

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Decision Making Q&A

Answer:
a.
Variable cost per unit on normal sales:
Direct materials $ 32.50
Direct labor 7.20
Variable manufacturing overhead 1.30
Variable selling & administrative expense 1.90
Variable cost per unit on normal sales $ 42.90

Variable cost per unit on special order:

Normal variable cost per unit $ 42.90
Reduction in variable selling & admin. 0.30
Variable cost per unit on special order $ 42.60

Selling price for special order $ 65.60

Variable cost per unit on special order 42.60
Unit contribution margin on special order $ 23.00
Number of units in special order 3,000
Financial advantage (disadvantage) $ 69,000

b.
The opportunity cost is just the contribution margin on normal sales:
Normal selling price per unit $ 75.00
Variable cost per unit on normal sales 42.90
Unit contribution margin on normal sales $ 32.10

c.
Minimum acceptable price:
Unit contribution margin on normal sales $ 32.10
Displaced normal sales 1,000
Lost contribution margin displaced sales $ 32,100
Total variable cost on special order 127,800
$ 159,900
Number of units in special order 3,000
Minimum acceptable price on special order $ 53.30

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Decision Making Q&A

QUESTION B5 – 10 Marks
192) Kneller Co. manufactures and sells medals for winners of athletic and other events. Its
manufacturing plant has the capacity to produce 12,000 medals each month; current monthly
production is 9,600 medals. The company normally charges $99 per medal. Cost data for the
current level of production are shown below:

Variable costs:
Direct materials $480,800
Direct labor $153,600
Selling and administrative $ 24,960
Fixed costs:
Manufacturing $144,000
Selling and administrative $ 78,720

The company has just received a special one-time order for 500 medals at $89 each. For this
particular order, no variable selling and administrative costs would be incurred. This order
would also have no effect on fixed costs. Assume that direct labor is a variable cost.

Required:
Should the company accept this special order?

Answer B5: Only the direct materials and direct labor costs are relevant in this decision. To
make the decision, we must compute the average direct materials and direct labor cost per
unit.

Direct materials $ 480,000

Direct labor 153,600
Total $ 633,600
Current monthly production 9,600
Average direct materials and direct labor cost per unit $ 66

Because the price on the special order is $89 per medal and the relevant cost is only $66, the
company would earn a profit of $23 per medal. Therefore, the special order should be
accepted.

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Decision Making Q&A

QUESTION B5 – 10 Marks

A customer has asked Lalka Corporation to supply 3,000 units of product H60, with some
modifications, for $34.70 each. The normal selling price of this product is $46.35 each. The
normal unit product cost of product H60 is computed as follows:

Direct materials $ 14.70

Direct labor 1.30
Variable manufacturing overhead 7.00
Fixed manufacturing overhead 7.90
Unit product cost $ 30.90

Direct labor is a variable cost. The special order would have no effect on the company's total
fixed manufacturing overhead costs. The customer would like some modifications made to
product H60 that would increase the variable costs by $3.80 per unit and that would require a
one-time investment of $24,000 in special molds that would have no salvage value. This
special order would have no effect on the company's other sales. The company has ample
spare capacity for producing the special order.

Required:
Determine the financial advantage or disadvantage of accepting the special order.

Answer B8:

Incremental revenue (3,000 units × $34.70 per unit) $ 104,100

Less incremental costs:
Direct materials (3,000 units × $14.70 per unit) 44,100
Direct labor (3,000 units × $1.30 per unit) 3,900
Variable manufacturing overhead (3,000 units × $7.00 per unit) 21,000
Modifications (3,000 units × $3.80 per unit) 11,400
Special molds 24,000
Total incremental cost 104,400
Financial advantage (disadvantage) $ (300)

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Decision Making Q&A

DECISION MAKING .

The Moony Company, which makes and sells two products, boys' and girls' bikes, has $30,000 to
spend on advertising. The company has estimated that using the $30,000 to advertise boys' bikes
would increase sales of that product by 1,000 units. Moony is uncertain, however, how many
additional girls' bikes could be sold by spending $30,000 on that product. Boys' bikes have a
contribution margin of $40 per unit and girls' bikes have a contribution margin of $30 per unit.

Required:

Prepare an analysis to answer each of the following independent questions.

(a) If spending $30,000 on girls' bikes would increase its sales by 1,200 units, which
product should be advertised?

(b) By how many units would sales of girls' bikes have to increase to justify spending
the $30,000 on girls' bikes instead of boys' bikes?

REF: pp 474–477
15. ANS:
(a)
THE MOONY COMPANY
Analysis of Product Mix Decision

Boys' Bikes Girls' Bikes

Contribution margin per unit $ 40 $ 30
Sales volume increase resulting
from additional advertising (units) x 1,000 x 1,200
Additional contribution margin $ 40,000 $36,000

Spend the advertising on boys' bikes.

(b)
Additional contribution margin on boys' bikes $40,000
Contribution margin per unit on girls' bikes ÷ $30
Additional girls' bikes 1,3434
units

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Decision Making Q&A

DECISION MAKING.

The Multiproducts Company currently purchases a component for $30 each.

The company has excess capacity and is considering the possibility of making the component. The
Cost Accounting Department estimates that the following costs would be incurred to make each unit
of the component:

Direct materials $ 8
Direct labor 10
Variable overhead 8
Total manufacturing cost $26 per unit

Additionally, if Multiproducts decides to make the component, additional foremen, custodial

personnel, and material handlers are required at a total cost of $150,000 per year.

(a) Assuming the company uses 40,000 components annually, prepare an analysis to
determine if the company should make or buy the component.
(b) At what annual volume of components would the company change its make or buy
decision?

13. ANS:
(a)
MULTIPRODUCTS COMPANY
Relevant Costs for the Make or Buy Decision

To Make To Buy
Annual volume 40,000 40,000
Relevant costs:
Direct materials $ 320,000
Direct labor 400,000
Variable overhead 320,000
Additional fixed costs for foremen,
custodians, and material handlers 150,000
Component purchase cost $1,200,000
Total relevant costs $1,190,000 $1,200,000

When the Multiproducts Company uses 40,000 components, the total annual cost saved by making the
components is $10,000 ($1,200,000 - $1,190,000).

(b) Variable costs of making the component = $26.00 per unit, while the cost to
purchase the component is $30 per unit. To obtain this $4 per unit variable cost
savings, the Multiproducts Company must incur $150,000 of additional fixed cost
for salaries of foremen, custodial personnel, and materials handlers. Thus, the
company incurs less cost to make the components than to buy them when the
savings in variable costs exceeds the additional fixed cost. This occurs as long as
more than $150,000/$4 per unit = 37,500 units are needed. The company should
begin buying the components if annual needs drop below 37,500 units.

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MA / Decision Making Pegasus Q&A

DECISION MAKING CASES

PROBLEM Discontinuing a Flight

CHECK FIGURE
(1) Decrease in net operating income if the flight is dropped: $8,700

Profits have been decreasing for several years at Pegasus Airlines. In an effort to improve the
company’s performance, consideration is being given to dropping several flights that appear
to be unprofitable.
A typical income statement for one such flight (flight 482) is given below (per flight):

Ticket revenue (200 passengers × 50% occupancy × $240 per passenger) .. $24,000
Less variable expenses (200 passengers × 50% occupancy × $60 per passenger)
.................................................................................................................... 6,000
Contribution margin ...................................................................................... 18,000
Less flight expenses:
Salaries, flight crew .................................................................................... 5,100
Flight promotion ......................................................................................... 700
Depreciation of aircraft .............................................................................. 1,600
Fuel for aircraft ........................................................................................... 6,000
Liability insurance ...................................................................................... 4,200
Salaries, flight assistants ............................................................................ 800
Baggage loading and flight preparation ..................................................... 1,400
Overnight costs for flight crew and assistants at destination ..................... 400
Total flight expenses ..................................................................................... 20,200
Net operating loss .......................................................................................... $(2,200)

The following additional information is available about flight 482:

a. Members of the flight crew are paid fixed annual salaries, whereas the flight assistants are
paid by the flight.
b. One-third of the liability insurance is a special charge assessed against flight 482 because
in the opinion of the insurance company, the destination of the flight is in a “high-risk”
area. The remaining two-thirds would be unaffected by a decision to drop flight 482.
c. The baggage loading and flight preparation expense is an allocation of ground crews’
salaries and depreciation of ground equipment. Dropping flight 482 would have no effect
on the company’s total baggage loading and flight preparation expenses.
d. If flight 482 is dropped, Pegasus Airlines has no authorization at present to replace it with
another flight.
e. Depreciation of aircraft is due entirely to obsolescence. Depreciation due to wear and tear
is negligible.
f. Dropping flight 482 would not allow Pegasus Airlines to reduce the number of aircraft in
its fleet or the number of flight crew on its payroll.

Required:
Prepare an analysis showing what impact dropping flight 482 would have on the airline’s
profits.

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MA / Decision Making Pegasus Q&A

ANSWER
1. Contribution margin lost if the flight is discontinued ....................... $(18,000)
Less flight costs that can be avoided if the flight is discontinued:
Flight promotion ........................................................................... $ 700
Fuel for aircraft ............................................................................. 6,000
Liability insurance (1/3 × $4,200)................................................. 1,400
Salaries, flight assistants ............................................................... 800
Overnight costs for flight crew and assistants .............................. 400 9,300
Net decrease in profits if the flight is discontinued ........................... $ (8,700)

The following costs are not relevant to the decision:

Cost Reason
Salaries, flight crew Fixed annual salaries that will not change.
Depreciation of aircraft Sunk cost.
Liability insurance (two-thirds) Two-thirds of the liability insurance is
unaffected by this decision.
Baggage loading and flight preparation This is an allocated cost that will continue
even if the flight is discontinued.
Alternative Solution:
Difference: Net
Operating
Keep the Drop the Income Increase
Flight Flight or (Decrease)

Ticket revenue ..................................................... $24,000 $ 0 $(24,000)

Less variable expenses......................................... 6,000 0 6,000
Contribution margin ............................................ 18,000 0 (18,000)
Less flight expenses:
Salaries, flight crew ......................................... 5,100 5,100 0
Flight promotion .............................................. 700 0 700
Depreciation of aircraft ................................... 1,600 1,600 0
Fuel for aircraft ................................................ 6,000 0 6,000
Liability insurance ........................................... 4,200 2,800 1,400
Salaries, flight assistants.................................. 800 0 800
Baggage loading and flight preparation .......... 1,400 1,400 0
Overnight costs for flight crew and assistants
at destination................................................. 400 0 400
Total flight expenses ............................................ 20,200 10,900 9,300
Net operating loss ................................................ $ (2,200) $(10,900) $ (8,700)

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MA (CASES) DECISION MAKING

MGB – Decision Making Polaski Company

PROBLEM 11-5A
Accept or Reject a Special Order
(LO5)

CHECK FIGURE
(1) Net increase in profits: $60,500

Polaski Company manufactures and sells a single product called a ret. Operating at capacity, the company can
produce and sell 20,000 rets per year. Costs associated with this level of production and sales are given below:

Unit Total
Direct materials...................................... $12.00 $240,000
Direct labor ............................................ 6.00 120,000
Variable manufacturing overhead .......... 4.00 80,000
Fixed manufacturing overhead .............. 7.00 140,000
Variable selling expense ........................ 3.00 60,000
Fixed selling expense............................. 4.00 80,000
Total cost ............................................... $36.00 $720,000

The rets normally sell for $42.00 each. Fixed manufacturing overhead is constant at $140,000 per year within
the range of 15,000 through 20,000 rets per year.

Required:

1. Assume that due to a recession, Polaski Company expects to sell only 15,000 rets through regular channels next
year. A large retail chain has offered to purchase 5,000 rets if Polaski Company is willing to accept a 15%
discount off the regular price. There would be no sales commissions on this order; thus, variable selling
expenses would be slashed by 80%. However, Polaski Company would have to purchase a special machine to
engrave the retail chain’s name on the 5,000 units. This machine would cost $5,000. This would be a one-time
order that would have no effect on regular sales. Determine the impact on profits next year if this special order
is accepted.
2. Refer to the original data. Assume again that Polaski Company expects to sell only 15,000 rets through regular
channels next year. The U.S. Army would like to make a one-time-only purchase of 5,000 rets. The Army
would pay a fixed fee of $7.00 per ret, and in addition it would reimburse Polaski Company for all costs of
production (variable and fixed) associated with the units. There would be no variable selling expenses of any
type associated with this order. If Polaski Company accepts the order, by how much will profits be increased or
decreased for the year?
3. Assume the same situation as that described in (2) above, except that the company expects to sell 20,000 rets
through regular channels next year. Thus, accepting the U.S. Army’s order would require giving up regular
sales of 5,000 rets. If the Army’s order is accepted, by how much will profits be increased or decreased from
what they would be if the 5,000 rets were sold through regular channels?

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MA (CASES) DECISION MAKING

INDICATIVE SOLUTIONS

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MA (CASES) DECISION MAKING

MGB Problem 11-5A (45 minutes)

1. Since the fixed costs will not change as a result of the order, they are
not relevant to the decision. The cost of the new machine is relevant,
and this cost will have to be recovered by the special order.
Unit Total—5,000 units
Revenue from the order ($42.00 × 85%) ................................................ $35.70 $178,500
Less costs associated with the order:
Direct materials ................................................................................. 12.00 60,000
Direct labor ........................................................................................ 6.00 30,000
Variable manufacturing overhead ...................................................... 4.00 20,000
Variable selling expense ($3.00 × 20%) ............................................ 0.60 3,000
Special machine ($5,000 ÷ 5,000 units) ............................................ 1.00 5,000
Total costs ............................................................................................... 23.60 118,000
Net change in profits .............................................................................. $12.10 $ 60,500

2. Revenue from the order:

Reimbursement for costs of production (variable production costs of $22.00 per unit, plus
fixed manufacturing overhead cost of $7.00 per unit = $29.00 per unit; $29.00 per unit
× 5,000 units) ..................................................................................................................... $145,000
Fixed fee ($7.00 per unit × 5,000 units) ................................................................................ 35,000
Total revenue .............................................................................................................................. 180,000
Less incremental costs—variable production costs
($22.00 per unit × 5,000 units) ............................................................................................... 110,000
Net change in profits .................................................................................................................. $ 70,000

3. Sales revenue
From the U.S. Army (above) ................................................................................................. $180,000
From regular channels ($42.00 per unit × 5,000 units) ......................................................... 210,000
Net change in revenue ................................................................................................................ (30,000)
Plus variable selling expenses avoided if the Army’s order is accepted ($3.00 per unit ×
5,000 units) ............................................................................................................................. 15,000
Net change in profits if the Army’s order is accepted ................................................................ $(15,000)

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Decision Making Q&A

QUESTION B2

Rosiek Corporation uses part A55 in one of its products. The company's Accounting
Department reports the following costs of producing the 4,000 units of the part that are
needed every year.

An outside supplier has offered to make the part and sell it to the company for $32.30 each. If
this offer is accepted, the supervisor's salary and all of the variable costs, including direct
labor, can be avoided. The special equipment used to make the part was purchased many
years ago and has no salvage value or other use. The allocated general overhead represents
fixed costs of the entire company. If the outside supplier's offer were accepted, only $4,000
of these allocated general overhead costs would be avoided. In addition, the space used to
produce part A55 could be used to make more of one of the company's other products,
generating an additional segment margin of $26,000 per year for that product.

Required: Show detailed supportive workings.

a. Prepare a report that shows the effect on the company's total net operating income of
buying part A55 from the supplier rather than continuing to make it inside the company. (6
marks)

b. Which alternative should the company choose? Explain why? (4 marks)

(Total 10 marks)

ANSWER B2

b. The total cost of the make alternative is lower by $18,400. Thus, net operating income
would decline by $18,400 if the offer from the supplier were accepted. Therefore, the
company should continue to make the part itself.

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Decision Making Q&A

DECISION MAKING

12. The Transporter Company produces material handling equipment for use in commercial
manufacturing. As part of its operations, Transporter has three distinct product lines: belts, conveyors,
and elevators. The company is currently considering the elimination of the belt product line. The belt
line's sales average $850,000 annually. Variable manufacturing costs and variable selling costs total
$320,000 and $140,000, respectively. Fixed costs total $450,000, of which $120,000 are considered to
be unavoidable.

(a) Prepare an analysis to determine the profit increase or decrease that would result if
production of belts is discontinued.

(b) Should the company drop the belt line?

12. ANS:
(a)
THE TRANSPORTER COMPANY
Relevant Costs and Revenues for the Decision
to Drop the Belt Product Line

Drop Continue Producing

Sales revenue $0 $ 850,000
Avoidable costs:
Variable manufacturing $0 $ 320,000
Variable selling 0 140,000
Fixed costs 0 330,000
Total avoidable costs 0 $(790,000)
Profit $0 $ 60,000

Therefore, if the belt line is eliminated, company profits will decrease by $60,000.

(b) Do not drop the belt line.

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Decision Making Q&A

Question B2
Part F77 is used in one of Wilcutt Corporation's products. The company's Accounting
Department reports the following costs of producing the 7,000 units of the part that
are needed every year.

An outside supplier has offered to make the part and sell it to the company for $28.30
each. If this offer is accepted, the supervisor's salary and all of the variable costs,
including direct labor, can be avoided. The special equipment used to make the part
was purchased many years ago and has no salvage value or other use. The allocated
general overhead represents fixed costs of the entire company. If the outside supplier's
offer were accepted, only $9,000 of these allocated general overhead costs would be
avoided.

Required: Show detailed supportive workings.

a) Prepare a report that shows the effect on the company's total net operating income of
buying part F77 from the supplier rather than continuing to make it inside the
company. (6 marks)

b) Which alternative should the company choose? Explain why. (4 marks)

(Total 10 marks)

Answer B2

b. The total cost of the make alternative is lower by $26,000. Thus, net operating income

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Decision Making Q&A

would decline by $26,000 if the offer from the supplier were accepted. Therefore, the
company should continue to make the part itself.

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