Exercise 12-11: Identification of Relevant Costs Given: Samantha Ringer purchased a used automobile for $10,000 at the beginning of last year and incurred the following operating costs: Depreciation ($10,000 / 5 years) $2,000 Insurance 960 Garage rent 480 Automobile tax and license 60 Variable operating costs $0.08 per mile The variable operating cost consist of gasoline, oil, tires, maintenance, and repairs. Samantha estimates that at her current rate of usage the car will have zero resale value in five years, so the annual straight- line depreciation is $2,000. The car is kept in a garage for a monthly fee. Required: 1. Samantha drove the car 10,000 miles last year. Compute the average cost per mile of owning and operating the car. Fixed costs Depreciation ($10,000 / 5 years) $2,000 Insurance 960 Garage rent 480 Automobile tax and license 60 $3,500 Variable costs Variable operating costs per mile $0.08 Miles 10,000 800 Total cost of operating the car $4,300 Miles 10,000 Average total cost per mile to operate car $0.43 2. Samantha is unsure about whether she should use her own car or rent a car to go on an extended cross-country trip for two weeks during spring break. What costs above are relevant in this decision? Explain. Variable operating costs: These are future costs which will only be incurred if Samantha uses her own car. Fixed costs: These are sunk cost that will be incurred regardless of her decision. These costs are not future costs and they do not differ between alternatives. 3. Samantha is thinking about buying an expensive sports car to replace the car she bought last year. She would drive the same number of miles regardless of which car she owns and would rent the same parking space. The sports car's variable operating costs would be roughly the same as the variable operating costs of her old car. However, her insurance and automobile tax and license costs would go up. What costs are relevant in estimating the incremental cost of owning the more expensive car? Explain. Cost Item: Relevant Reason Cost of new sports car Yes Future cost which differs between alternatives Sales value of older car Yes Future cost which differs between alternatives Residual value of new sports car Yes Future cost which differs between alternatives Insurance on new sports car Yes Future cost which differs between alternatives Automobile tax & license on new car Yes Future cost which differs between alternatives Cost of older car No Past Cost -- Sunk Cost Insurance on older car No Past Cost -- Sunk Cost Automobile tax & license on older car No Past Cost -- Sunk Cost Variable operating costs: same No Future cost which does not differ between alternatives Garage rent: same No Future cost which does not differ between alternatives nd incurred the ntha estimates nual straight- n this decision? ght last year. d rent the same s the variable costs would go ensive car? een alternatives een alternatives een alternatives een alternatives een alternatives fer between alternatives fer between alternatives Exercise 15 Dropping or Retaining a Segment Given: Boyle's Home Center, a retailing company, has two departments, Bath and Kitchen. The company's most recent monthly contribution format income statement follows: Bath Kitchen Total Sales $1,000,000 $4,000,000 $5,000,000 Variable expenses 300,000 1,600,000 1,900,000 Contribution margin $700,000 $2,400,000 $3,100,000 Fixed expenses 900,000 1,800,000 2,700,000 Net operating income (loss) ($200,000) $600,000 $400,000 A study indicates that $370,000 of the fixed expenses being charged to the Bath Department are sunk costs or allocated costs that will continue even if the Bath Department is dropped. In addition, the elimination of the Bath Department would result in a 10% decrease in the sales of the Kitchen Department. Required: If the Bath Department is dropped, what will be the effect on the net operating income of the company as a whole? Bath Kitchen Total Sales $0 $3,600,000 $3,600,000 Variable expenses 0 1,440,000 1,440,000 Contribution margin $0 $2,160,000 $2,160,000 Fixed expenses 370,000 1,800,000 2,170,000 Net operating income (loss) ($370,000) $360,000 ($10,000) Disadvantage of closing Bath Department $410,000 Alternate Solution: Bath Department contribution margin lost (100%) ($700,000) Kitchen Department contribution margin lost (10%) (240,000) Avoidable fixed cost saved by closing Bath Department 530,000 Decrease in net operating income if Bath Department is closed ($410,000) Exercise 12-3 Make or Buy A Component Given: Climate-Control, Inc., manufactures a variety of heating and air conditioning units. The company is currently manufacturing all of its own component parts. An outside supplier has offered to sell a theromostat to Climate-Control for $20 per unit. To evaluate this offer, Climate-Control, Inc., has gathered the following information relating to its own cost of producing the thermostat internally: 15,000 Per Units Per Unit Year Direct materials $6 $90,000 Direct labor 8 120,000 Variable manufacturing overhead 1 15,000 Fixed manufacturing overhead, traceable *** 5 75,000 Fixed mfg. overhead, common, and allocated 10 150,000 Total cost $30 $450,000 *** 40% supervisory salaries; 60% depreciation of special equipment (no resale value). Required: 1. Assuming that the company has no alternative use for the facilities now being used to produce the thermostst, should the outside supplier's offer be accepted? 15,000 Per Units Per Cost savings by not producing component internally Unit Year Direct materials $6 $90,000 Direct labor 8 120,000 Variable manufacturing overhead 1 15,000 Fixed manufacturing overhead, traceable and avoidable 2 30,000 Fixed mfg. overhead, common, and allocated 0 0 Total cost $17 $255,000 Cost of purchasing component from outside supplier (20) (300,000) Disadvantage of buying component from outside supplier ($3) ($45,000) Disadvantage of buying component from outside supplier ($45,000) Alternate Solution: Total costs if units are produced internally $450,000 Total costs if units are purchased from external supplier: Cost paid to external supplier $300,000 Unavoidable fixed costs Traceable but unavoidable 45,000 Allocated and unavoidable 150,000 495,000 Disadvantage of buying component from outside supplier ($45,000) 2. Suppose that if the thermostats were purchased, Climate-Control, Inc., could use the freed capacity to launch a new product. The segment margin of the new product would be $65,000 per year. Should Climate-Control, Inc., accept the offer to buy the thermostats from the outside supplier for $20 each? Segment margin generated by using freed capacity to launch a new product $65,000 Disadvantage of buying component from outside supplier with idle freed capacity (45,000) Advantage of using freed capacity to launch a new product and outsource $20,000 Thus, the company should accept the offer and purchase the parts from the outside supplier. Exercise 12-14: Special Order Given: Glade Company produces a single product. The costs of producing and selling a single unit of this product at the company's current activity level of 8,000 units per month are: Per Part Direct materials $2.50 Direct labor 3.00 Variable manufacturing overhead 0.50 Fixed manufacturing overhead 4.25 Variable selling & administrative expenses 1.50 Fixed selling & administrative expenses 2.00 $13.75 The normal selling price is $15 per unit. The company's capacity is 10,000 units per month. An order has been received from a potential customer overseas for 2,000 units at a price of $12.00 per unit. This order would not affect regular sales. Required: 1. If the order is accepted, by how much will monthly profits increase or decrease? (The order would not change the company's total fixed costs.) Total for Per Part 2,000 Units Increase in revenue from special order $12.00 $24,000 Increase in cost related to special order Direct materials $2.50 $5,000 Direct labor 3.00 6,000 Variable manufacturing overhead 0.50 1,000 Variable selling & administrative expenses 1.50 3,000 Incremental cost $7.50 $15,000 Increased contribution margin from special order $4.50 $9,000 $9,000 2. Assume the company has 500 units of this product left over from last year that are inferior to the current model. The units must be sold through regular channels at reduced prices. What unit cost is relevant for establishing a minimum selling price for these units? Explain. The only unit cost that is relevant is the variable selling & administrative expense of $1.50. All of the other costs are past unit costs and not future costs. All of these other costs are sunk and will not increase or decrease because of distressed sales. gle unit of this er month. An rice of $12.00 rices. What Exercise 12-13 Utilization of a Constrained Resource Given: Banner Company produces three products: A, B, and C. The selling price, variable costs and contribution margin for one unit of each product follow: A B C Selling price $60 $90 $80 Variable costs: Direct materials $27 $14 $40 Direct labor 12 32 16 Variable manufacturing overhead 3 8 4 Total variable cost $42 $54 $60 Contribution margin per unit $18 $36 $20 Contribution margin ratio 30% 40% 25% Due to a strike in the plant of one of its competitors, demand for the company's products far exceeds its capacity to produce. Management is trying to determine which product(s) to concentrate on next week in filling its backlog of orders. The direct labor rate is $8 per hour, and only 3,000 hours of labor time are available each week. Required: 1. Compute the amount of contribution margin that will be obtained per hour of labor time spent on each product. A B C Contribution margin per unit $18 $36 $20 Direct labor $12 $32 $16 Direct labor rate per hour 8 8 8 Direct labor hours required per unit 1.50 4.00 2.00 CM per unit of limiting resource (DLH) $12.00 $9.00 $10.00 2. Which orders would you recommend that the company work on next week -- the orders for product A, product B, or product C? Banner Company should work on meeting the demand for Product A first, then Product C, and finally Product B. This work order is based on contribution margin generated per unit of limiting resource which at this time is direct labor hours available. 3. By paying overtime wages, more than 3,000 hours of direct labor time can be made available next week. Up to how much should the company be willing to pay per hour in overtime wages as long as there is unfilled demand for the three products? The amount Banner Company should be willing to pay in overtime wages for additional direct labor hours depends on how the time would be used: A B C Normal direct labor rate per hour $8.00 $8.00 $8.00 CM per direct labor hour 12.00 9.00 10.00 Maximum overtime hourly rate $20.00 $17.00 $18.00 Acceptable overtime pay range: $8 to $20 $8 to $17 $8 to $18 Management would prefer to pay as close to the $8.00 rate as possible. Note: Fill back orders in the following order A, C, then B provided additional hours can be acquired within the product DL pay range. Proof: A B C Selling price $60 $90 $80 Variable costs: Direct materials $27 $14 $40 DL (based on maximum overtime rate)**** 30 68 36 Variable manufacturing overhead 3 8 4 Total variable cost $60 $90 $80 Contribution margin per unit $0 $0 $0 Contribution margin ratio 0% 0% 0% **** If pay was any higher CM would become negative. per unit Exercise 12-19 Sell or Process Further Given: Abilene Meat Processing Corporation is a major processor of beef and other meat products. The company has a large amount of T-bone steak on hand, and it is trying to decide whether to sell the T-bone steaks "as is" or to process them further into filet mignon and New York cut steaks. Management believes that a 1-pound T-bone steak would yield the following profit: Wholesale selling price per pound $2.25 Less joint costs incurred up to the split-off point where T-bone steaks can be identified as a separate product 1.70 Profit per pound $0.55 As mentioned above, instead of being sold as is, the T-bone steaks could be further processed into filet mignon and New York cut steaks. Cutting one side of a T-bone steak provides the filet mignon, and cutting the other side provides the New York cut. One 16-ounce T-bone steak cut in this way will yield one 6-ounce filet mignon and one 8-ounce New York cut; the remaining ounces are waste. The cost of processing the T-bone steaks into these cuts is $.20 per pound. The filet mignon can be sold for $3.60 per pound, and the New York cut can be sold wholesale $2.90 per pound. Break-even point: 400 Required: Total Expenses Fixed Expenses Total Sales 1. Determine the profit per pound from processing the T-bone steaks further into filet mignon and New York cut steaks. Incremental Revenue Revenue from processing further a one-pound T-bone steak 6-ounce filet mignon @ $3.60 per pound $1.35 8-ounce New York cut @ $2.90 per pound 1.45 $2.80 Wholesale selling price of a one-pound T-bone steak 2.25 Increase in revenue from processing further $0.55 Incremental Cost Per pound cost of processing a one-pound T-bone steak into a 6-ounce filet mignon and a 8-ounce New York cut 0.20 Incremental benefit of further processing per one-pound T-bone $0.35 2. Would you recommend that the t-bone steaks be sold as is or processed further? Why? Yes. There is a $.35 benefit per one-pound T-bone steak processed further. Note: The allocated joint cost of $1.70 is irrelevant. The cost will be incurred regardless of whether the T-bone steaks are processed further or not. To be relevant a cost or revenue must: 1. be a future cost or revenue, not a past cost or past revenue, and 2. the future cost or revenue must differ between alternatives.