Chapter 6 Homework Assignment

Hector, Inc. currently makes and sells approximately 5,000 shovels per year. Hector has an offer to buy the shovels it currently makes at a price that is below its cost of making them. Based on this information Hector is faced with a(n)

outsourcing decision.

The Lamp Company (TLC) currently makes and sells approximately 5,000 lamps per year. TLC recently received an offer from a new customer to purchase 500 lamps. TLC has the capacity to make the additional lamps but is reluctant to accept the offer because the price offered is significantly below the normal selling price. Based on this information TLC if faced with a(n)

special order decision.

Which of the following are not relevant to decision making?

sunk cost Sunk costs are based on historical events that cannot be changed by current or future events. In other words, you cannot change the past. In other words, the past is the same regardless of which alternatives are selected in a current decision. Since sunk costs do not differ between the alternatives and do not affect present or future conditions they are not relevant for decision making purposes.

All other things being equal, a company should promote the sale of products with higher contribution margins. This statement is

true

Managers may act in their self-interest even if this action is detrimental to the interest of the company that employs them. This statement is

true

Harcourt Manufacturing (HM) has the capacity to produce 10,000 fax machines per year. HM currently produces and sells 7,000 units per year. The fax machines normally sell for $100 each. Modem Products has offered to buy 2,000 fax machines from HM for $60 each. Unit-level costs associated with manufacturing the fax machines are $15 each for direct labor and $40 each for direct materials. Product-level and facility-level costs are $50,000 and $65,000, respectively. How much would profit increase (decrease) if HM accepted this special order?

$10,000 Explanation Accepting the special order will provide the following contribution to profit. Revenue (2,000× $60)$120,000 Unit-Level Costs (2,000 × ($15 + $40)) (110,000) Contribution to Profit$10,000 The product and facility costs are not relevant because they will be incurred regardless of whether the special offer is accepted. Since these costs do not differ between the alternatives (accept or reject the offer), they are not relevant to the decision.

Tom's Toolery is operating at 80% of its productive capacity. It is currently paying $20 per unit for a part used in its manufacturing operation. Tom's estimates it could make the part internally for a total cost of $24 per unit, consisting of $18 of unit-level production costs and $6 of facility-level costs that are currently attributed to other products. Tom's usually purchases 50,000 units of the part each year. These units could be manufactured using Tom's excess capacity. What is the effect on cost if the company decides to start making the part?

$100,000 cost decrease Explanation Cost to purchase$20 Relevant cost to make* 18 Decrease in cost per unit$2 *The facility-level costs are incurred regardless of whether the part is purchased or made. Since these costs cannot be avoided by selecting one alternative over the other, they are not relevant to the decision.

Based on the segment income statement below, Chips, Inc. is considering eliminating its Barbecue Division line. Revenue from Barbecue Division sales$500,000 Salaries for Barbecue Division workers (100,000) Direct material (300,000) Sunk costs (equipment depreciation) (75,000) Allocated company-wide facility-sustaining costs (50,000) Net loss$(25,000) If the Division is eliminated, what is the total amount of avoidable cost?

$400,000 If the Division is eliminated Chips, Inc. could avoid paying for the salaries and direct materials incurred to make the barbecue chips. The sunk cost and the facility-level cost cannot be avoided regardless of whether the Division is eliminated. Total avoidable cost is $400,000 ($100,000 salaries + $300,000 materials).

Jason Company is considering replacing equipment which originally cost $600,000. New equipment costs $500,000 and the old equipment can be sold for $400,000. What is the sunk cost in this situation?

$600,000 The original cost of the old equipment is the result of a historical event that cannot be changed by current or future action. In other words, you cannot change the past. Therefore the original cost of old equipment is a sunk cost that is not relevant to current or future decisions.

To be relevant, information must

both of the answers are characteristics of relevant information.

Which of the following could motivate a manager to pursue short-term performance over long-term performance?

Both threats and bonus systems can motivate an inappropriate focus on short-term performance.

Fanning Bicycle Manufacturing Company currently produces the handlebars used in manufacturing its bicycles, which are high-quality racing bikes with limited sales. Fanning produces and sells only 7,000 bikes each year. Due to the low volume of activity, Fanning is unable to obtain the economies of scale that larger producers achieve. For example, Fanning could buy the handlebars for $33 each; they cost $36 each to make. The following is a detailed breakdown of current production costs. ItemUnit Cost TotalUnit-level costs Materials $15 $105,000 Labor 10 70,000 Overhead 2 14,000 Allocated facility-level costs 9 63,000 Total $36 $252,000 After seeing these figures, Fanning's president remarked that it would be foolish for the company to continue to produce the handlebars at $36 each when it can buy them for $33 each.RequiredCalculate the total relevant cost. Do you agree with the president's conclusion?

Explanation The allocated facility-sustaining costs are not avoidable because they will be incurred regardless of whether the handlebars are made or outsourced. The relevant (avoidable) costs are shown below: ItemPer Unit TotalCost of materials $15 $105,000 Cost of labor 10 70,000 Overhead 2 14,000 Total cost $27 $189,000 The analysis does not support the president's conclusion. Since it would cost more to buy the handlebars ($33 versus $27), Steele would be better off to continue to make the handlebars.

Solomon Concrete Company pours concrete slabs for single-family dwellings. Lancing Construction Company, which operates outside Solomon's normal sales territory, asks Solomon to pour 49 slabs for Lancing's new development of homes. Solomon has the capacity to build 460 slabs and is presently working on 110 of them. Lancing is willing to pay only $2,530 per slab. Solomon estimates the cost of a typical job to include unit-level materials, $900; unit-level labor, $590; and an allocated portion of facility-level overhead, $1,100.RequiredCalculate the contribution to profit from the special order. Should Solomon accept or reject the special order to pour 49 slabs for $2,530 each?

Explanation The facility-sustaining overhead is not relevant because it will be incurred regardless of whether the special order is accepted or rejected. The differential revenue and avoidable costs are shown below: Relevant Revenue and Costs Sales revenue ($2,530 × 49 slabs)$123,970 Cost of raw materials ($900 × 49 slabs) (44,100)Cost of direct labor ($590 × 49 slabs) (28,910)Contribution to profit$50,960 Since differential revenue is greater than avoidable costs, the order should be accepted.

A machine purchased three years ago for $308,000 has a current book value using straight-line depreciation of $188,000; its operating expenses are $36,000 per year. A replacement machine would cost $221,000, have a useful life of nine years, and would require $9,000 per year in operating expenses. It has an expected salvage value of $79,000 after nine years. The current disposal value of the old machine is $88,000; if it is kept 9 more years, its residual value would be $15,000.RequiredCalculate the total costs in keeping the old machine and purchase a new machine. Should the old machine be replaced?

Explanation The original cost and book value of the old machine are different measures of the same sunk cost and are therefore not relevant. The opportunity cost of using the old machine in future accounting periods is its current market value less its future salvage value ($88,000 − $15,000 = $73,000). Similarly, using the new machine would cost $142,000 ($221,000 − $79,000). The relevant (avoidable) cost of operating each machine for nine years is shown below: DecisionKeep Old MachinePurchase New MachineOpportunity cost$73,000 Purchase price less salvage $142,000 Operating costs 324,000 81,000 Total costs$397,000 $223,000 Since the cost of the new machine is less than the old, the old machine should be replaced. Stated alternatively, by operating the new machine, the cost of the old is avoided. To avoid as much cost as possible, the old machine should be replaced.

Zachary Company operates three segments. Income statements for the segments imply that profitability could be improved if Segment A were eliminated. ZACHARY COMPANYIncome Statements for Year 2SegmentA B CSales$170,000 $244,000 $253,000 Cost of goods sold (130,000) (79,000) (82,000)Sales commissions (18,000) (30,000) (28,000)Contribution margin 22,000 135,000 143,000 General fixed operating expenses (allocation of president's salary) (34,000) (46,000) (37,000)Advertising expense (specific to individual divisions) (5,000) (19,000) 0 Net income (loss)$(17,000) $70,000 $106,000 Required Prepare a schedule of relevant sales and costs for Segment A. Prepare comparative income statements for the company as a whole under two alternatives: (1) the retention of Segment A and (2) the elimination of Segment A.

Explanation a.First, identify all of the revenues and costs associated with the operation of Segment A. These items are listed in the problem under the column labeled Segment A. Remember the two alternatives are to either keep Segment A or to eliminate the segment. Eliminate the items that do not differ between these alternatives and the sunk costs. The ($34,000) of general fixed costs will continue regardless of whether the segment is eliminated. Consequently, this cost is not avoidable.The analysis suggests the segment is contributing $17,000 to the profitability of the company as a whole. This analysis can be verified by creating comparative company income statements under the two alternatives.b.Since Segment A contributes $17,000 to profitability, it should not be eliminated.

Which of the following items would not be relevant to an asset replacement decision?

The book value of the asset being replaced. The book value is the original cost of the asset minus accumulated depreciation. These are historical facts that cannot be changed by present or future events. In other words, the book value of the old asset is a sunk cost that is not relevant to the decision.

A segment elimination decision involves a comparison between revenue that will be lost through the elimination and the

avoidable cost of operating the segment. Explanation Only the costs that can be avoided or saved by the decision to eliminate are relevant to the revenue versus cost comparison.

Variable cost is frequently used as a proxy for

avoidable cost.