Chapter 7 - BUSI 1002 PDF

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68 7 – Decision Making – Relevant Costs Part 1 – Special Orders and Make vs. Buy

Multiple Choice Questions

1.

Moore Company produces a part used in the manufacture of one of its products. The unit product cost of the part is $33, computed as follows: Direct materials Direct labour Variable manufacturing overhead Fixed manufacturing overhead

$12 8 3 10

Unit product cost

$33

An outside supplier has offered to provide the annual requirement of 10,000 of the parts for only $27 each. The company estimates that 30% of the fixed manufacturing overhead costs above will continue if the parts are purchased from the outside supplier. Assume that direct labour is an avoidable cost in this decision. Based on these data, what will be the per-unit dollar advantage or disadvantage of purchasing the parts from the outside supplier? a) $1 advantage b) $1 disadvantage c) $3 advantage d) $3 disadvantage

2.

An entity produces 1,000 parts per year, which are used in the assembly of one of its products. The unit product cost of these parts is:

Variable manufacturing cost Fixed manufacturing cost Unit product cost

$12 9 $21

The part can be purchased from an outside supplier for $20 per unit. If the part is purchased from the outside supplier, two-thirds of the fixed manufacturing costs can be eliminated. What will be the annual impact on the company's net operating income of buying the part from the outside supplier? Positive numbers represent an increase, negative numbers represent a decrease. a) ($5,000) b) $5,000 c) ($2,000) d) ($8,000)

69 3.

An entity makes a line of bathroom accessories. Because of a decline in sales, the company has 10,000 machine hours of idle capacity available each year. This idle capacity could be used by the company to make, rather than buy, one of the components used in its production process. The entity needs 5,000 units of this component each year. At present, the component is being purchased from an outside supplier at $7.50 per unit. Variable production cost for the component would be $4.10 per unit, and additional supervisory costs would need to be incurred. Already existing fixed costs, which would be allocated to this part, amount to $300,000 per year. What would the annual cost of additional supervision have to be in order for Hadley to be economically indifferent to making or buying the component? a) $17,000 b) $18,000 c) $19,000 d) $20,000

The following information pertains to questions 4-5: Johnson Company manufactures a part for its production cycle. The costs per unit for 5,000 units of this part are as follows: Direct materials Direct labor Variable factory overhead Fixed factory overhead Total costs

$3 5 4 2 $14

The fixed factory overhead costs are unavoidable. 4.

Erikson Company has offered to sell 5,000 units of the same part to Johnson for $13 a unit. Assuming no other use for the facilities, Johnson should: a) buy from Erikson as this would save $1 per unit b) make the part as this would save $1 per unit c) buy from Erikson as this would save $5 per unit d) make the part as this would save $5 per unit

5.

Assuming no other use of their facilities, the highest price that Johnson should be willing to pay for the part is: a) $12 b) $14 c) $13 d) $11

70 Problems

Problem 1 Each year Molly Madison makes and sells 30,000 statues of “The Thinker” for $60/unit. She only has capacity to make 30,000 statues. Unit costs, based on this quantity, is as follows: Direct materials Direct labour Variable production overhead Fixed overhead Variable selling expenses

$ 7 5 12 10 5

Fixed overhead will be incurred regardless of production. An art dealer wants 5,000 statues with his label. The label will cost Molly an additional $1, but there would be no variable selling expenses on this special sale. Molly decides to accept the art dealer’s order at $58 per unit because she believes that he could become a valuable resource in the future. How much would Molly’s pre-tax profit change by accepting the order?

Problem 2 Joyner Co. makes 60,000 units of Part M per year at a cost of $36 per unit, including $8 of fixed overhead. Walker Co. will provide Part M to Joyner Co. for $33 per unit. If Joyner buys the parts, $120,000 of annual fixed overhead will be eliminated. Joyner Co. can rent the unused capacity and generate annual rental income of $300,000. What is the incremental income to Joyner if it purchases the parts from Walker?

71 Problem 3 The Melville Company produces a single product called a Pong. Melville has the capacity to produce 60,000 Pongs each year. If Melville produces at capacity, the per unit costs to produce and sell one Pong are as follows: Direct materials Direct labour Variable factory overhead Fixed factory overhead Variable selling expense Fixed selling expense

$15 12 8 9 8 3

The regular selling price for one Pong is $80. A special order has been received by Melville from Mowen Company to purchase 6,000 Pongs during 20x5. If this special order is accepted, the variable selling expense will be reduced by 75%. However, Melville will have to purchase a specialized machine to engrave the Mowen name on each Pong in the special order. This machine will cost $9,000 and it will have no use after the special order is filled. Required Assume Melville can sell 58,000 units of Pong to regular customers during 20x5. If Mowen Company offers to buy the special order units at $70 per unit, what will the effect of accepting the special order on Melville's net income for 20x5 be? Would you recommend they accept the offer? Use the incremental approach in your calculations.

Problem 4 An entity currently manufactures 4,000 units of part A506 per year. Cost data is as follows: Variable manufacturing costs per unit Fixed manufacturing costs (total)

$35 200,000

The entity was approached by a supplier who offered to supply the 4,000 units of part A506 each year at a cost of $55 per unit. If the entity accepts the supplier’s offer, then $50,000 of the fixed manufacturing costs would be avoidable. The space used to manufacture part A506 could be used to expand the capacity of another product. This other product generates a contribution margin of $40 per unit and the product’s sales would increase by 1,500 units annually. Required – Calculate the net advantage/disadvantage of purchasing the part from the external supplier.

72 Problem 5 Golden Company makes and sells 3,000 units per month of a product called a “XMIX”. Data concerning the unit production costs of XMIX follow (based on 3,000 units monthly capacity): Selling price per unit Direct materials per unit Direct labour per unit Variable manufacturing overhead per unit Fixed manufacturing overhead per unit Variable selling expense per unit

$129 35 10 8 35 25

An outside buyer needs 500 units of XMIX and has offered to buy them at a price of $85 each. Golden will not incur any selling costs to sell the 500 units of XMIX. Required – Assume that Golden makes and sells only 2,800 units per month. What would Golden’s incremental income/loss be if it accepted this order? Should Golden accept the order? Show your calculations. Start by calculating the contribution margin per unit for a regular sale

Problem 6 The Penn Corporation currently manufactures a part that is one of the main components of one of their most important products. They are currently manufacturing 8,000 units of the part annually. The unit cost to manufacture one part is as follows: Direct materials $35 Direct labour 24 Variable overhead 12 Fixed overhead 16 $87 An external supplier is offering to provide the part at a cost of $75 and Penn is considering the offer. If the part is purchased externally, Penn has determined that the impact would be as follows: • the supervisor overseeing the manufacture of the parts would be laid off. The supervisor’s salary is $58,000 per year and is included in fixed overhead. • the area used to make the part could be used to expand production of the main component. This would increase the annual production and sales of another product manufactured by Penn by 200 units per year. Each sale of this product generates a contribution margin of $250. Required – Calculate the net benefit to Penn of accepting the supplier’s offer.

73 Problem 7 JC Kenny Corp. has plant capacity to make 1,500,000 units of product X89, and is currently operating at 80% capacity. Current information pertaining to X89 is as follows: Selling price per unit Direct material cost per unit Direct labour cost per unit Total overhead allocated per unit

$9.00 2.10 3.50 1.40

The total overhead allocated per unit is based on the current production level. The fixed portion of total budgeted overhead was $1,500,000. JC Kenny has been negotiating with a new customer who would like 450,000 units of X89 for a sales price of $6.95 per unit. Required – If JC Kenny were to accept the customer’s offer, by how much would JC be better or worse off financially? Show all your work. Use incremental analysis, i.e. DO NOT prepare a before and after income statement. Calculate the incremental income directly.

74 Problem 8 Ward Co manufactures portable scanners. The firm received a special-order inquiry for a scanner that will be sold in a market that Ward does not operate in. The customer has offered to purchase 11,000 scanners if the order can be completed by the end of the month. The cost data for the scanner is as follows: Direct materials Direct labour – 0.25 hours at $18 per hour Variable overhead – 0.5 machine hours at $15 per hour Fixed overhead – 0.5 machine hours at $25 per hour

$16.40 4.50 7.50 12.50 $40.90

Additional Data – • the normal selling price for a scanner is $53; however, the customer has offered Ward only $31.50 because of the large quantity it is willing to purchase • Ward’s capacity is based on machine hours. The currently monthly capacity is 15,000 machine hours and Ward is currently operating at 75% capacity. Required a. b. c.

Calculate the number of units of regular sales that will be lost if this special order is taken. (Hint: start by calculating the number of machine hours we need and then convert this to units.) Calculate the contribution margin per unit of special order. Calculate the incremental income to Ward if they accept the special order. Would you recommend they accept the special order?

75 Problem 9 The Dober Corporation is considering discontinuing the manufacture of a part and instead, purchasing it from an external supplier. The external supplier has quoted a price of $35 per unit. The current annual production of this part is 65,000 units and is expected to remain constant. The costs of manufacturing the part are as follows: Direct materials Direct labour – 1 hour @$15 Variable overhead – 1 hour @ $5 Fixed overhead – 1 hour @ $12

$10 15 5 12 $42

If the part is purchased from the external supplier, Dober will be able to increase the sales of one of its other products by 20,000 units. This other product currently sells for $40 and has variable costs of $25. In addition, the part line supervisor will be hired by the external supplier. The external supplier will therefore be responsible for paying the part line supervisor’s annual salary of $56,000. Required Determine if the part should be manufactured or purchased externally. Show all of your computations.

76 7 – Decision Making – Relevant Costs Part 1 – Special Orders and Make vs. Buy SOLUTIONS

Multiple Choice Questions 1.

c

Cost to make = $12 + 8 + 3 + (10 x 0.7) = $30 Advantage to making = $33 – 30 = $3

2.

c

Cost to buy (1,000 x $20) Cost to make VC: $1,000 x 12 Avoidable FC: 1,000 x $9 x 2/3 Disadvantage to buying

3.

a

Net benefit of making = 5,000 (7.50 – 4.10) = $17,000

4.

b

Cost to make = $12 Cost to buy = $13 Make the part and save $1.

5.

a

$12 = cost to make

$20,000 12,000 6,000

18,000 ($2,000)

77 Problems

Problem 1 CM on special order 5,000 statues x ($58 – 7 – 5 – 12 – 1) = $165,000 2 marks CM on foregone regular sales = 5,000 x ($60 – 7 – 5 – 12 – 5) = $155,000 2 marks Increase in profits = $10,000 1 mark Alternative Solution – Before: Sales (30,000 x $60) Variable costs (30,000 x $29) Contribution margin

2 marks

$1,800,000 870,000 $930,000

After: Sales – 25,000 x $60 5,000 x $58 Variable costs: $25,000 x $29 5,000 x 25 Contribution margin

1,500,000 290,000 1,790,000 (725,000) (125,000) $940,000

2 marks

Increase in CM = $940,000 – 930,000 = $10,000 1 mark Another Alternate Solution 5,000 x ($5 Variable Selling - $2 Sales Price Difference – 1 Increased Cost) = $10,000 5 marks

Problem 2 Cost to buy (60,000 x $33)

1

$1,980,000

Cost to make Variable costs: 60,000 x ($36 – 8) Fixed costs eliminated Rental income

1 1 1

1,680,000 120,000 300,000 2,100,000

Advantage to buying

1

$120,000

78 Problem 3 CM per unit on special order = $70 - 15 - 12 - 8 - 2 = $33

2 marks

Total CM on Special Order: 6,000 x $33 CM lost on regular sales 4,000 units x (80 - 43) Cost of machine Incremental income of special order

1 1 1

$198,000 (148,000) (9,000) $41,000

Because the order disrupts regular sales, this needs to be considered when making a decision. 1 mark Problem 4 Cost to buy: 4,000 x $55 Cost to make: Variable costs: 4,000 x $35 Avoidable fixed costs Contribution margin: 1,500 x $40

$140,000 50,000 60,000

Advantage to buying

$220,000

1

250,000

1 1 1

$30,000

1

Problem 5 CM per unit for units in Special Order = $85 – 35 – 10 – 8 = $32 2 marks CM per unit of a regular sale = $129 - 35 – 10 – 8 – 25 = $51 2 marks CM on special order: 500 units x $32 CM lost on regular sales: 300 units x $51

2 marks 2 marks

Incremental income if the special order is taken If there is no future impact on the 300 units of regular sales lost, then accept the special order If there is a future impact, then do not accept the special order.

$16,000 (15,300) $700 1 mark 1 mark

79 Problem 6 Cost to buy (8,000 x $75) Cost to make Variable costs [(8,000 x ($35 + 24 + 12)] Avoidable fixed costs – Supervisor Salary CM on new product: 200 x $250

2 2 2

1

$600,000

$568,000 58,000 50,000

676,000

Advantage to buying

$76,000

Problem 7 Excess capacity: 1,500,000 x 20% = 300,000 Units displaced by special order = 450,000 – 300,000 = 150,000

1 mark

Fixed cost per unit = $1,500,000 / (1,500,000 x 80%) = $1,500,000 / 1,200,000 = $1.25

1 mark

Variable cost/unit = $1.40 – 1.25 = $0.15

1 mark

CM generated by special order 450,000 x ($6.95 – 2.10 – 3.50 – 0.15) CM lost on regular sales 150,000 x ($9.00 – 2.10 – 3.50 – 0.15) Incremental income of taking the special order

1.5

$540,000

1.5

(487,500) $52,500

80 Problem 8 a.

Available capacity = 15,000 x 25% = 3,750 machine hours Special order requires 11,000 x 0.5 = 5,500 machine hours Lost regular sales = 5,500 – 3,750 = 1,750 machine hours / .5 = 3500 units 3 marks

b. Selling price per unit of special order Variable costs Direct materials Direct labour Variable overhead: 0.5 MH x $15 CM per unit of SO

c.

$31.50 16.40 4.50 7.50 2 marks

28.40 $ 3.10

2 TCM on special order: 11,000 x $3.10 $34,100 CM lost 2 3,500 units x (53 – 16.40 – 4.50 – 7.50) (86,100) Incremental income of accepting the special order $(52,000) Recommend they do not accept the special order 1 mark

Problem 9 Cost to buy: 65,000 x $35 Cost to make: Variable costs: 65,000 x $30 CM on product line: 20,000 x $15 Supervisor Salary Net benefit of buying Recommend they buy

$2,275,000 1,950,000 300,000 56,000

2,306,000 $ 31,000

1

1 2 2

1

81 7 – Decision Making – Relevant Costs Part 2 – Add/Drop, Scarce Resources, Sell or Process Further

Multiple Choice Questions 1.

The Cook Company has two divisions: Eastern and Western. The divisions have the following revenues and expenses: Sales Variable Costs Direct Fixed Costs Allocated Corporate Costs Net Income (Loss)

Eastern $550,000 $275,000 $180,000 $170,000 ($75,000)

Western $500,000 $200,000 $150,000 $135,000 $ 15,000

The management of Cook is considering the elimination of the Eastern Division. If the Eastern Division were eliminated, the direct fixed costs associated with this division could be avoided. However, corporate costs would still be $305,000 in total. Given these data, what would be the overall company's net income (loss) if the Eastern Division were eliminated? a) ($155,000) b) ($95,000) c) ($60,000) d) $15,000

2.

Derringer Ltd. is considering closing its Newfoundland division. Which of the following would NOT be relevant to the closure decision? a) All variable production costs b) Contribution margin on lost sales c) Site cleanup costs d) The salary of the branch manager to be transferred to the Alberta division

82 Problems

Problem 1 Each of the following parts are independent. In all cases, show computations to support your answer. a)

A merchandising company has two departments, 101 and 102. A recent monthly income statement for the company follows:

Total Sales Less variable expenses

Department 101

102

$4,000,000 1,300,000

$3,000,000 900,000

$1,000,000 400,000

Contribution margin Less fixed expenses

2,700,000 2,200,000

2,100,000 1,400,000

600,000 800,000

Net operating income (loss)

$ 500,000

$ 700,000

($200,000)

A study indicates that $340,000 of the fixed expenses being charged to Department 102 are sunk costs or allocated costs that will continue even if department 102 is dropped. In addition, the elimination of Department 102 will result in a 10% increase in the sales of Department 101. If Department 102 is dropped, what will be the effect on the net operating income of the company as a whole? Would you recommend Department 102 be dropped? Briefly explain why. (7 marks) b)

Crain Company produces several products from the processing of Vulumus, a rare mineral. Material and processing costs total $50,000 per ton, one third of which is allocable to product A. The amount of product A received from a ton of Vulumus can either be sold at the split-off point or processed further at a cost of $13,000 and then sold for $31 per kilogram. The sales value of product A at the split-off point is $18 per kilogram. The volume of A that can be sold at the split-off point is 1,000 kg. If A is processed further, the volume is 900 kg. Should product A be processed further or sold at the split-off point? At what selling price after processing further would Crain be indifferent between selling at the split-off point or processing further? (7 marks)

83 c)

Cardall Company produces three products, A, B, and C. Data concerning the three products follows (per unit):

Sellin...