10.7: Chapter 10- Exercises

Short-Answer Questions, Exercises, and Problems

Questions

➢ Identify types of decisions that can be made using differential analysis.

➢ What is a committed fixed cost? Give some examples.

➢ What is a discretionary fixed cost? Give some examples.

➢ Give an example of a fixed cost that might be considered committed for one company and discretionary for another.

➢ What is the disadvantage of a company having all committed fixed costs? Explain.

➢ What is an opportunity cost? Give some examples.

➢ What essential feature distinguishes the contribution margin income statement from the traditional income statement?

➢ Real world question Give an example of a make-or-buy decision that you have made or someone you know has made.

➢ Real world question Give an example in which your campus bookstore replaces one of its departments with another it currently does not have. (For example, it stops selling magazines and starts selling cameras.) What revenues and costs would be differential?

➢ Real world question Assume that McDonald’s, of McDonald’s fast-food restaurants, currently buys its french fries from agricultural growers and food processors. In doing so, McDonald’s has decided to buy the materials for its french fries instead of “make” them. (Assume that making french fries includes growing the potatoes.) What factors would go into McDonald’s decision to buy instead of make french fries?➢ Real world question Suppose that Wal-Mart, one of the fastest growing companies in the world, were to close one of its stores. Which differential revenues and costs would be affected by that decision?ExercisesExercise A The following data are for Paso Robles Company for the year ended 2009 December 31:

Costs:
Direct material	$ 90,000
Direct labor	130,000
Manufacturing overhead:
Variable	45,000
Fixed	90,000
Sales commissions (variable)	25,000
Sales salaries (fixed)	20,000
Administrative expenses (fixed)	35,000
Selling price per unit	$ 10
Units produced and sold	60,000

Assume direct materials and direct labor are variable costs. Prepare a contribution margin income statement and a traditional income statement.

Exercise B Assume you had invested $1,000 in a lawn mower to set up a lawn mowing business for the summer. During the first week, you could choose either to mow the grounds at a housing development for $1,400 or to help paint a garage for $1,360. Each job would take one week. You cannot do both. You would incur additional costs of $160 for lawn mowing and $80 for garage painting. These costs include $60 under each alternative for transportation to the job. Prepare a schedule showing the net benefit or advantage of selecting one alternative over the other.

Exercise C The marketing department of Specialty Coffees estimates the following monthly demand for espresso in these four price-quantity relationships:

	Demand
1	9,000 cups at $1.00 per cup
2	8,000 cups at $1.25 per cup
3	6,000 cups at $1.50 per cup
4	4,000 cups at $1.75 per cup

The fixed costs of $3,000 per month are not affected by the different price-volume alternatives. Variable costs are $0.25 per cup. What price should Specialty Coffees set for espresso?

Exercise D Viking Corporation is operating at 80% of capacity, which means it produces 8,000 units. Variable cost is $100 per unit. Wholesaler Y offers to buy 2,000 additional units at $120 per unit. Wholesaler Z proposes to buy 1,500 additional units at $140 per unit. Which offer, if either, should Viking Corporation accept? Fixed costs are not affected by accepting either offer.

Exercise E Analysis of Hair Care Company’s citrus hair conditioner reveals that it is losing $5,000 annually. The company sells 5,000 units of citrus hair conditioner each year at $10 per unit. Variable costs are $6 per unit. None of the company’s fixed costs would be saved if the citrus hair conditioner were eliminated. What would be the increase or decrease in company net income if citrus hair condition were eliminated?

Exercise F The luggage department of Sampson Company has revenues of $1,000,000; variable expenses of $250,000; direct fixed costs of $500,000; and allocated, indirect fixed costs of $300,000 in an average year. If the company eliminates this department, what would be the effect on net income?

Exercise G Raiders Company manufactures two joint products. At the split-off point, they have sales values of:

Product 1	$18 per unit
Product 2	12 per unit

After further processing, the company can sell them for $36 and $16, respectively. Product 1 costs $12 per unit to process further and Product 2 costs $8 to process further. Should further processing be done on either or both of these products? Why or why not?

Exercise H Gopherit Corporation currently is manufacturing 40,000 units per year of a part used in its final product. The cost of producing this part is $50 per unit. The variable portion of this cost consists of direct materials of $25, direct labor of $15, and variable manufacturing overhead of $3. The company could earn $100,000 per year from the space now used to manufacture this part. Assuming equal quality and availability, what is the maximum price per unit that Gopherit Corporation should pay to buy the part rather than make it? (The total fixed costs would not be affected by this decision.)

Exercise I Ortez Company buys strawberries and produces strawberry jam. The variable cost of a case of strawberry jam is as follows:

Materials (strawberries and jars)	$10.00
Inspection and rework costs	4.00
All other variable costs	8.00
Total variable cost per case	$22.00

In addition, the company has $1,000,000 of fixed costs per year.

The company inspects the product at various stages. The cost of inspecting the product and replacing jam and/or jars averages $4.00 per case, shown as in the inspection and rework costs.

Management is considering purchasing high-quality strawberries. This would increase materials costs to $12.00 per case, while decreasing inspection and rework costs to $2.00 per case. All other costs would remain at $8.00 per case for variable costs and $1,000,000 for fixed costs whether or not the high-quality strawberries were purchased. Ortez’s jam sells for $40 per case. If the high-quality strawberries were purchased, the company could sell 100,000 cases of jam this year at $40 per case. If the company continued to use the current low-quality berries, it could sell 80,000 cases of jam this year at $40 per case.

Should Ortez purchase the high-quality strawberries?

Problems

Problem A Montonya Company has the following selected data for the current year:

Sales (10,000 units)	$90,000
Direct materials	30,000
Direct labor costs	10,000
Variable manufacturing overhead	3,500
Fixed manufacturing overhead	7,500
Variable selling and administrative expenses	2,500
Fixed selling and administrative expenses	15,000

The company produced and sold 10,000 units. Direct materials and direct labor are variable costs.

1. Prepare an income statement for the current year using the contribution margin format.
2. Prepare an income statement for the current year using the traditional format.
3. What additional information do you learn from the contribution margin format?

Problem B Pick-Me-Up Company is introducing a new coffee in its stores and must decide what price to set for the coffee beans. An estimated demand schedule for the product follows:

Price	One-pound units demanded
$ 5	80,000
6	72,000
7	56,000
8	48,000
9	36,000
10	30,000

Estimated costs follow:

Variable manufacturing costs	$2 per unit
Fixed manufacturing costs	$40,000 per year
Variable selling and administrative costs	$1 per unit
Fixed selling and administrative costs	$20,000 per year

1. Prepare a schedule showing management the total revenue, total cost, and total profit or loss for each selling price.
2. Which price do you recommend to the management of Pick-Me-Up? Explain your answer.

Problem C Ocean View Company operates tour boats. Its predicted operations for the year are as follows:

Sales (1,000 tours per year)	$400,000
Costs:
Variable	$250 per tour
Fixed	$100,000 per year

The company has received a request to offer 100 tours for $300 each. Ocean View has plenty of capacity to do these tours in addition to its regular business. Doing these tours would not affect the company’s regular sales or its fixed costs.

1. Should the company do the special tours for $300 per tour?
2. What is the effect of the decision on the company’s operating profit?

Problem D Following are sales and other operating data for the three products made and sold by Ranger Company:

		Product
	A	B	C	Total
Sales	$ 600,000	$ 300,000	$ 200,000	$ 1,100,000
Manufacturing costs:
Fixed	$ 60,000	$ 20,000	$ 60,000	$ 140,000
Variable	280,000	220,000	100,000	600,000
Selling and administrative expenses:
Fixed	20,000	20,000	12,000	52,000
Variable	40,000	20,000	30,000	90,000
Total costs	$ 400,000	$ 280,000	$ 202,000	$ 882,000
Net income	$ 200,000	$ 20,000	$ (2,000)	$ 218,000

In view of the net loss for Product C, Ranger’s management is considering dropping that product. All variable costs are direct costs and would be eliminated if Product C were dropped. Fixed costs are indirect costs; no fixed costs would be eliminated. Assume that the space used to produce Product C would be left idle.

Would you recommend the elimination of Product C? Give supporting computations.

Problem E Sierra Lumber Company produces lumber. The company has two grades of lumber at the split-off point, A and B. Grade A sells for $4 per board foot and Grade B sells for $2 per board foot. This lumber is suitable for framing and most exterior work but not for the interior of buildings. Either grade can be further processed to make it suitable for interior work at a cost of $1.20 per board foot. After this further processing, the firm can sell Grade A lumber for $5.50 per board foot and Grade B for $3.00 per board foot.

Would you recommend the company sell the lumber at the split-off point or process it further to make it suitable for interior work? Explain and give supporting computations.

Problem F Skate-Right Company, a skateboard manufacturer, is currently operating at 60% capacity and producing about 8,000 units a year. To use more capacity, the manager has been considering the research and development department’s suggestion that the company manufacture its own wheels.

Currently the company purchases wheels from a supplier at a unit price of $20. (Each unit is a set of wheels for a skateboard.) Estimates show the company can manufacture its own wheels at $10 for direct materials costs and $4 for direct labor cost per unit. The variable factory overhead is $1 per unit. The company’s accountants would probably allocate another $6 per unit to the wheels.

1. Should Skate-Right make or buy the wheels?
2. Suppose Skate-Right could rent out the factory space needed to make the wheels for $30,000 a month. How would this affect your decision in (a), if at all?

Problem G Quality Calc, Inc., purchases calculator components and assembles them into handheld calculators. The variable cost of one Model A-25 is as follows:

Materials	$10
Inspection and rework costs	2
All other variable costs	5
Total variable cost per case	$17

In addition, this product incurs $5,000,000 of fixed costs per year.

The company inspects the product at various stages. The cost of inspecting the product and replacing components averages $2 per calculator, shown as the inspection and rework costs.

Management is considering purchasing better components that would both increase quality and expand the calculator’s capacity. These new components would increase materials costs to $12.50 per calculator, but would decrease inspection and rework costs to $1.50 per calculator. All other variables cost would remain at $5 per calculator. Fixed costs would remain at $5,000,000 per year.

Quality Calc currently sells each A-25 calculator for $25 at a volume of 1 million calculators per year. Management believes it can increase the price of the calculator (which would now be called the A-25 STAR) to $30 per calculator because of its increased capability. Sales volume would remain at 1 million calculators per year for the improved A-25 STAR. Should Quality Calc purchase the better components?

Alternate problems

Alternate problem A The following data are for Nets Company for the current year:

Sales (20,000 units)	$750,000
Direct materials	270,000
Direct labor cost	90,000
Variable manufacturing overhead	27,000
Fixed manufacturing overhead	36,000
Variable selling and administrative expenses	45,000
Fixed selling and administrative expenses	150,000

The company produced and sold 20,000 units.

1. Prepare an income statement for the current year using the contribution margin format.
2. Prepare an income statement for the current year using the traditional format.
3. What additional information does the contribution margin format provide compared to the traditional format?

Alternate problem B The Havana Company is introducing a new product and must decide its price. An estimated demand schedule for the product is as follows:

Price	Units demanded
$ 5	20,000
6	18,000
7	14,000
8	12,000
9	9,000
10	8,000

Estimated costs are as follows:

Variable manufacturing costs	$2.20 per unit
Fixed manufacturing costs	$20,000 per year
Variable selling and administrative costs	$1.00 per unit
Fixed selling and administrative costs	$5,000 per year

1. Prepare a schedule showing the total revenue, total cost, and total profit or loss for each selling price.
2. Which price should Havana select? Explain.

Alternate problem C Following are sales and other operating data for the three products made and sold by Marine Enterprises:

		Product
	A	B	C	Total
Sales	$150,000	$90,000	$240,000	$480,000
Manufacturing costs:
Fixed	$ 15,000	$25,000	$ 30,000	$ 70,000
Variable	120,000	35,000	134,000	289,000
Selling and administrative expenses:
Fixed	5,000	30,000	10,000	45,000
Variable	2,500	5,000	6,000	13,500
Total costs	$142,500	$95,000	$180,000	$417,500
Net income (loss)	$ 7,500	$(5,000)	$ 60,000	$ 62,500

In view of the net loss shown for Product B, company management is considering dropping that product. All variable costs are direct costs and would be eliminated if Product B were dropped; all fixed costs are indirect costs and would not be eliminated. Assume that the space used to produce Product B would be left idle.

Would you recommend the elimination of Product B? Give supporting computations.

Alternate problem D Sailboard Enterprises, a wind sailing board manufacturer, is currently operating at 70% capacity and producing about 20,000 units a year. To use more capacity, the manager has been considering the research and development department’s suggestion that Sailboard manufacture its own sails. Currently Sailboard purchases sails from a supplier at a unit price of $100. Estimates show that Sailboard can manufacture its own sails for a $40 direct materials cost and a $32 direct labor cost per unit. The variable factory overhead is $8 per sail. The company’s accountants would allocate fixed manufacturing overhead of $30 per sail to the sail production.

1. Should Sailboard Enterprises make or buy the sails?
2. Suppose that Sailboard Enterprises could rent out the part of the factory that would otherwise be used for sail manufacturing for $8,000 a month. How would this affect the decision in (a)?

Alternate problem E Cool-Snacks Company produces and sells ice cream for ice cream shops. Management is considering purchasing better ingredients. The variable cost of producing a gallon of ice cream is as follows:

Materials (cream, containers, etc.)	$1.40
Inspection and replacement costs	.40
All other variable costs	.70
Total variable cost per gallon	$2.50

In addition, the company has $1,000,000 of fixed costs per year.

The company inspects the product at various stages. The cost of inspecting the product and replacing ice cream averages $0.40 per gallon, shown as the inspection and replacement costs.

Management is considering purchasing high-quality ingredients, in particular, high-quality dairy products. These high-quality ingredients would increase materials costs to $1.80 per gallon, but would decrease inspection and replacement costs to $0.30 per gallon. All other costs would remain at $0.70 per gallon for variable costs and $1,000,000 for fixed costs whether or not the high-quality ingredients are purchased. If the high-quality ingredients are purchased, the company expects to sell 1,200,000 gallons of ice cream this year at $4 per gallon. If the company continues to use the current low-quality ingredients, the company expects to sell 1,000,000 gallons of ice cream at $3.50 per gallon. Should Cool-Snacks Company buy the high-quality ingredients for its ice cream?

Beyond the numbers—Critical thinking

Business decision case A Prior to 2011, Starks Wholesalers Company had not kept department income statements. To achieve better management control, the company decided to install department-by-department accounts. At the end of 2011, the new accounts showed that although as a whole the business was profitable, the dry goods department had a substantial loss. The following income statement for the dry goods department reports on operations for 2011:

Starks wholesalers company
Dry goods department
Partial income statement for 2011
Sales		$1,200,000
Cost of goods sold		800,000
Gross margin		$ 400,000
Costs:
Payroll, direct labor, and supervision	$120,000
Commissions of sales staff a	60,000
Rent b	40,000
Insurance on inventory	20,000
Depreciation c	80,000
Administration and general office d	80,000
Interest for inventory carrying costs e	10,000
Total costs		410,000
Net income (loss)		$ (10,000)

A All sales staff are compensated on straight commission on sales.

B Rent charged to departments on a square-foot basis. The company rents an entire building, and the dry goods department occupies 15% of the building.

C Depreciation is 8.5% of the cost of the departmental equipment.

D Allocated on basis of departmental sales as a fraction of total company sales.

D Based on average inventory quantity multiplied by the company’s borrowing rate for three-month loans.

Analysis of these results has led management to suggest closing the dry goods department. Members of the management team agree that keeping the dry goods department is not essential to maintaining good customer relations and supporting the rest of the company’s business. In other words, eliminating the dry goods department is expected to have no effect on the amount of business done by the other departments.

Prepare a written report recommending whether or not Starks should close the dry goods department. Explain why. State your assumptions.

Business decision case B After working for a software company for several years, Chris and Terry quit their jobs and set up their own consulting firm called C & T Software, Inc. Major customers include corporate, professional, and government organizations that are setting up information networks.

The cost per billable hour of service at the company’s normal volume of 3,000 billable hours per month follows. (A billable hour is one hour billed to a client.)

Average cost per hour billed to client:
Variable labor – consultants	$50
Variable overhead, including supplies and clerical support	20
Fixed overhead, including allowance for unbilled hours	80
		$150
Marketing and administrative costs per billable hour (all fixed)		40
Total hourly cost		$190

Treat each of the following questions independently. Unless given otherwise, the regular fee per hour is $200.

1. How many hours must the firm bill per month to break even? (You may need to refer to Chapter 21 to answer this question.)
2. Market research estimates that a fee increase to $250 per hour would decrease monthly volume to 2,000 hours. The accounting department estimates that fixed overhead costs would be $120 per hour, while variable cost per hour would remain unchanged. What effect would a fee increase have on profits?
3. Assume C & T Software is operating at its normal volume of 3,000 hours per month. It has received a special request from one of its long-time customers to provide services on a special-order basis. Because of the long-term nature of the contract (four months) and the magnitude (1,000 hours per month), the customer believes a fee reduction is in order. C & T Software has a capacity limitation of 4,000 hours per month. Fixed costs would not change if the firm accepts the special order. What is the lowest fee C & T Software would be willing to charge?

Business decision case C Refer to “A broader perspective: Differential analysis in sports”. In a memorandum to your instructor identify which costs and revenues you think would be differential for a sports team acquiring a major star like Bonds. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.

Group project D In teams of two or three students, visit a local department store and imagine the types of costs that it would save if it closed a significant department (for example, the housewares department). List the types of costs that would be saved, but do not attempt to assign numbers to those costs. For example, would rent be saved? Would security be saved? What about taxes on inventories? Consider the effects of closing the department on the people who work there. As a team, write a memorandum describing the costs saved and the effects of closing a department in a local department store. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.

Group project E A manager in your organization just received a special order at a price that is “below cost”. The manager points to the document and says, “These are the kinds of orders that will get you in trouble. Every sale must bear its share of the full costs of running the business. If we sell below our full cost, we will be out of business in no time.” In groups of two or three students, write a memorandum to your instructor stating whether you agree with this comment or not and explain why. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.

Group project F Form a group of two or three students. Assume you are considering driving to a weekend resort for a quick break from school. What are the differential costs of operating your car for the drive? Write a memorandum to your instructor addressing this question. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.

Using the Internet—A view of the real world

Visit the website for Intel Corporation, a high technology manufacturing company.

http:/www.intel.com

Go to the company’s most recent financial statements and review the consolidated statement of income. Looking at the most recent year on the statement of income, assume 70% of the cost of sales are variable costs and the remaining 30% are fixed costs. Furthermore, assume all other costs and expenses (research and development, marketing, general and administrative, interest, taxes, etc.) are 60% variable and 40% fixed. Prepare an income statement using the contribution margin format. Be sure to submit a copy of Intel’s consolidated statement of income with the contribution margin income statement.

Visit the following website for Wal-Mart, a retail company.

http:/www.walmart.com

Go to the company’s most recent financial statements and review the statement of income. Looking at the most recent year on the statement of income, assume 45% of the cost of sales are variable costs and the remaining 55% are fixed costs. Furthermore, assume all other costs and expenses (research and development, marketing, general and administrative, interest, taxes, etc.) are 30% variable and 70% fixed. Prepare an income statement using the contribution margin format. Be sure to submit acopy of Wal-Mart’s income statement with the contribution margin income statement.