Exercise 13-2 |EXERCISE 13–2 |The Regal Cycle Company manufactures three types of bicycles—a dirt bike, a mountain bike, and a racing | |(30 minutes) |bike. Data on sales and expenses for the past quarter follow: LO2 | | | |[pic] | |Management is concerned about the continued losses shown by the racing bikes and wants a recommendation as to whether or not | |the line should be discontinued.
The special equipment used to produce racing bikes has no resale value and does not wear out. | 1. No, production and sale of the racing bikes should not be discontinued. If the racing bikes were discontinued, then the net operating income for the company as a whole would decrease by $11,000 each quarter: Lost contribution margin | |$(27,000) | |Fixed costs that can be avoided: | | | |Advertising, traceable |$ 6,000 | | |Salary of the product line manager | 10,000 | 16,000 | |Decrease in net operating income for the company as a whole | |$(11,000) |
The depreciation of the special equipment is a sunk cost and is not relevant to the decision. The common costs are allocated and will continue regardless of whether or not the racing bikes are discontinued; thus, they are not relevant to the decision. Alternative Solution: | |Current
Total |Total If Racing Bikes|Difference: Net | | | |Are Dropped |Operating Income | | | | |Increase or (Decrease) | |Sales |$300,000 |$240,000 |$(60,000) | |Variable expenses | 120,000 | 87,000 | 33,000 | |Contribution margin | 180,000 | 153,000 | (27,000) | |Fixed expenses: | | | | |Advertising, traceable |30,000 |24,000 |6,000 | |Depreciation on special |23,000 |23,000 |0 | |equipment* | | | | |Salaries of product managers |35,000 |25,000 |10,000 | |Common allocated costs | 60,000 | 60,000 | 0 | |Total fixed expenses | 148,000 | 132,000 | 16,000 | |Net operating income |$ 32,000 |$ 21,000 |$ (11,000) | *Includes pro-rated loss on the special equipment if it is disposed of. Exercise 13-2 (continued) 2. The segmented report can be improved by eliminating the allocation of the common fixed expenses. Following the format introduced in Chapter 12 for a segmented income statement, a better report would be: | | |Total |Dirt Bikes |Mountain Bikes |Racing Bikes | | |Sales |$300,000 |$90,000 $150,000 |$60,000 | | |Variable manufacturing and selling expenses | 120,000 | 27,000 | 60,000 | 33,000 | | |Contribution margin | 180,000 | 63,000 | 90,000 | 27,000 | | |Traceable fixed expenses: | | | | | | |Advertising |30,000 |10,000 |14,000 |6,000 | | |Depreciation of special equipment |23,000 |6,000 |9,000 |8,000 | | |Salaries of the product line managers | 35,000 | 12,000 | 13,000 | 10,000 | | |Total traceable fixed | 88,000 | 28,000 | 36,000 | 24,000 | | |expenses | | | | | | |Product line segment margin |92,000 |$35,000 |$ 54,000 |$? 3,000 | | |Common fixed expenses | 60,000 | | | | | |Net operating income |$? 32,000 | | | | EXERCISE 13–3 |Make or Buy a Component LO3 | |(30 minutes) | | |Troy Engines, Ltd. , manufactures a variety of engines for use in heavy equipment. The company has always produced all of the | |necessary parts for its engines, including all of the carburetors. An outside supplier has offered to sell one type of | |carburetor to Troy Engines, Ltd. , for a cost of $35 per unit. To evaluate this offer, Troy Engines, Ltd. , has gathered the | |following information relating to its own cost of producing the carburetor internally: | |[pic] | Required: | |Assuming that the company has no alternative use for the facilities that are now being used to produce the carburetors, should | |the outside supplier’s offer be accepted? Show all computations. | |Suppose that if the carburetors were purchased, Troy Engines, Ltd. , could use the freed capacity to launch a new product. The | |segment margin of the new product would be $150,000 per year. Should Troy Engines, Ltd. , accept the offer to buy the | |carburetors for $35 per unit? Show all computations. | | 1. |Per Unit Differential | |15,000 units | | | |Costs | | | | | |Make |Buy | |Make |Buy | | |Cost of purchasing | |$35 | | |$525,000 | | |Direct materials |$14 | | |$210,000 | | | |Direct labor |10 | | |150,000 | | | |Variable manufacturing overhead |3 | | |45,000 | | | |Fixed manufacturing overhead, traceable1 |2 | | |30,000 | | | |Fixed manufacturing overhead, common | | | | | | | |Total costs |$29 |$35 | |$435,000 |$525,000 | | |Difference in favor of continuing to make the carburetors | |$6 | | | |$90,000 | | |1 |Only the supervisory salaries can be avoided if the carburetors are purchased. The remaining book value of the special | | |equipment is a sunk cost; hence, the $4 per unit depreciation expense is not relevant to this decision. | Based on these data, the company should reject the offer and should continue to produce the carburetors internally. | 2. |Make |Buy | | |Cost of purchasing (part 1) | |$525,000 | | |Cost of making (part 1) |$435,000 | | | |Opportunity cost—segment margin foregone on a potential new product line | 150,000 | | | |Total cost |$585,000 |$525,000 | | |Difference in favor of purchasing from the outside supplier | |$60,000 | | Thus, the company should accept the offer and purchase the carburetors from the outside supplier. |EXERCISE 13–4 |Evaluating a Special Order LO4 | |Imperial Jewelers is considering a special order for 20 handcrafted gold bracelets to be given as gifts to members of a wedding| |party. The normal selling price of a gold bracelet is $189. 95 and its unit product cost is $149. 0 as shown below: | |[pic] | |Most of the manufacturing overhead is fixed and unaffected by variations in how much jewelry is produced in any given period. | |However, $4. 00 of the overhead is variable with respect to the number of bracelets produced. The customer who is interested in | |the special bracelet order would like special filigree applied to the bracelets. This filigree would require additional | |materials costing $2. 00 per bracelet and would also require acquisition of a special tool costing $250 that would have no other| |use once the special order is completed.
This order would have no effect on the company’s regular sales and the order could be | |fulfilled using the company’s existing capacity without affecting any other order. | |Required: | |What effect would accepting this order have on the company’s net operating income if a special price of $169. 95 per bracelet is| |offered for this order? Should the special order be accepted at this price? | Only the incremental costs and benefits are relevant. In particular, only the variable manufacturing overhead and the cost of the special tool are relevant overhead costs in this situation. The other manufacturing overhead costs are fixed and are not affected by the decision. |Per Unit |Total | | | |for 20 | | | |Bracelets | |Incremental revenue |$169. 95 |$3,399. 00 | |Incremental costs: | | | |Variable costs: | | | |Direct materials |$ 84. 00 |1,680. 00 | |Direct labor |45. 00 |900. 0 | |Variable manufacturing overhead |4. 00 |80. 00 | |Special filigree | 2. 00 | 40. 00 | |Total variable cost |$135. 00 |2,700. 00 | |Fixed costs: | | | |Purchase of special tool | | 250. 00 | |Total incremental cost | | 2,950. 0 | |Incremental net operating income | |$ 449. 00 | Even though the price for the special order is below the company’s regular price for such an item, the special order would add to the company’s net operating income and should be accepted. This conclusion would not necessarily follow if the special order affected the regular selling price of bracelets or if it required the use of a constrained resource. |EXERCISE 13–10 |Identification of Relevant Costs LO1 | |Bill has just returned from a duck hunting trip. He has brought home eight ducks.
Bill’s friend, John, disapproves of duck | |hunting, and to discourage Bill from further hunting, John has presented him with the following cost estimate per duck: | |[pic][pic] | |[pic] | |Required: | |Assuming that the duck hunting trip Bill has just completed is typical, what costs are relevant to a decision as to whether | |Bill should go duck hunting again this season? | |Suppose that Bill gets lucky on his next hunting trip and shoots 10 ducks in the amount of time it took him to shoot 8 ducks on| |his last trip. How much would it have cost him to shoot the last two ducks? Explain. | |Which costs are relevant in a decision of whether Bill should give up hunting? Explain. | 1. The relevant costs of a hunting trip would be: | |Travel expense (100 miles @ $0. 21 per mile) |$21 | | |Shotgun shells 20 | | |One bottle of whiskey | 15 | | |Total |$56 | This answer assumes that Bill would not be drinking the bottle of whiskey anyway. It also assumes that the resale values of the camper, pickup truck, and boat are not affected by taking one more hunting trip. The money lost in the poker game is not relevant because Bill would have played poker even if he did not go hunting. He plays poker every weekend. The other costs are sunk at the point at which the decision is made to go on another hunting trip. 2. If Bill gets lucky and bags another two ducks, all of his costs are likely to be about the same as they were on his last trip.
Therefore, it really doesn’t cost him anything to shoot the last two ducks—except possibly the costs for extra shotgun shells. The costs are really incurred in order to be able to hunt ducks and would be the same whether one, two, three, or a dozen ducks were actually shot. All of the costs, with the possible exception of the costs of the shotgun shells, are basically fixed with respect to how many ducks are actually bagged during any one hunting trip. 3. In a decision of whether to give up hunting entirely, more of the costs listed by John are relevant. If Bill did not hunt, he would not need to pay for: gas, oil, and tires; shotgun shells; the hunting license; and the whiskey.
In addition, he would be able to sell his camper, equipment, boat, and possibly pickup truck, the proceeds of which would be considered relevant in this decision. The original costs of these items are not relevant, but their resale values are relevant. Exercise 13-10 (continued) These three requirements illustrate the slippery nature of costs. A cost that is relevant in one situation can be irrelevant in the next. None of the costs—except possibly the cost of the shotgun shells—are relevant when we compute the cost of bagging a particular duck; some of them are relevant when we compute the cost of a hunting trip; and more of them are relevant when we consider the possibility of giving up hunting. PROBLEM 13–18 |Dropping or Retaining a Flight LO2 | |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 round-trip of one such flight (flight 482) is as follows: | |[pic] | |The following additional information is available about flight 482: | |Members of the flight crew are paid fixed annual salaries, whereas the flight assistants are paid based on the number of | |round trips they complete. |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. | |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. | |If flight 482 is dropped, Pegasus Airlines has no authorization at present to replace it with another flight. | |Aircraft depreciation is due entirely to obsolescence. Depreciation due to wear and tear is negligible. |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. | |The airline’s scheduling officer has been criticized because only about 50% of the seats on Pegasus’ flights are being | |filled compared to an industry average of 60%. The scheduling officer has explained that Pegasus’ average seat occupancy | |could be improved considerably by eliminating about 10% of its flights, but that doing so would reduce profits. Explain how | |this could happen. | |Contribution margin lost if the flight is | |$(12,950) | | |discontinued | | | | |Flight costs that can be avoided if the flight is discontinued: | | | | |Flight promotion |$ 750 | | | |Fuel for aircraft |5,800 | | | |Liability insurance (1/3 ? $4,200) |1,400 | | | |Salaries, flight assistants |1,500 | | | |Overnight costs for flight crew and assistants | 300 | 9,750 | | |Net decrease in profits if the flight is discontinued | |$? 3,200) | The following costs are not relevant to the decision: |Cost | |Reason | | | | | |Salaries, flight crew | |Fixed annual salaries, which 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. | Problem 13-18 (continued) Alternative Solution: |Keep the Flight |Drop the Flight |Difference: Net | | | | |Operating Income | | | | |Increase or (Decrease) | |Ticket revenue |$14,000 |$ 0 |$(14,000) | |Variable expenses | 1,050 | 0 | 1,050 | |Contribution margin | 12,950 | 0 | (12,950) | |Less flight expenses: | | | | |Salaries, flight crew |1,800 |1,800 |0 | |Flight promotion |750 |0 |750 | |Depreciation of aircraft |1,550 |1,550 |0 | |Fuel for aircraft |5,800 |0 |5,800 | |Liability insurance |4,200 |2,800 |1,400 | |Salaries, flight assistants 1,500 |0 |1,500 | |Baggage loading and flight preparation |1,700 |1,700 |0 | |Overnight costs for flight crew and | 300 | 0 | 300 | |assistants at destination | | | | |Total flight expenses | 17,600 | 7,850 | 9,750 | |Net operating loss |$ (4,650) |$ (7,850) |$ (3,200) | 2. The goal of increasing the seat occupancy could be obtained by eliminating flights with a lower-than-average seat occupancy. By eliminating these flights and keeping the flights with a higher-than-average seat occupancy, the overall average seat occupancy for the company as a whole would be improved. This could reduce profits in at least two ways. First, the flights that are eliminated could have contribution margins that exceed their avoidable costs (such as in the case of flight 482 in part 1).
If so, then eliminating these flights would reduce the company’s total contribution margin more than it would reduce total costs, and profits would decline. Second, these flights might be acting as “feeder” flights, bringing passengers to cities where connections to more profitable flights are made. |PROBLEM 13–20 |Dropping or Retaining a Segment LO2 | |Jackson County Senior Services is a nonprofit organization devoted to providing essential services to seniors who live in their| |own homes within the Jackson County area. Three services are provided for seniors—home nursing, meals on wheels, and | |housekeeping.
In the home nursing program, nurses visit seniors on a regular basis to check on their general health and to | |perform tests ordered by their physicians. The meals on wheels program delivers a hot meal once a day to each senior enrolled | |in the program. The housekeeping service provides weekly housecleaning and maintenance services. Data on revenue and expenses | |for the past year follow: | |[pic] | |The head administrator of Jackson County Senior Services, Judith Miyama, is concerned about the organization’s finances and | |considers the net operating income of $5,000 last year to be razor-thin. Last year’s results were very similar to the results | |for previous years and are representative of what would be expected in the future. ) She feels that the organization should be | |building its financial reserves at a more rapid rate in order to prepare for the next inevitable recession. After seeing the | |above report, Ms. Miyama asked for more information about the financial advisability of perhaps discontinuing the housekeeping | |program. | |The depreciation in housekeeping is for a small van that is used to carry the housekeepers and their equipment from job to job. | |If the program were discontinued, the van would be donated to a charitable organization.
None of the general administrative | |overhead would be avoided if the housekeeping program were dropped, but the liability insurance and the salary of the program | |administrator would be avoided. | |Required: | |Should the housekeeping program be discontinued? Explain. Show computations to support your answer. | |Recast the above data in a format that would be more useful to management in assessing the long-run financial viability of the | |various services. | 1. No, the housekeeping program should not be discontinued. It is actually generating a positive program segment margin and is, of course, providing a valuable service to seniors. Computations to support this conclusion follow: |Contribution margin lost if the housekeeping program is dropped | |$(80,000) | | |Fixed costs that can be avoided: | | | | |Liability insurance |$15,000 | | | |Program administrator’s salary | 37,000 | 52,000 | | |Decrease in net operating income for the organization as a whole | |$(28,000) | Depreciation on the van is a sunk cost and the van has no salvage value since it would be donated to another organization. The general administrative overhead is allocated and none of it would be avoided if the program were dropped; thus it is not relevant to the decision. The same result can be obtained with the alternative analysis below: | |Current Total |Total If |Difference: Net Operating | | | | |House-keeping Is |Income Increase or | | | | |Dropped |(Decrease) | | |Revenues |$900,000 |$660,000 |$(240,000) | | |Variable expenses | 490,000 | 330,000 | 160,000 | | |Contribution margin | 410,000 | 330,000 | (80,000) | | |Fixed expenses: | | | | | |Depreciation* |68,000 |68,000 |0 | | |Liability insurance |42,000 |27,000 |15,000 | | |Program administrators’ salaries |115,000 |78,000 |37,000 | | |General administrative overhead | 180,000 | 180,000 | 0 | | |Total fixed expenses | 405,000 | 353,000 | 52,000 | | |Net operating income (loss) |$ 5,000 |$(23,000) |$? (28,000) | *Includes pro-rated loss on disposal of the van if it is donated to a charity. Problem 13-20 (continued) 2. To give the administrator of the entire organization a clearer picture of the financial viability of each of the organization’s programs, the general administrative overhead should not be allocated. It is a common cost that should be deducted from the total program segment margin. A better income statement would be: | |Home Nursing |Meals on Wheels |House-keeping |Total | | |Revenues |$260,000 |$400,000 |$240,000 |$900,000 | | |Variable expenses | 120,000 | 210,000 | 160,000 | 490,000 | | |Contribution margin | 140,000 | 190,000 | 80,000 | 410,000 | | |Traceable fixed expenses: | | | | | |Depreciation |8,000 |40,000 |20,000 |68,000 | | |Liability insurance |20,000 |7,000 |15,000 |42,000 | | |Program administrators’ salaries | 40,000 | 38,000 | 37,000 | 115,000 | | |Total traceable fixed expenses | 68,000 | 85,000 | 72,000 | 225,000 | | |Program segment margins |$? 72,000 |$105,000 |$?? 8,000 | 185,000 | | |General administrative overhead | | | | 180,000 | | |Net operating income (loss) | | | |$?? 5,000 | |PROBLEM 13–22 |Close or Retain a Store LO2 | |Superior Markets, Inc. , operates three stores in a large metropolitan area.
A segmented absorption costing income statement for | |the company for the last quarter is given below: | |[pic][pic][pic] | |[pic] | |The North Store has consistently shown losses over the past two years. For this reason, management is giving consideration to | |closing the store. The company has asked you to make a recommendation as to whether the store should be closed or kept open.
The| |following additional information is available for your use: | |The breakdown of the selling and administrative expenses is as follows: | |[pic] | |[pic] | |The lease on the building housing the North Store can be broken with no penalty. | |The fixtures being used in the North Store would be transferred to the other two stores if the North Store were closed. | |The general manager of the North Store would be retained and transferred to another position in the company if the North Store | |were closed. She would be filling a position that would otherwise be filled by hiring a new employee at a salary of $11,000 per | |quarter. The general manager of the North Store would be retained at her normal salary of $12,000 per quarter. All other | |employees in the store would be discharged. | |The company has one delivery crew that serves all three stores.
One delivery person could be discharged if the North Store were | |closed. This person’s salary is $4,000 per quarter. The delivery equipment would be distributed to the other stores. The | |equipment does not wear out through use, but does eventually become obsolete. | |The company’s employment taxes are 15% of salaries. | |One-third of the insurance in the North Store is on the store’s fixtures. | |The “General office salaries” and “General office—other” relate to the overall management of Superior Markets, Inc. If the North| |Store were closed, one person in the general office could be discharged because of the decrease in overall workload. This | |person’s compensation is $6,000 per quarter. |Required: | |Prepare a schedule showing the change in revenues and expenses and the impact on the company’s overall net operating income that| |would result if the North Store were closed. | |Assuming that the store space can’t be subleased, what recommendation would you make to the management of Superior Markets, | |Inc.? | |Disregard requirement 2. Assume that if the North Store were closed, at least one-fourth of its sales would transfer to the East| |Store, due to strong customer loyalty to Superior Markets. The East Store has enough capacity to handle the increased sales. You| |may assume that the increased sales in the East Store would yield the same gross margin as a percentage of sales as present | |sales in that store.
What effect would these factors have on your recommendation concerning the North Store? Show all | |computations to support your answer. | 1. The simplest approach to the solution is: |Gross margin lost if the store is closed | | |$(316,800) | |Costs that can be avoided: | | | | |Sales salaries |$70,000 | | | |Direct advertising |51,000 | | | |Store rent 85,000 | | | |Delivery salaries |4,000 | | | |Store management salaries |9,000 | | | |($21,000 – $12,000) | | | | |Salary of new manager |11,000 | | | |General office compensation |6,000 | | | |Insurance on inventories ($7,500 ? 2/3) |5,000 | | | |Utilities |31,000 | | | |Employment taxes | 15,000 |* | 287,000 | |Decrease in company profits if the North Store is closed | | |$ (29,800) | *Salaries avoided by closing the store: | | | Sales salaries |$70,000 | | Delivery salaries |4,000 | | Store management salaries |9,000 | | Salary of new manager |11,000 | | General office compensation | 6,000 | | Total avoided |100,000 | | Employment tax rate |?? 5% | | Employment taxes avoided |$15,000 | Problem 13-22 (continued) Alternative Solution: | |North Store Kept |North Store Closed |Difference: Net | | |Open | |Operating Income | | | | |Increase or (Decrease) | |Sales |$720,000 |$? |$(720,000) | | |Cost of goods sold | 403,200 | 0 | 403,200 | | |Gross margin | 316,800 | 0 | (316,800) | | |Selling and administrative expenses: | | | | | |Selling expenses: | | | | | |Sales salaries |70,000 |0 |70,000 | | |Direct advertising |51,000 |0 |51,000 | | |General advertising |10,800 |10,800 |0 | | |Store rent |85,000 |0 |85,000 | | |Depreciation of store fixtures |4,600 |4,600 |0 | | |Delivery salaries |7,000 |3,000 |4,000 | | |Depreciation of delivery equipment | 3,000 | 3,000 | 0 | | |Total selling expenses | 231,400 | 21,400 | 210,000 | | |Administrative expenses: | | | | | |Store management salaries |21,000 |12,000 |9,000 | | |Salary of new manager |11,000 |0 |11,000 | | |General office compensation |12,000 |6,000 |6,000 | | |Insurance on ixtures and |7,500 |2,500 |5,000 | | |inventory | | | | | |Utilities |31,000 |0 |31,000 | | |Employment taxes |18,150 |3,150 |15,000 |* | |General office—other | 18,000 | 18,000 | 0 | | |Total administrative expenses | 118,650 | 41,650 | 77,000 | | |Total operating expenses | 350,050 | 63,050 | 287,000 | | |Net operating income (loss) |$(33,250) |$(63,050) |$ (29,800) | | *See the computation on the prior page.
Problem 13-22 (continued) 2. Based on the data in (1), the North Store should not be closed. If the store is closed, then the company’s overall net operating income will decrease by $29,800 per quarter. If the store space cannot be subleased or the lease broken without penalty, a decision to close the store would cause an even greater decline in the company’s overall net income. If the $85,000 rent cannot be avoided and the North Store is closed, the company’s overall net operating income would be reduced by $114,800 per quarter ($29,800 + $85,000). 3. Under these circumstances, the North Store should be closed. The computations are as follows: Gross margin lost if the North Store is closed (part 1) |$(316,800) | |Gross margin gained from the East Store: $720,000 ? 1/4 = $180,000; $180,000 ? 45%* = $81,000 | 81,000 | |Net operating loss in gross margin |(235,800) | |Less costs that can be avoided if the North Store is closed (part 1) | 287,000 | |Net advantage of closing the North Store |$? 51,200 | *The East Store’s gross margin percentage is: $486,000 ? $1,080,000 = 45%