CHAPTER 14

Decision Making: Relevant Costs and Benefits

SOLUTIONS TO EXERCISES
EXERCISE 14-31 (15 MINUTES)
1.

The owners reasoning probably reflects the following calculation:

Savings in annual operating expenses if old pizza oven is replaced .............
Write-off of old ovens remaining book value ($10,000 x 1/5) ..........................
Loss associated with replacement ................................................................

$1,500
(2,000)
$ (500)

2.

The owners analysis is flawed, because the book value of the old pizza oven is a sunk
cost. It should not enter into the equipment replacement decision.

3.

Correct analysis:
Savings in annual operating expenses if old pizza oven is replaced .............
Acquisition cost of new oven, which will be operable for one year ................
Net benefit from replacing old pizza oven ........................................................

$1,500
(1,400)
$ 100

EXERCISE 14-39 (15 MINUTES)

(a)

$45,000 salary of Packaging Department manager: Irrelevant, since this manager will
be employed by the company at $45,000 per year regardless of whether the
Packaging Department is kept in operation.

(b)

$60,000 salary of Cutting Department manager if a new person must be hired:

Relevant, since this cost will be incurred only if the Packaging Department is kept in
operation. If the Packaging Department is eliminated, then that departments current
manager will move to the Cutting Department at $45,000 per year.
The following comparison may help to clarify the analysis:

Annual Salary Cost Incurred By Fusion Metals Company

Salary of the person currently managing the

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If Packaging
Department
is Kept
$ 45,000*

If Packaging
Department
is Eliminated
$45,000

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Packaging Department ...................................

Salary of newly hired person to manage the
Cutting Department .......................................... 60,000
Total ..................................................................... $105,000
Difference ............................................................
*

__
$45,000

$60,000

Continues to manage Packaging Department.

Moves to Cutting Department position.

Additional comment:
There are many possible reasons why it might cost Fusion Metals Company more to
hire a new Cutting Department manager than to transfer a current employee to the position.
One possible scenario is that the current Packaging Department manager is a relatively
young and inexperienced manager, to whom top management is willing to give the Cutting
Department opportunity if the Packaging Department is eliminated. However, if a new
person must be hired, Fusion Metals Company will be forced to go into the job market for
more senior and experienced managers. Other possible reasons include existing
contractual agreements, union contracts, and so forth.
EXERCISE 14-40 (20 MINUTES)
Sales revenue for one jar of silver polish .........................................
Sales revenue for 250 grams of Grit 337 ..........................................
Incremental revenue from further processing .................................
Incremental costs of further processing:
Processing costs ...........................................................................
Selling costs ...................................................................................
Incremental contribution margin from further
processing into silver polish (per jar) .............................................
Indifference point in units

$4.00
.50
$3.50
$2.50
.30

2.80
$ .70

avoidable fixed costs of further processing

incremental contribution margin

$5,600
= 8,000 jars
$.70

If more than 8,000 jars of silver polish can be sold, Zytel Corporation should process the
required amount of Grit 337 further into the polish.
EXERCISE 14-41 (10 MINUTES)
The most profitable product is the one that yields the highest contribution margin per unit
of the scarce resource, which is direct labor. We do not know the amount of direct-labor
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time required per unit of either product, but we do know that Dos requires six times as
much direct labor per unit as Uno. Define an arbitrary time period for which direct laborers
earn $1.00, and call this a time unit. The two products contribution margins per time
unit are calculated as follows:
Unit contribution margin .....................................................
Time units required per unit of product .........................
Contribution margin per time unit
Uno: ($3.00 1) ................................................................
Dos: ($12.00 6) ..............................................................

Uno
$3.00
1

Dos
$12.00
6

$3.00
$2.00

Therefore, Uno is a more profitable product. Any arbitrary amount of direct labor
time expended on Uno production will result in a greater contribution margin than an
equivalent amount of labor time spent on Dos production.

SOLUTIONS TO PROBLEMS
PROBLEM 14-44 (25 MINUTES)
1.
Electric
Blender Mixer
Unit cost if purchased from an outside supplier ............................. $20
$38
Incremental unit cost if manufactured:
Direct material ................................................................................ $6
$11
Direct labor ..................................................................................... 4
9
Variable overhead
$16 $10 per hour fixed ............................................................ 6
$32 (2)($10 per hour fixed) .....................................................
12
Total ............................................................................................ $16
$32
Unit cost savings if manufactured .................................................... $4
$6
Machine hours required per unit ....................................................... 1
2
Cost savings per machine hour if manufactured
$4 1 hour .....................................................................................
$4
$6 2 hours ...................................................................................
$3
Therefore, each machine hour devoted to the production of blenders saves the
company more than a machine hour devoted to mixer production.
Machine hours available .....................................................................................
Machine hours needed to manufacture 20,000 blenders .................................
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50,000
20,000

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2.

Remaining machine hours .................................................................................

30,000

Number of mixers to be produced (30,000 2) ................................................

Conclusion: Manufacture 20,000 blenders
Manufacture 15,000 mixers
Purchase
13,000 mixers

15,000

If the companys management team is able to reduce the direct material cost per
mixer to $6 ($5 less than previously assumed), then the cost savings from
manufacturing a mixer are $11 per unit ($6 savings computed in requirement (1) plus
$5 reduction in material cost):

New unit cost savings if manufactured ..........................................

Machine hours required per unit ....................................................
Cost savings per machine hour if manufactured
$4 1 hour ...................................................................................
$11 2 hours ...............................................................................

Electric
Blender Mixer
$4.00 $11.00
1 MH 2 MH
$4.00

$5.50

Therefore, devote all 50,000 hours to the production of 25,000 mixers.

Conclusion:

3.

Manufacture: 25,000 mixers

Purchase: 3,000 mixers
Purchase: 20,000 blenders

In the electronic version of the solutions manual, press the CTRL key and click on
the following link: Build a Spreadsheet 14-44.xls

PROBLEM 14-47 (25 MINUTES)

1.

Tipton will be worse off by $12,800 if it discontinues wallpaper sales.

Sales..
Less: Variable costs.
Contribution margin.

Paint and
Supplies

Carpeting Wallpaper

$380,000
228,000
$152,000

$460,000
322,000
$138,000

$140,000
112,000
$ 28,000

If wallpaper is closed, then:

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Loss of wallpaper contribution margin... $(28,000)

Remodeling. (12,400)
Added profitability from carpet sales*
65,000
Fixed cost savings ($45,000 x 40%).
18,000
Decreased contribution margin from paint
and supplies ($152,000 x 20%).. (30,400)
Increased advertising..
(25,000)
Income (loss) from closure $(12,800)
* The current contribution margin ratio for carpeting is 30% ($138,000
$460,000). This ratio will increase to 35%, producing a new contribution for
the line of $203,000 [($460,000 + $120,000) x 35%]. The end result is that
carpetings contribution margin will rise by $65,000 ($203,000 - $138,000),
boosting firm profitability by the same amount.
2.

This cost should be ignored. The inventory cost is sunk (i.e., a past cost that is not
relevant to the decision). Regardless of whether the department is closed, Tipton
will have a wallpaper inventory of $23,700.

3.

The Internet- and magazine-based firms likely have several advantages:

4.

These companies probably carry little or no inventory. When a customer places

an order, the firm simply calls its supplier and acquires the goods. The result
may be lower expenditures for storage and warehousing.
These firms do not need retail space for walk-in customers.
Internet- and magazine-based firms can conduct business globally. Tipton, on
the other hand, is confined to a single store in Des Moines.
In the electronic version of the solutions manual, press the CTRL key and click on
the following link: Build a Spreadsheet 14-47.xls

PROBLEM 14-49 (20 MINUTES)

The analysis prepared by the engineering, manufacturing, and accounting departments of
CTR was not correct. However, their recommendation was correct, provided that potential
labor-cost improvements are ignored. An incremental cost analysis similar to the following
table should have been prepared to determine whether the pump should be purchased or
manufactured. In the following analysis, fixed factory overhead costs and general and
administrative overhead costs have not been included because they are not relevant; these
costs would not increase, because no additional equipment, space, or supervision would be
required if the pumps were manufactured. Therefore, if potential labor cost improvements
are ignored, CTR should purchase the pumps because the purchase price of $68.00 is less
than the $71.00 relevant cost to manufacture.
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Incremental cost analysis:

Purchased components ..................................................................

Assembly labor ................................................................................
Variable manufacturing overhead ..................................................
Total relevant cost........................................................................

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Cost of
10,000 Unit
Assembly Run Per Unit
$110,000
$11.00
300,000
30.00
300,000
30.00
$710,000
$71.00

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