LA CONSOLACION COLLEGE OF

MANILA
Graduate School of Business
Managerial Accounting
Case Studies Ch. 16 1 & 2
Presented by:
Group 1
Bobis, Nova Amor
Castro, Carl Francis
Pascual, Kate-Lyn
Tronco, Anabelle
1

Hospital Supply Inc.

Case 16 - 1

This case is comprised of various situations that

deal with behavioral costs in order to maximize
profits. The use of break-even analysis and
opportunity cost is used along with recognizing
and using the fixed and variable cost. The Hospital
Supply, Inc. case is where they manufacture
hydraulic hoists and have a normal volume of
3,000 units per month. Using a break-even
analysis the determination of the sales volume
and prices will reveal what the company will need
to profitably sell its product. There are also
scenarios given to determine which options to
take to maximize profit or at least minimize loss.
3

Exhibit 1 displays the cost per unit for

hydraulic hoists and will provide the
information needed to determine how
Hospital Supply Inc. can maximize its profit
in the following various scenarios.
Part one is to determine both the breakeven volume in units and in sales dollars.

EXHIBIT 1 Costs per Unit for Hydraulic

Hoists
Unit manufacturing costs:
Variable materials ...........................................$550
Variable labor....................................................825
Variable overhead .............................................420
Fixed overhead.................................................660
Total unit manufacturing costs
2,455
Unit marketing costs:
Variable.............................................................275
Fixed..............................................................770
Total unit marketing costs.........................................1,045
Total unit costs........................................................$3,500
5

1. What is the break-even volume in

units? In sales dollars?
variable costs per unit = $550 + $825 + $420 + $275 = $
2,070
fixed costs per unit = $660 + $770 = $1,430.

Given information within the problem include:

Normal volume = 3,000 units
Regular selling price = $4,350
To find total fixed cost = 3,000 units *$1,430/unit =
$4,290,000
unit contribution = regular selling price subtract the variable
cost per unit :
= price/unit - variable cost/unit = $4,350 - $2,070 = $2,280
6

Contribution percent = $2,280/$4,350

= 0.524138
Break-even volume in units = fixed cost/unit
contribution
= $4,290,000/$2,280 = 1,882 units
Break-even volume in sales = fixed cost/
contribution percent
= $4,290,000/$0.524138 = $8,184,867

2. Market research estimates that monthly

volume could increase to 3,500 units,
which is well within hoist production
capacity limitations, if the price were cut
from $4,350 to $3,850 per unit. Assuming
the cost behavior patterns implied by the
data in Exhibit 1 are correct, would you
recommend that this action be taken?
What would be the impact on monthly
sales, costs, and income?

Market research estimates that monthly

volume could increase to 3,500 units, which
is well within hoist production capacity
limitations, if the price were cut from
$4,350 to $3,850 per unit.

Assuming the cost behavior patterns

implied by the given data are correct, would
you recommend that this action be taken?

Income (with regular price) = Revenues -Total

costs
= $13,050,000 - $10,500,000 = $2,550,000
After price reduction, income = $13,475,000$11,535,000 = $1,940,000
In regards to problem 2, reducing the price
would result in reduction of income, since
$1,940,000 - $2,550,000 = $610,000.
Even though price reduction has its
advantages such as increasing demand, it
greatly reduces income and wouldn't
recommend this approach.

10

3. On March 1 a contract offer is made to Hospital

Supply by the federal government to supply 500
units to Veterans Administration hospitals for
delivery by March 31. Because of an unusually large
number of rush orders from their regular customers,
Hospital Supply plans to produce 4,000 units during
March, which will use all available capacity. If the
government order is accepted, 500 units normally
sold to regular customers would be lost to a
competitor. The contract given by the government
would reimburse the governments share of March
production costs, plus pay a fixed fee (profit) of
$275,000. (There would be no variable marketing
costs incurred on the governments units.) What
impact would accepting the government contract
have on March income?
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A contract offer is made to Hospital Supply by the federal

government is supply 500 units to VA hospitals for
delivery by March 31. Because of an unusually large
number from rush orders from its regular customers,
Hospital Supply plans to produce 4,000 units during
March, which will use all available capacity. If the
government order is accepted, 500 units normally sold to
regular customers will be lost to a competitor. The
contract given by the government would reimburse the
government share of March production costs, plus pay a
fixed fee(profit) of $275,000. What impact would
accepting the government contract have on March
income?
If government contract is accepted: income from
government = 500 x unit contribution
= 500units x $2,280/unit = $1,140,000
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Profit from fixed fee = $275,000

Fixed manufacturing cost prorated =
($660/unit) x 3000 units x 500units / 4000
units = 990,000,000/4000 = $247,500
Differential income = income - profit fixed fee prorated fixed manufacturing costs
= 1,140,000 - $275,000 - $247,500
= -$615,500
If the government contract is accepted, the
negative differential income (-$615,500) in
question 3 analysis indicates a loss, suggesting
a bad deal. Therefore, I would suggest turning
down the government offer.

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4.Hospital Supply has an opportunity to enter a

foreign market in which price competition is keen.
An attraction of the foreign market is that demand
there is greatest when demand in the domestic
market is quite low; thus, idle production facilities
could be used without affecting domestic business.
An order for 1,000 units is being sought at a
belownormal price in order to enter this market.
Shipping costs for this order will amount to $410
per unit, while total costs of obtaining the contract
(marketing costs) will be $22,000. Domestic
business would be unaffected by this order. What
is the minimum unit price Hospital Supply should
consider for this order of 1,000 units?

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Hospital Supply has an opportunity to enter a

foreign market in which price competition is keen.
An attraction to the foreign market is that demand
there is greatest when the demand in the
domestic market is quite low. Thus, idle
production facilities could be used without
affecting domestic business. An order for 1,000
units is being sought at a below-normal price in
order to enter this market. Shipping costs for this
order will amount to 410 per unit, while total costs
of obtaining the contract will be $22,000.00.
Domestic business would be unaffected by this
order. What is the minimum unit price Hospital
Supply should consider for this order of 1,000
units?
15

The minimum price to be considered = variable

manufacturing costs plus shipping costs plus
marketing cost. With marketing cost/unit =
$22,000/1,000 = $22.
Then the minimum acceptable price equals
($550 + $825 + $420) + $410 + $22 = $2,227/
unit.
At this price, there will be no profits. There are
definitely advantages in selling in foreign market
such as new market opportunity which could
increase sales. However, fluctuation in
currencies should be closely watched as well as
shipping costs that could change from time to
time.
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5. An inventory of 200 units of an obsolete

model of the hoist remains in the
stockroom. These must be sold through
regular channels at reduced prices or the
inventory will soon be valueless. What is the
minimum price that would be acceptable in
selling these units?

17

An inventory of 200 units of an obsolete

model of hoist remains in the stockroom.
These must be sold through regular
channels at reduced prices or the inventory
will soon be valueless. What is the minimum
price that would be acceptable in selling
these units?

18

Other than variable marketing costs, other

costs related to the manufacture of these
200 units have been consumed. Therefore,
any selling price above the differential costs
would be automatically considered as an
income. Since the 200 units have to be sold
through regular channels at reduced prices,
the differential cost per unit = variable
marketing cost = $275 per unit. This price
corresponds to the break-even price just for
those 200 units.

19

6. A proposal is received from an outside contractor

who will make 1,000 hydraulic hoist units per month
and ship them directly to Hospital Supplys
customers as orders are received from Hospital
Supplys sales force. Hospital Supplys fixed
marketing costs would be unaffected, but its variable
marketing costs would be cut by 20 percent (to $220
per unit) for these 1,000 units produced by the
contractor. Hospital Supplys plant would operate at
two-thirds of its normal level, and total fixed
manufacturing costs would be cut by 30 percent (to
$1,386,000). What in-house unit cost should be used
to compare with the quotation received from the
supplier? Should the proposal be accepted for a price
(i.e., payment to the contractor) of $2,475 per unit?
20

A proposal is received from an outside

contractor who will make 1,000 hydraulic hoist
units per month and ship directly to Hospital
Supply's customers as orders are received from
Hospital Supplies sales force. Hospital Supply's
fixed marketing costs would be unaffected, but
its variable marketing costs would be cut by 20
percent for these 1,000 units produced by the
contractor. Hospital Supply's plant would
operate at 2/3 of its normal level. And total
fixed manufacturing costs would be cut by
30%. What in house units cost should be used
to compare with the quotation from the
supplier? Should the proposal be accepted for a
price of $2475.00 per unit?
21

In-house cost (as shown above) equals

$2,444 per unit. The proposal should not be
accepted since it would reduce total income
by $31,000.

22

7. Assume the same facts as above in Question 6

except that the idle facilities would be used to
produce 800 modified hydraulic hoists per month for
use in hospital operating rooms. These modified
hoists could be sold for $4,950 each, while the
variable manufacturing costs would be $3,025 per
unit. Variable marketing costs would be $550 per
unit. Fixed marketing and manufacturing costs would
be unchanged whether the original 3,000 regular
hoists were manufactured or the mix of 2,000 regular
hoists plus 800 modified hoists was produced. What
is the maximum purchase price per unit that Hospital
Supply should be willing to pay the outside
contractor? Should the proposal be accepted for a
price of $2,475 per unit to the contractor?

23

Assume the same facts as in problem 6 except that

the idle facilities would be used to purchase 800
modified hydraulic hoists per month for the use in
hospital operating rooms. These modified hoists
could be sold for $4,950 each, while the variable
manufacturing costs would be $3,025 per unit.
Variable marketing costs would be $550 per unit.
Fixed marketing and manufacturing costs would be
unchanged whether the original 3,000 regular hoists
were manufactured or the mix of 2,000 regular
hoists, plus 800 modified hoists was produced. What
is the maximum purchase price per unit that
Hospital Supply should be willing to pay the outside
contractor? Should the proposal be accepted for a
price of $2,475 per unit to the contractor?

24

Income with outsourcing = $17,010,000 ($4,290,000 + $7,220,000) - payment to

outsourcing company. Therefore, income =
$5,550,000 - payment to outsourcing co.
As we see in analysis for question 7 above,
with outsourcing, the income would be
$5,500,000 - payment to outsourcing co.,
while income without outsourcing is
$2,550,000. Therefore, the very maximum
payment to outsourcing company should
be: $5,500,000 - $2,550,000 = $2,950,000,
or $2,950/unit.

25

In contrast to the previous problem, the

proposed price of $2,475/unit is acceptable
since it is below the maximum acceptable
payment, which is $2,950.

26

Conclusion

This case, with the various problems,

provides an opportunity to determine
alternative results in order to capitalize on
profits taking in account costs and entity
total capacity. Important approaches and
terms are also emphasized: break-even
analysis, fixed costs, variable costs,
overhead costs, target profit, unit
contribution, differential income and
contribution percent.

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Prestige Telephone
Company

28

1.) Identify the costs that are relevant to the analysis to

discontinue Prestige Data Services:

Relevant costs in the analysis by Prestige Telephone Co.

Decision to discontinue Prestige Data Services include:
fixed costs which must be absorbed by the parent company
(Prestige Telephone Co.) upon shutdown; outstanding
Prestige Data Services debts; costs of retraining retained
employees; costs associated with outsourcing data
previously provided by Prestige Data Services; opportunity
cost of using space rented to Prestige Data Services ;
marketing costs attributed to acquiring additional Prestige
Data Services customers; costs of increasing promotional
activites of Prestige Data Services . In Addition, Prestige
Telephone Co. Should consider the qualitative cost of
reduced employee morale which may result upon shutdown
of Prestige Data Services.

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2. Justify why each of the costs in item 1 is relevant:

The costs listed above are all relevant because they each vary with
the shutdown decision.
- Fixed Costs which must be absorbed by the parent co. (Prestige
Telephone) upon shutdown: Payroll, billing, collections, and other
corporate services were provided by Prestige Telephone in return for
an amount from Data Services based on wages and salaries. These
fixed costs allocated to prestige Data Services must now be
accounted for by the parent company.
- Costs of retraining employees: If employees are retained by
Prestige Telephone, wages and salaries that were previously incurred
by the Data Services line will hit Prestige Telephones Budget. Also,
new skills will be required of employees retaine dby the company as
well as accompanying training expenses.

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- Costs associated with outsourcing data services previously provided by

Prestige Data Services: Prestige Telephone will still require the services
Prestige Data Services supply, thus will need to outsource them. Since
Prestige Telephone was using a price cap based on estimated data usage in
1999, they were effectively getting discounted data service rates from the
subsidiary. If Data Services is shut down, the company might incur much
higher service expenses.
- The maintenance cost is relevant because if Data Sevices is shut down
the company will no longer incur this costs, thus it needs to be considered as
a cost the parent company can eliminate.
- Opportunity cost of using space rented to Prestige Data Services: If
Prestige Telephone decides to shut down the Data Services Company, the
parent company will lose the $8,000.00 monthly rental fee paid by the current
subsidiary. Additionally, Prestige Telephone must consider the opportunity cost
of renting cost of renting the space to another company or service that may
provide them with more income.

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- If Prestige Data Services is shut down, marketing

costs attributed to acquiring additional Prestige Data
Services customers and promotional activities will no longer
be necessary.
- Termination of Prestige Data Services employees as a
result of shut down may reduce the morale of any retained
employees or employees of the parents company. Prestige
might experience decreased productivity or increased
turnover as a result.

32

3.) Identify the costs that are NOT relevant to the analysis to
discontinue Prestige Data Services:
Costs not relevant to the decision are sunk costs such as the
costs of training Prestige Data Services employees, investments in
the IT infrastructure, and any owned Prestige Data Services
Equipment. In addition, the fixed portion of the electricity costs is not
relevant. Depreciation costs are also not relevant.
The leases for computer equipment are non-cancelable and
therefore may be considered sunk costs because because Data
Services is expected to cover the costs associated with the leases
prior to being shutdown. However if Prestige Data Services is unable
to pay off the leases, these costs will become relevant because the
parent company, Prestige Telephone would be responsible for debts
owed.

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4.) Justify why each of the costs in item 3 is not relevant

Fixed cost: Costs of equipment and fixtures are incurred

whether or not Prestige Data Service continues to operate.
Even if the subsidiary company is shut down, these fixed
costs must still be taken into consideration.

Some costs, such as electricity, whether used or not, will be

charged for a certain basic amount every month and
therefore should not be considered relevant.

Depreciation is not relevant because cost of equipment is a

sunk cost. There is no significant salvage value for the
equipment.

34

5.) Identify the revenues that are relevant to the analysis to

discontinue Prestige Data Services:
Revenues relevant to the analysis to discontinue the
operation are commercial sales revenue which includes
computer use and other.
6.) Justify why the revenues in item 5 are relevant:
The revenues in item 5 differ across alternatives. In other
words, these revenues are directly tied to Prestige Data
Services. If the production capacity of Prestige Data
Services decreases to zero, all the revenue resulting from
these operations will also decrease to $0, which decreases
the subsidiarys contribution to its parent company.

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7.) Identify the revenues that are NOT relevant to the analysis to
discontinue Prestige Data Services.
The revenue of Prestige Telephone and the revenue from
intercompany Sales are not relevant to the decision.
8.) Justify why the revenues in item 7 are NOT relevant.
As we explained in item 6, all revenues from Prestige Data
Services will change depending on the decision. As the
production capacity is varied, all the revenues will vary. These
changes show the expected overall effect on net income.
Revenue at Prestige Data Service because Prestige
Telephones revenue is not tied to the operations of the
subsidiary.
From the perspective of the Parent Company, Intercompany
Sales are a revenue stream for the subsidiary, but an equal cost
to the parent, thus it doesnt affect the balance sheet of the
parent company.

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9.) Is Prestige Data Services really a problem to the parent company?

Prestige Data Services is not a problem to the parent company. This

is primarily because:
- Prestige Telephone will have to pay higher rates for services
previously provided by Prestige Data Services.
- Prestige Telephone will have to pay higher rates for services
previously provided by Prestige Data Services.
Regardless of possible sunk costs such as equipment
leases(95,000.00), Prestige Data Service positively contributes to the
parent company.
Additionally, if Prestige Data Services were to charge Prestige
Telephone the same rates ($800 per service hour) it charges for
commercial services, the company would not be operating at a loss.
If these commercial rates are considered competitive then the
subsidiary is saving its parent money.
Furthermore, there are several strategies that can be implemented
to increase the business value of Prestige Data Services, such as
reducing computer usage.

37

Prestige Data Services

Income Statement
For the months ended January 31, February 28 and March 31, 2003

Revenues
Intercompany sales
Commercial Sales
Net Revenue

January

February

March

$ 82, 400.00

$ 72, 400.00

$ 89, 200.00

107, 641.00

117, 184.00

123, 085.00

$ 190, 041.00

$189,584.00

$ 212, 285.00

$ 1, 633.00

$ 1,592.00

$ 1, 803.00

29, 496.00

29, 184.00

30, 264.00

9,031.00

8,731.00

10, 317.00

7, 909.00

7, 039.00

8, 083.00

15, 424.00

15, 359.00

15, 236.00

$ 63, 493.00

$ 61, 905.00

$65, 703.00

$ 126, 548.00

$ 127, 679.00

$ 146, 582.00

Less: Variables
Costs
Power
Wages & Sal.-Optns
Materials
Sales Promotions
Corporate Services
Total Variable Costs
Contribution
Margin

38

Prestige Data Services

Income Statement
For the months ended January 31, February 28 and March 31, 2003

January
Contribution Margin

February

March

$ 126, 548.00

$ 127, 679.00

$ 146, 582.00

$ 9, 240.00

$ 9, 240.00

$ 9, 240.00

126, 580.00

126, 580.00

126, 580.00

12, 000.00

12, 000.00

12, 000.00

9,000.00

9,000.00

9,000.00

11, 200.00

11, 200.00

11, 200.00

Total Fixed Costs

$ 168, 020.00

$ 168, 020.00

$ 168, 020.00

Net Income (Loss)

$ (41, 472.00)

$ (40, 341.00)

$ (21, 438.00)

Less: Fixed Costs

Space Costs
Equipment Costs
Wages & Salaries:
Systems Devpt &
Maint.
Administration
Sales

39