Chapter 19 : Making Short-run Profit Management Decisionsspartan.ac.brocku.ca/~pscarbrough/Chapters...

CHAPTER 19

MAKING SHORT-RUN PROFIT MANAGEMENT DECISIONS PAGE 1

Chapter 19 : Making Short-run Profit Management Decisions

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1. Identify the relevant profit elements for short-run profit management decision mak-ing.

2. Use incremental CVP analysis in special-order decisions, and discuss the qualitative and legal factors associated with setting prices.

3. Analyze scarce-resource situations.

4. Perform incremental CVP analysis for the make-or-buy decision, and discuss the qualitative factors applicable to such decisions.

5. Apply incremental CVP analysis to the sell-or-process-further decision.

6. Describe how incremental CVP analysis is used for decision making under conditions of uncertainty and risk.

INTRODUCTION

This topic is one of the most popular for instructors because it seems very important. After all, the whole idea of management-by-analysis makes it seem like it is really possi-ble to just make a few computations and then do the right thing. And, it seems very tech-nical and planned. The paradox of this subject is that it seems much more valuable than it is, and yet it forms much of the common language of business decisions. People say that accounting is the language of business, but really it is the material in this chapter that is the language of business. Marketing, accounting, finance and operations people very often talk with each other in terms of “break-even point” and “fixed cost”. Even so, that does not change the fact that this material is not very pragmatically useful on a day-to-day basis. One big reason is that there is no sense of “improvement” in this topic. If you look at any textbook or discussion of CVP analysis there is a strong assumption that no improvement is possible. In fact, that is actually in the definition of “short-run.” We know by having come this far in the book that this is not really true. Nonetheless, this

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topic is still important because of the extent that it is used in discussion and in profes-sional exams.

So, you need to regard this material as the most “business-like” of the older traditional techniques. As such it may be somewhat useful from time to time, but it will never be a core tool in world-class or Lean operations.

Traditionally, profit center managers are thought to be continually faced with the prob-lem of choosing among alternative courses of action. Although this was fairly rare, this chapter considers typical questions addressed by managers in these circumstances, such as the following:• What price should management set for special orders?• What if an insufficient amount of a component, used in multiple products, is available? Which products

should continue to be produced, and which should be temporarily stopped?• Should the enterprise make a component used in the manufacture of a product or should it buy the com-

ponent from an outside supplier?• Should the organization sell a product at some intermediate stage or should it process the product further?• How can the differential profits of various alternatives be calculated if outcomes are uncertain or probabi-

listic?

How successful the enterprise will be depends largely on whether it finds the right answers to decision problems like these. Relevant information about costs and revenues helps produce the right answers. In profit management information systems design, rele-vance and incremental CVP analysis are key factors. This chapter illustrates the use of these techniques in the following:• The special-order decision• The scarce-resource decision• The make-or-buy decision• The sell-or-process-further decision• Profitability analysis of uncertain and probabilistic outcomes

This chapter focuses primarily on short-run operational decisions. Short-run decisions are tactical, operating decisions that usually do not require significant and permanent resource commitments and involve a period of a year or less. In other words, short-run decisions involve only revenues, variable costs, and avoidable fixed costs. A second characteristic of short-run decisions is that they usually can be changed or reversed very quickly if more advantageous opportunities become available.

Generally, long-run decisions (sometimes referred to as strategic or capital project investment decisions) require large outlays of money, which increase fixed costs substan-tially. Net cash flow over several years and income tax considerations are important deci-sion criteria for long-run decisions (covered in Part V of this text). One of the major differences between short-run and long-run decisions is that for long-run decisions, the future net cash flows must be discounted to the present using an appropriate discount factor. For short-run decision making, the discount factor is ignored. In other words, unlike long-run decisions, short-run decisions do not include the time value of money.

Decision making, both short run and long run, is usually thought of as a rational process. Rationality implies that the decision maker seeks to optimize outcomes. A rational deci-sion-making process includes the following steps:

1. Identify and define the problem or need.2. Analyze the problem or need, and define the desired objective to achieve. 3. Identify and develop alternatives.

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4. Analyze and determine the consequences of each alternative. 5. Choose the best alternative.6. Implement the alternative.7. Review and evaluate the decision, and report on its progress.

This rational decision-making process is often performed under conditions of uncer-tainty and risk. Later, this chapter presents decision-making criteria for resolving deci-sions under these conditions. The roles of the management accounting system and the management accountant are to provide both the financial and nonfinancial information needed, facilitate and coordinate the gathering and use of information, and assure that proper decision-making techniques are employed.

IDENTIFYING RELEVANT PROFIT ELEMENTSLEARNING OBJECTIVE 1

Identify the rele-vant profit elements for short-run profit management deci-sion making.

Before any decision is made, the profit elements (sales volume, sales price, variable costs, contribution margin, and fixed costs) that are relevant to that decision must be identified. In order for profit elements to be relevant, they must possess two characteris-tics:• They must occur in the future.• They must be different for each alternative (“differential items”).

A SUNK COST IS NOT A RELEVANT COSTA sunk cost is a cost incurred in the past. Past decisions cannot be changed. Only new decisions can be made in the future. Consequently, costs already incurred because of a past decision should not affect a new decision. These costs cannot be refunded and the decision undone. Because the past cannot be changed, sunk costs cannot be changed; therefore, they are irrelevant to decisions involving future actions and alternatives.

For example, Snowski Company has 1,000 pairs of defective downhill racing skis. They have a standard absorptive manufacturing cost of $80 per pair. Since the skis already have been manufactured and the production costs spent, the $80 is irrelevant to a future decision about what to do with them. The skis cannot be “unmade” and the money “unspent.”

RELEVANT PROFIT ELEMENTS OCCUR IN THE FUTUREJohn Kali, an ex-Olympic downhill medallist and new manager of the Snowski product line, is considering what to do with the defects. If the skis are remachined at a (future) cost of $10 per set, they can be sold for $70 per pair. Alternatively, the defective skis can be sold now (as is) for $55 per pair. Which alternative is more desirable, and what are the relevant costs and revenues? John Kali's incremental CVP analysis comparing the two alternatives is presented in Exhibit 19-1. Snowski should remachine the defective skis, realizing a $5,000 increase in net profit, rather than sell the defective skis now.1

1. All profit calculations are pretax. See Chapter 18 for converting pretax profits to aftertax profits.


ANALYZING DIFFERENTIAL AND INCREMENTAL COST AND REVENUEIn addition to pertaining to the future, a relevant item must differ among the alternatives being considered. All costs and revenues that remain the same regardless of the decision should be removed from the analysis so attention can be focused on incremental cost and revenue and differential cost and revenue that influence the decision's outcome and the choice between alternatives. Incremental cost and revenue are profit elements unique to an alternative being considered. Differential cost and revenue are those profit elements that differ between alternatives. For example, in Exhibit 19-1, the sales price of $70 per pair and the additional manufacturing costs of $10 per pair for the rework option are incremental profit elements associated with that alternative. When comparing this alternative to the option of selling the defective skis now, the difference in sales price of $15 and the incremental variable costs of $10 are differential elements relevant to the choice between the two alternatives2.

The alternatives are analyzed by calculating the incremental and differential costs, cost savings, and revenues for each alternative and selecting the one offering the greatest eco-nomic and qualitative advantages. The Silver State Mining example will illustrate the irrelevance of future costs that do not differ between alternatives and the relevance of future costs that do differ. Silver State Mining is considering the purchase of a new labor-saving machine. The present cost structure without the machine and the expected cost structure with the machine are as follows:

The new machine promises a cost savings of $20 per ton in direct labor costs, but will increase fixed costs by $600,000 per period. Revenues, all other costs, and the total num-ber of tons produced, will remain the same. Therefore, the only relevant costs are the per-unit labor costs and the fixed costs associated with the new machine:

Exhibit 19-1 Snowski's Differential CVP Analysis

Sales price: Remachined $70

Sold now <55> $15Less variable costs <10>

Contribution margin per pair (CMU) $ 5

X Volume x 1,000 pairs of skisContribution margin and pretax profit $5,000

Note: = “the change in.”

2. Differential and incremental cost and revenue are the same when only one future alternative is compared with the status quo. For example, if the only alternative being considered is to sell the defective skis now for $55, then the decision is between throwing them away and selling them as defects. Throwing away defects is the current policy and, therefore, the status quo. The incremental revenue (the $55 sales price) is the only differential element between this alternative and maintaining the status quo. Incremental and differential cost and revenue are not the same when multiple future alterna-tives are considered, as demonstrated in Exhibit 19-2.

Present Costs Expected Costs With The New Machine

Tons of ore produced 100,000 100,000Sales price per ton $1,000 $1,000Direct labor cost per ton $300 $280Variable overhead per ton $200 $200Fixed overhead, other $1,200,000 $1,200,000Fixed overhead, new machine -0- $600,000

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This example focuses attention on the differential variable and fixed costs. It is one thing to define whether a cost is variable or fixed, but it is something else to determine how costs are related to decisions. At times, profit center managers are too quick to classify fixed costs as sunk. Fixed costs that have occurred in the past are sunk and are irrelevant to the decision, but other fixed costs-those that will occur in the future and are different between alternatives-are relevant. The $600,000 in fixed overhead (FOH) for the new machine will occur in the future if it is purchased and will not occur if the machine is not purchased. Thus, the $600,000 is both a future and a differential cost. Therefore, it is rel-evant to the analysis. The $1,200,000 in other FOH, though it will occur in the future, is not relevant because it is not different between the two alternatives. For a profit element to be relevant, it must be both a future and a differential item.

The management accountant must also consider the relevant range in incremental CVP analysis3. In periods of rapid sales growth, certain fixed costs behave as step costs; that is, if sales grow fast enough, fixed costs can change in total beyond the relevant range for the profit equation. Supervisory salaries, administrative and marketing costs, and rents are fixed costs that can increase quickly. Simply identifying these costs as fixed and not allowing for potential increases can lead to wrong decisions.

OPPORTUNITY COSTS AND BENEFITSAn opportunity cost is the differential benefit from another more profitable alternative that is given up when a less profitable alternative is chosen. Although opportunity costs are not recorded in the accounting system's general ledger, all decisions involving alter-native courses of action entail such costs. Considering opportunity costs forces manag-ers to recognize the potential profits foregone by not choosing a more profitable alternative. Opportunity costs and benefits also provide a means of ranking alternatives in terms of their opportunities to generate extra profits.

Continuing the Snowski example from Exhibit 19-1, if the defective skis are sold now, John Kali is giving up the opportunity to make another $5,000 in profits from remachin-ing them. The decision to sell the skis now has a $5,000 opportunity cost. However, John has identified another alternative. He considers Snowski to be a world-class manufac-turer and believes these defects should not have happened. Normally, these skis sell for $100 per pair. Selling them now or remachining them so they can be sold at a discounted price may hurt the company's quality image with its customers. Thus, neither of the orig-inal two alternatives may be a good idea. John's new alternative is to rework the skis to their normal quality at a cost of $50 per pair and then sell them at their normal sales price of $100. The three alternatives are compared in Exhibit 19-2a.

Which alternative should John choose? If profit is the only criterion, alternative 2 (rema-chining) generates $5 per pair ($5,000 in total for the 1,000 skis) more in incremental profit than alternative 3 (selling now as is), and $10 per pair more than alternative 1

Savings in direct labor costs (100,000 tons at a cost savings of $20 per ton) $2,000,000Less increase in fixed costs <600,000>Net cost savings expected with the new machine $1,400,000

3. The relevant range was first discussed in Chapter 7 and again in Chapter 18.


(rework). Therefore, alternative 3 (the second best alternative) has an opportunity cost of $5 per pair. Choosing this alternative means giving up the opportunity to have another $5 per pair profit, which is available if alternative 2 is chosen.

Similarly, by choosing alternative 1, John Kali will give up the opportunity to have another $10 per pair profit, which he can have by choosing alternative 2 instead. So, alternative 1 has a $10 per pair opportunity cost.

What about the most profitable alternative (alternative 2)? It cannot (by definition) have an opportunity cost because there is no better alternative that has been identified, at least in terms of profit. In fact, alternative 2 creates an opportunity to realize $ 5 per pair in additional profits over the next best alternative (alternative 3). Modifying the microeco-nomic idea of opportunity cost to aid profit management decision making, alternative 2 has an opportunity benefit of $ 5 per pair. Only the alternative with the greatest incre-mental profit has an opportunity benefit. All less profitable alternatives have an opportu-nity cost. The opportunity benefit of the best alternative is the differential profit between it and the second best alternative. The formulas for calculating opportunity costs and benefits are shown in Exhibit 19-2b.

John Kali did not choose alternative 2, though. Snowski is a world-class manufacturer, and selling inferior-quality skis (defects, whether remachined or not) is not congruent with its product quality goal. Snowski's customers consider its skis to be the best, not cheap seconds. John chose alternative 1, even though it has an opportunity cost of $10 per pair ($10,000 in total).

John discussed his choice with his boss, arguing that the marginal utility of maintaining a high-quality image is greater than the marginal utility for the differential profits of $10,000 that could be realized by choosing alternative 2 instead of alternative 1. His boss was impressed with how John quantified and measured the concept of marginal utility. Though the boss's marginal utility for another $10,000 was greater than her marginal utility for maintaining a quality image, she respected John's decision.

Exhibit 19-2 Snowski's Opportunity Costs and Benefitsa

a.Note: The best alternative is defined as the alternative with the greatest incremental profit.

a.Opportunity

Alternatives: Sales price - Variable costs = Profit Benefit <Cost>

1: Rework $100 - $50 = +$50 per pair <$10> per pair2: Remachine $70 - $10 = +$60 per pair $5 per pair3: Sell now $55 - $0 = +$55 per pair <$5> per pairb.

Opportunity benefit: The incremental profit of the best alternative less the incremental profit of the second best alternative.

Opportunity cost: The incremental profit of this alternative less the incremental profit of the best alternative.

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THE SPECIAL-ORDER PRICING DECISIONLEARNING OBJECTIVE 2

Use incremental CVP analysis in special-order deci-sions, and discuss the qualitative and legal factors associ-ated with setting prices.

One of the primary responsibilities of a profit center manager is the setting of sales prices. There are three types of price-setting decisions:• Normal pricing for the sales forecast volume• Special sales order pricing• Pricing of products sold between profit centers within the same enterprise

The first two types of pricing decisions are considered next. The third, called transfer pricing, is reserved for Chapter 21.

The long-run pricing of products and services for the general marketplace is a complex process. Cost is only one factor to be considered. Other factors that are often more important include competitors' prices and customers' desires. Costs, however, play an important and direct role in pricing special orders.

Sometimes a company receives an order for a standard product but is asked to quote a special, one-time only price. To get this business, a company often finds itself engaged in competitive bidding that it otherwise would not do. A special-order decision then involves the sale of normal or customized products at a discounted or special price. Most management accountants believe that such problems can be efficiently solved by the contribution margin approach to CVP analysis.

SPECIAL-ORDER DECISION WHEN IDLE CAPACITY EXISTSIf idle capacity4 exists, the lowest price that can be quoted for a special order must cover its incremental costs. In this case, the order will yield zero profit. The minimum price, then, is a break-even price for the special order. Normal fixed costs are not relevant to pricing special orders when sufficient idle capacity exists to fill the order, because the fixed costs will be incurred whether the order is accepted or not. When there are no dif-ferential fixed costs associated with a special order, the sales price only has to recover the variable costs. In other words, the minimum acceptable sales price, or the break-even price on the order, is the price that creates a zero contribution margin per unit (CMU). Any additional revenue in excess of the variable costs will increase profits. This increase is equal to the CMU multiplied by the sales volume involved in the special order.

In considering a special order that will allow a company to make use of current idle capacity, the relevant costs are direct materials, direct labor, variable overhead, and any incremental selling or administrative expenses. Depreciation, as well as other fixed costs, are irrelevant because these costs will be incurred whether the company takes the special order or not. In the Storagetek case on the next page, review how management sets the price on data storage drives.

4. Idle capacity means that the enterprise is not producing at its maximum, full capacity level. It has some surplus capac-ity available that can be used to make more products if there is a demand for them.


In negotiating a price for the special order, Storagetek should set the minimum selling price so that it is equal to the incremental costs associated with the special order:

In considering overhead, only VOH is included in the incremental costs because FOH will be incurred regardless of whether the order is accepted. The minimum sales price of $17 yields a zero CMU. At this price, Storagetek just breaks even on the order.

What if Storagetek wants to increase its operating income by $40,000 from this special order? The $40,000 averages $2 per tape drive unit ($40,000 / 20,000 units). Thus, the sales order must generate a $2 CMU, and a sales price of $19 should be charged. The minimum (break-even) price of $17 just covers variable costs, generating zero CMU and profit. With a profit goal of $40,000, an increase in selling price of $2 per unit is neces-sary. Therefore, the minimum price of $17 plus $2 will give a selling price that covers all variable costs and contributes $2 per unit to operating profit. This can be calculated by using the profit equation in its factored form and solving for volume:

Target sales volume = ( (Fixed costs + Profit) / CMU

20,000 units = ($40,000 + $0) / CMU

CMU = +$2 per unit

SPECIAL-ORDER DECISION WHEN NOT ENOUGH SURPLUS CAPACITY EXISTSIn some cases, a firm may not have enough capacity to manufacture the special order and still continue normal production levels. The Metalcraft case on page 883 illustrates this situation.

Should the special order from Oxnard be accepted? The following calculations show that Metalcraft does not have the necessary plant capacity in the third quarter to produce the special order for 20,000 toolboxes from Oxnard:

The machine hours required to produce this special order (volume x standard machine hours) are calculated as follows:

Direct materials $10Direct labor 4Variable overhead 2Distribution cost 1Incremental cost per unit $17

INSIGHTS & APPLICATIONS

Storagetek s Pricing of a Special Order When Idle Capacity Exists

Storagetek, a manufacturer of computer auxiliary storage devices, received a special order for 20,000 magnetic tape drive units from the public school system in its community. As part of its long-range strategic perspective, Storagetek views the com-munity as an important stakeholder. Realizing the financial con-dition of the school district, management wants to make a concession in its normal sales price.

Storagetek normally sells its magnetic tape drive units for $40 each. Incremental distribution costs for this order will be $1 per unit. Storagetek has sufficient existing capacity to manufacture the additional units. Storagetek's standard absorptive manufac-turing cost, based on a production quota of 300,000 units, is as follows:

Direct materials $10

Direct labor 4

Fixed overhead 3

Variable overhead 2

Total = $19

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Required Mhr = 20,000 toolboxes x 3 Mhr per toolbox = 60,000 Mhr

The Oxnard order for 20,000 toolboxes will require 60,000 machine hours, but only 48,000 machine hours are available in the third quarter. To accept this order, Metalcraft will have to give up making regular toolboxes for normal sales so that the extra machine hours required for the Oxnard order are available. What if Metalcraft diverts 12,000 machine hours of regular production to produce the special order? In this case, 4,000 toolboxes of normal production and sales will have to be sacrificed (12,000 machine hours needed - 3 standard machine hours per toolbox). From an economic viewpoint, is this a proper decision? As Exhibit 19-3 shows, a $30,000 opportunity cost is associated with this special order.

Even if this special order would produce an opportunity benefit, appropriate profit man-agement requires consideration of other factors before accepting the order. Giving up normal sales, even though only in the short run, raises the potential for customer ill will. In other words, normal customers may purchase from a competitor of Metalcraft. The loss of normal customers is more serious in situations where products have a short cus-tomer use life and resales to the same customers (repeat business) are important. For example, a dairy products company will sell milk, butter, and cheese to the same cus-tomers over and over again. If these customers purchase from a competitor because a special order has cut off the normal supply, then future sales may also be lost. If the company loses market share permanently, fixed costs per unit will increase, and man-

Monthly plant capacity 80,000 MhrEstimated monthly capacity use (based on production quota: 80,000Mhr x .80)

<64,000> Mhr

Excess capacity per month 16,000 MhrPeriod for special order (third quarter) x 3 monthsTotal excess capacity available 48,000 Mhr


Metalcraft's Special- Order Decision When Not Enough Capacity Exists

Metalcraft manufactures a toolbox for do-it-yourself mechan-ics. Metalcraft has received a special-order inquiry for 20,000 toolboxes from Oxnard Corporation, a large chain of hardware stores based in Europe. The toolboxes are to be manufactured during the third quarter. The toolboxes will be marketed under Oxnard's own label. Oxnard has offered Metalcraft $60 per tool-box for the 20,000 toolboxes to be delivered by October 1.

The selling price and standard cost card for regular tool-boxes are as follows:

Regular sales price per toolbox $95.00

Standard costs per toolbox:

Direct materials $25.00

Direct labor ($6.00 x 5 labor hours) = 30.00

Variable overhead ($1.50 x 3 machine hours) = 4.50

Fixed overhead = ($2.50 x 3 machine hours) 7.50

Standard absorptive manufacturing cost $67.00

In addition, Metalcraft normally incurs $10.50 per tool-box in variable selling expenses. No incremental selling or administra-tive expenses are expected with this special order, though. Oxnard has specified the use of plastic instead of metal for cer-tain components of the toolbox. Because of these different spec-ifications, direct materials will cost $22 instead of $25 per toolbox. Management has estimated that the remaining costs, labor time and machine time, will be the same.

Metalcraft's production capacity is limited to the total machine hours available, which is 80,000 machine hours per month. Management estimates that the plant will be operating at 80 per-cent of full capacity during the third quarter.


agement may be tempted to raise normal sales prices to compensate for the reduced vol-ume. This price increase may drive more customers to the competition, which, in turn, may prompt management to continue to raise prices as volume drops and fixed costs per unit increase. Thus, a vicious circle is created that could, in the long run, drive the firm out of business.

Consider the effect on Metalcraft's competition. As customers flee to Metalcraft's com-petitors, the competitors's volume increases. Consequently, they can reduce sales prices (because their fixed costs per unit will go down) while maintaining the same total contri-bution margin. As their prices drop, more customers may leave Metalcraft for the compe-tition's products. In the long run, the result may be a further decline in the competitors' prices. Even more customers may leave Metalcraft, accelerating the loss of its market share and eventual exit from the business.

While this scenario is extreme, it illustrates the need to consider customer satisfaction (a characteristic of a world-class manufacturer) and the possible effects on long-run sales from accepting a special order when insufficient surplus capacity exists.

SPECIAL-ORDER DECISIONS WHEN DIFFERENTIAL FIXED COSTS ARE INCURREDSpecial orders can require special equipment, special product (or packaging) design work, special shipping, and other unique activities that will create an incremental fixed cost for the special order. In such cases, these fixed costs are relevant to the special-order decision. The Magic Keyboard case illustrates this situation.

Exhibit 19-3 Metalcraft's Special Order When Insufficient Capacity Exists to Fill It

Contribution margin from special order: Sales price $60.00Less incremental variable costs: Direct materials $22.00Direct labor ($6.00 x 5 labor hours) 30.00Variable overhead ($1.50 x 3 machine hours) 4.50 <56.50>CMU $ 3.50Total contribution margin ($3.50 x 20,000 toolboxes) $ 70,000Opportunity cost because of lost regular sales: Regular sales price $95.00Less variable costs: Direct materials $25.00Direct labor 30.00Variable overhead 4.50Selling expenses 10.50 <70.00>Normal CMU $25.00Total opportunity cost ($25.00 x 4,000 regular toolboxes) <100,000>Net opportunity benefit <cost> of accepting special order <$ 30,000>

Incremental CVP analysis: Special-order CMU $ 3.50

x Volume X 20,000

Contribution margin on special order $ 70,000

Less CM lost from normal sales ($25 x 4,000 toolboxes) < 100,000>Net contribution margin and net Profit <$ 30,000>

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This analysis is presented in Exhibit 19-4. The Worldwide order should be rejected because it is unprofitable in the short run with the present price and cost structure. But what sales volume or price will make this order acceptable? First, consider the break-even volume (BEP) necessary for this order:

BEP = Fixed costs / CMU = $50,000 / $5 = 10,000 keyboards

The BEP is the indifference volume for this order. If exactly 10,000 keyboards are ordered, there will be zero profit on the special order. More than 10,000 keyboards will generate an incremental contribution margin and profit of $5 per keyboard (the CMU). If less than 10,000 keyboards are ordered, this order will be unprofitable at a rate of $5 per keyboard below the BEP. In this example, the order is for only 8,000 keyboards. This creates a loss of $10,000 (2,000 units below BEP x $5 per unit).

What is the minimum acceptable sales price for this special order? This question is also conceptualized as a BEP question:5

Exhibit 19-4 Magic Keyboard's Special Order Containing Differential Fixed Costs

Contribution margin from special order: Price offered per keyboard $82Less incremental variable costs per keyboard: Direct materials $35Direct labor ($8 x 4 hours) 32Variable overhead ($2 x 5 machine hours) 10 <77>Contribution margin per keyboard (CMU) $ 5Total contribution margin ($5 x 8,000 keyboards) $ 40,000Less differential fixed costs of order: Setup costs $20,000Special machine 30,000 <50,000>Net loss of accepting special order <$10,000>Incremental CVP analysis: Special-order CMU $5x Volume x 8,000

Contribution margin on special order $40,000

Less fixed costs <50,000>

Net profit <$10,000>


Magic Keyboard's Special-Order Decision When Differential Fixed Costs Are Incurred

Magic Keyboard makes keyboards for personal computers. It has received a special-order inquiry from Worldwide Corpora-tion, a manufacturer of personal computers to be marketed in China, The order calls for 8,000 keyboards containing Chinese characters. The standard absorptive manufacturing cost for this keyboard is as follows:

Direct materials $ 35

Direct labor ($8 x 4 labor hours) 32

Variable overhead ($2 x 5 machine hours) 10

Normal fixed overhead ($6 x 5 machine hours) 30

Standard absorptive manufacturing cost $107

In addition, Magic Keyboard will incur $20,000 in special setup costs and will have to purchase a $30,000 special machine to manufacture the keys containing Chinese characters. This machine will be discarded once the special order is completed. Should Magic Keyboard accept an offer of $82 per keyboard from Worldwide?

5. In this situation, the BEP is given, and the equation is solved for the CMU.


BEP = Fixed costs / CMU

= 8,000 keyboards = $50,000 / CMU

Therefore, CMU = $6.25 per keyboard

CMU will have to increase by $1.25 over the original CMU of $5.00 projected in Exhibit 19-4. If variable costs cannot be reduced, then the sales price will have to be increased from $82.00 per keyboard to $83.25. In the absence of overriding qualitative factors, the order should be rejected if volume or sales price cannot be renegotiated to the minimum amounts calculated.

In the Snowski case earlier, John Kali chose a suboptimal profit alternative because of his desire to maintain Snowski's product quality image. Are there any qualitative factors in the Magic Keyboard case that might have a greater marginal utility to management than the marginal utility of the Worldwide order's opportunity cost? One factor may be the desire to enter this new foreign market on a long-run basis. Selling initially at a loss to gain permanent entry into this market may be justified within Magic Keyboard's mar-ket penetration strategy.

THE FULL COST APPROACH VERSUS THE CONTRIBUTION MARGIN APPROACH TO PRICINGThe preceding analyses are suitable for price setting in the short run, but the contribution margin approach (using incremental CVP analysis) may be inappropriate for long-run pricing decisions. An enterprise must recover not only its normal variable costs, but also its normal fixed costs if it intends to remain in business.

A general cost-based price-setting model can be illustrated as follows:

The full cost approach to price setting is based on absorption costing. The target sales price, if set at the ceiling, includes all variable costs, an allocation of fixed costs includ-ing marketing and administrative costs, and the desired profit. The major drawback to this approach is that fixed costs and profit are expressed on a per-unit basis. If volume changes, fixed costs per unit change inversely. Therefore, this model is only appropriate in short-term decisions when the volume is known (a fixed amount).

The contribution margin approach to price setting, starting with the floor price, provides the price setter with flexibility for setting prices within the pricing range. The main criti-cism levelled against the contribution margin approach is that it is not appropriate for set-ting normal sales prices (for the sales projection used in the master budget). Absorption costs are required in setting normal sales prices so that all costs can be recovered through sales prices, and the firm's profit goal realized.

The general model presents a range for setting sales prices that is bounded by a floor and a ceiling price. The floor price reminds the price setter that a special sales order can be priced as low as its variable cost per unit. This is the contribution margin approach to pricing. The ceiling price reminds the price setter that in order to cover fixed costs and realize the master budget profit goal, the normal sales price must be set for the products

Variable costs per unit $xxx (floor)+ Fixed costs per unit xxx

Pricing range+ Desired profit per unit xxx

Target sales price xxx (ceiling)

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included in the master budget's sales forecast. The normal price is based on an absorp-tive (full) cost including a target profit. Thus, the ceiling represents the price manage-ment must set on regular sales to achieve its profit goal.

Under what conditions can the price setter move toward the floor and set a price based on variable costs alone? Appropriate conditions include the following:• A company receives a special order that does not affect the attainment of normal sales volume, and fixed

costs truly will not change.• A company with idle capacity receives a special order that does not affect the attainment of normal sales

volume, as in the Storagetek case.• A company faced with stiff competition and tough competitive bidding situations may be willing to

forego profits in the short run in order to capture market share (penetration pricing) for long-run benefit.• Without the order, the lack of work will necessitate shutting down part of production, thus causing the

company to incur increased unemployment insurance, training costs if the skilled employees do not return after the layoff, and huge start-up costs after returning from a lengthy shutdown.

Using the contribution margin approach for short-run decision making generates more meaningful information for management such as the relationship of the variable and fixed costs to volume and profit, as described in Chapter 18. This approach permits man-agement to determine the impact that volume changes, resulting from price adjustments, will have on net profit.

One area where the full cost approach to price setting is frequently used, however, is in government contracts. Here, the full cost includes administrative costs along with an allowable profit margin. Similarly, most utility commissions use the full cost approach in setting rates. Many utility companies are publicly owned and must provide an ade-quate return to their stockholders in order to generate future expansion capital. Finally, companies use the full cost approach (at least as a starting point) when considering long-term pricing of new products.

CONSIDERING QUALITATIVE AND LEGAL FACTORS WHEN SETTING PRICESManagement must also consider certain qualitative and legal factors when setting prices. What will be the impact on regular customers if they find out that other customers, some of whom may be their competitors, received special prices? Will they take their business elsewhere? How will competitors react? Will special pricing spark a price war?6

What about legal ramifications? When setting prices, management must take care to abide by certain legislation such as the Robinson-Patman Act, in the United States, which forbids quoting different prices to competing customers unless the difference in price can be traced directly to differences in manufacturing, selling, or distribution costs. The prices used in enforcing the act are based on full costs. Thus, a price difference can-not be justified by omitting the fixed overhead for special orders in cases where excess capacity exists. Most price differences are justified on the basis of marketing and trans-portation cost variations rather than on FOH costs.

6. In many industries, it may be difficult to keep a special price a secret. In the Metalcraft and Magic Keyboard cases, however, the orders involved foreign markets. If the two firms are otherwise only in domestic markets, these foreign cus-tomers may not compete with current customers.


Also, pricing is subject to antidumping laws in many foreign markets. These laws are designed to protect a domestic manufacturer in its home market in instances where it is in direct competition with a foreign supplier. Therefore, the price setter has to charge a “fair” price for goods being shipped abroad.

In addition to making decisions about sales prices and special orders, profit center man-agers are responsible for different types of production decisions involving the following:• Scarce resources• Making or buying components• Selling or further processing of components

Each of these decisions will be considered in turn.

THE SCARCE-RESOURCE DECISIONLEARNING OBJECTIVE 3

Analyze scarce-resource situations.

The scarce-resource decision involves choosing which product to produce when there is a shortage of a component part used in more than one product. Management at Quick-Calc, Inc., faces such a decision (see p. 888).

QCI should produce the product that has the highest contribution margin per unit of the scarce resource. As Exhibit 19-5 shows, the company should produce desktop calcula-tors. For every chip used in producing desktop calculators, QCI will realize $5 in contri-bution margin. In the short run, this will be the most productive use of this scarce resource.

Maximizing short-run profit should not be the only decision criterion, though. QCI should consider whether any customers will be lost if either of the other products is not available. This analysis also assumes that the products are heterogeneous in that the sales of one product line do not affect the sales of the other product lines. QCI management may also wish to consider the possibility of future supply shortages.

This last concern may involve the analyses presented in the next two sections. Continu-ing supply problems and/or internal and external failure costs for a component may lead management to consider making it instead of buying it.


QuickCalc's Supply

QuickCalc, Inc. (QCI), manufactures hand-held calculators, desktop calculators, and tablets. Each product uses a different number of standard computer chips.

QCI's JIT suppler is Entil. The Entil plant, located in Iowa, was recently damaged by a tornado, and QCI will not receive enough chips during the next month to support production of all three prod-uct lines. QCI management is considering which product line to con-tinue producing in the short run and which products to suspend temporarily. The following information is available within the man-agement accounting LAN:

Hand-held calculators: 4 chips with a CMU of 10 $/unit

Desktop calculators: 3 chips with a CMU of 5 $/unit

Tablets: 6 chips with a CMU of 24 $/unit

CHAPTER 19


THE MAKE-OR-BUY DECISIONLEARNING OBJECTIVE 4

Perform incremen-tal CVP analysis for the make-or-buy decision, and dis-cuss the qualitative factors applicable to such decisions.

The decision of whether to make a fabricated part or component internally, or to pur-chase it from an external supplier, is called a make-or-buy decision. For example, a division of General Motors may make headlights for its automobiles, or it may buy the headlights from one or more external suppliers.

As with all decisions, management must deal with both qualitative and quantitative fac-tors. Qualitative factors relate to the:• Quality of the component• Reliability of the supplier• Technical capability of the supplier• Financial strength and reputation of the supplier• Ability of the supplier to maintain confidential information that may otherwise be revealed to competi-

tors by the supplier• Impact on the morale of the enterprise's employees if the labor force is reduced• Type of contract entered into with the supplier, such as length of time and number of units

Quantitative factors relate to the:• Incremental production costs for each unit• Unit cost of purchasing from the supplier

Exhibit 19-5 QuickCalc's Scarce-Resource Decision

Chips' Standard Quantities Hand-held calculators Desktop calculators Tablets4 chips 3 chips 6 chips

Products' CMUs $10 per unit $15 per unit $24 per unit/ Chips’ standard quantities / 4 chips per unit / 3 chips per unit / 6 chips per unitContribution margin per unit of the scarce resource (per chip)

$2.50 per chip $5.00 per chip $4.00 per chip


Nextyme’s Make-or-Buy Decision

For the past five years, Nextyme has produced harddrives for its personal computers. Because material costs have steadily increased, Nextyme's management is reviewing the decision to continue to make the hard drives and has identified the following facts:

1. Nextyme's equipment used to manufacture harddrives has a book value of $500,000.

2. A $75,000 unsecured note is still outstanding on the equipment used to manufacture hard drives.

3. The space now used by the hard drives production department could be used by an assembly department.

Expanded assembly production will generate an additional $250,000 contribution margin annually.

4. Otherwise, the current facility will have to be expanded at a cost of $250,000.

5. Fifty employees who work in Nextyme's hard drives production department will be terminated and given eight weeks' severance pay if hard drives are purchased.

6. Cegate, a reputable manufacturer, produces harddrives of equal quality by a new efficient process.

7. Hard drives can be purchased from Cegate for $87.50 per unit.

8. Cegate is willing to sign a long-term contract and agree to JIT delivery.

9. Cegate has a large supply of a special chip that is in short sup-ply. This chip is critical in the production of hard drives.

10. Nextyme is planning on entering the educational market.


• Availability of production capacity to manufacture the components• Opportunity costs and benefits from using facilities for production rather than for other purposes

The above Nextyme case highlights both qualitative and quantitative factors relative to a make-or-buy decision. The relevant quantitative and qualitative factors are marked by an x in the following table:

Because of the factors involved in terminating employees, Nextyme's management should consider retraining them so that they can be used in the new expanded assembly production. If this decision is made, then the severance pay will not be paid. The employ-ees' salaries or wages will not be a differential cost because they will be paid under both alternatives. However, the retraining costs do become a relevant cost.

THE MAKE-OR-BUY DECISION WHEN NO SIGNIFICANT RESOURCE COMMITMENT IS INVOLVEDIn this section, no significant change in asset or capital commitment is associated with the decision of whether to manufacture the part or purchase it from an outside supplier. To illustrate the quantitative side of the make-or-buy decision, Wanderer management (see following Insights & Applications) is trying to decide whether to continue making 10,000 cooling units or buy them from Thermo, an outside supplier. Thermo can supply all the units needed and meet Wanderer's quality specifications.

The relevant cost of “making” the unit compared with the cost of “buying it” is shown in Exhibit 19-6. All the variable costs are relevant because they are also avoidable costs. The FOH standard cost ($20) multiplied by the production quota (10,000 cooling units) equals the budgeted FOH of $200,000 per year. If 70 percent is unavoidable ($140,000), then only 30 percent ($60,000) is avoidable and, therefore, relevant. If exactly 10,000 cooling units are made, then the average opportunity benefit from continuing production (versus buying the units from Thermo) is $10 per unit ($100,000 difference if bought 10,000 cooling units).

The analysis shown in Exhibit 19-6 can be done using just the differential amounts between the two alternatives, which are shown in the last (rightmost) column. Modern management accountants, confident in their abilities, will use the differential analysis at profit planning meetings to provide quick answers to such “what-if” questions. If profit managers want a hard-copy analysis or computer screen display, the management accountant should consider designing the three-column format in Exhibit 19-6. It may prove to be more understandable to the managers.

Facts Quantitative factors Qualitative Factors1. Book value - -2. Unsecured note - -3. Opportunity cost X -4. Expansion cost X -5. Employee terminations X X6. Supplier's reputation - X7. Price per unit X -8. Sales contract and JIT delivery - X9. Availability of chip - X10. Market strategy - -

CHAPTER 19


The 10,000 cooling units expected to be needed may not be the actual quantity needed next year. Seldom will the production quota and actual output be the same. At what vol-ume will Wanderer be indifferent between making and buying the units?

BEP = Fixed costs / CMU = $60,000 / $16 = 3,750 cooling units

If only 3,750 cooling units are actually needed, there will be no differential effect on profits from making them or buying them. The 3,750-volume level is the indifference volume between the two alternatives. If less than 3,750 units are actually needed, then buying the units is the more profitable alternative. If more than 3,750 units are needed, however, then making them is the more profitable alternative. Every time one more part is made (instead of purchased), Wanderer saves another $16. If another 6,250 units (10,000-unit production quota less 3,750 to “break even”) are needed, the company will save $16 on each, and differential profits will increase by $100,000 (the difference shown in Exhibit 19-6).

The 6,250 units expected to be needed above the indifference volume is a margin of safety of 62.5 percent. In other words, demand for cooling units would have to drop more than 62.5 percent before the decision to continue making cooling units becomes unprofitable.7

Exhibit 19-6 Wanderer's Make-or-Buy Decision

Make Buy Difference If Bought

Incremental variable costs(90+ $40 + $10) $140 $156 $16x Volume x 10,000 x 10,000 10,000

Total variable costs $1,400,000 x$1,560,000 $160,000

Contribution margin <$1,400,000> <$1,400,000> <$1,560,000> <$160,000>

Less fixed costs <-60,000> <-60,000>

Profit <$1,400,000> <$1,400,000> <$1,500,000> <$100,000>


Wanderer's Make-or-Buy Decision

Wanderer, Inc., makes recreational vehicles. For its yearly pro-duction, Wanderer needs 10,000 cooling units that it currently makes in-house. The following quantitative information is available:

Standard absorptive manufacturing cost to make one cooling unit:

Direct materials $ 90

Direct labor $40

Applied variable overhead $10

Applied fixed overhead 20

Total $160

Wanderer can buy the cooling units from Thermo (a maker of simi-lar cooling units) for a price of $156 per unit. Seventy percent of the applied fixed overhead will continue regardless of which decision is made. What should Wanderer do?

7. Margin of safety calculations were presented in Chapter 17.


If the facilities now being used to produce the cooling units would otherwise be idle, Wanderer should continue to produce its own cooling units. But suppose the new-prod-uct design group presents a proposal for a portable cooling unit for summertime campers who want to maintain the comforts of home. This new product, called KoolPac, will gen-erate an annual contribution margin of $300,000 and can be manufactured in the produc-tion department currently used to make cooling units. The analysis is presented in Exhibit 19-7. Now, continuing production of cooling units involves an opportunity cost. The original differential profits of $100,000 (Exhibit 19-6) are more than offset by the additional $300,000 in profits generated by Koolpac. If Koolpac can generate $300,000 in incremental profits, Wanderer will be $200,000 better off from buying the cooling units and making KoolPac products.

THE MAKE-OR-BUY DECISION WHEN A SIGNIFICANT RESOURCE COMMITMENT IS INVOLVEDIf the make-or-buy decision calls for investment in facilities necessary to make the part, extensive capital budgeting analysis is required. Such long-run asset commitments involve projecting cash flows and discounting them to their present value and then com-paring the net present value of the make alternative with those of other available projects. Also, tax consequences of the investment in the productive facilities have to be evalu-ated. These situations entail a long-run investment decision analysis that is not consid-ered in this chapter. Such decisions are covered in Part V.

MAKE-OR-BUY DECISIONS FOR SERVICESMake-or-buy decisions also are made for services, sometimes referred to as outsourcing. Outsourcing occurs when an organization decides to acquire a service from an external supplier rather than performing that service internally. For example, an enterprise may turn over its information systems hardware, software, and personnel to an outside ven-dor, which then supplies the information system as a service to the enterprise for a fee. The advantage of outsourcing is that it allows a vendor that specializes in a service to provide that service while the enterprise concentrates on its core business, focusing on what it does best. As an executive of Kodak said, “We're in the photographic, pharma-ceutical, and chemical businesses, not information system services. Therefore, we have outsourced all of these services.”

Another form of outsourcing is privatization, in which a service provided by local, state, or federal government agencies is changed from public to private control. Notwithstand-ing the political factors, the decision to privatize is similar to a make-or-buy decision.

Exhibit 19-7 Wanderer's Make-or-Buy Decision with an Alternative Use for Its Facilities

Make Buy Difference If BoughtIncremental variable costs ($90 + $40 + $10) $140 $156 $16x Volume x 10,000 x 10,000 x 10,000

Total variable costs $1,400,000 $1,560,000 $160,000

Contribution margin: From the change invariable costs <$1,400,000> <$1,560,000> <$160,000>

From KoolPac sales 300,000 300,000Net Contribution margin <1,400,000> <1,260,000> 140,000

Less fixed costs <-60,000> <-60,000>

Profit <$1,400,000> <$1,200,000> $200,000

CHAPTER 19


THE SELL-OR-PROCESS-FURTHER DECISIONLEARNING OBJECTIVE 5

Apply incremental CVP analysis to the sell-or-process-fur-ther decision.

The sell-or-process-further decision involves choosing whether to sell a marketable product at some intermediate stage or to process it further into a different (“final”) prod-uct. As a general rule, it will always be more profitable to continue processing so long as the incremental revenue from the sale of the final product exceeds the incremental pro-cessing costs to make it.

For example, should Wham-O (see p. 893) sell Quik-Gro or process it further into Quik-Kleen? Exhibit 19-8 presents this decision within a decision-tree format. The decision tree contains two types of nodes:• The square node represents a decision or action point. This is the action chosen by the decision maker.• The circle or oval node represents an event. In this case, events are incremental revenues.

The net advantage (opportunity benefit) of processing Quik-Gro further into Quik-Kleen is $5,000 per batch. The initial production costs incurred to produce Quik-Gro (direct materials and conversion costs) are irrelevant in deciding whether to process Quik-Gro further. These initial costs are incurred regardless of whether Quik-Kleen is produced and, therefore, are not differential costs.

In many industries with vertically integrated enterprises, such as oil and gas, the selling or further processing of joint products often becomes a short-run operational decision. Product mixes need to be adjusted in response to changing market demands, competi-tion, and volatility in raw material prices. Finding the most profitable mix given the cur-rent circumstances involves the sell-or-process-further analysis. For example, should raw crude oil be sold from the oil fields or processed further in the refining plant? If refined, should motor oil, gasoline, fuel oil, kerosene, or lubricants be made?

In deciding to process a joint product further, all costs previously incurred become sunk costs and are irrelevant.' These joint product costs are incurred prior to the stage at which processing can stop and the product can be sold. That is, joint product costs are irrelevant8 in decisions about what to do with a product from the split-off point forward. Relevant items are the future, differential costs that will be incurred and the future, dif-ferential revenue that will be generated as a result of subsequent processing into final


Wham' O's Decision to Sell or Process Further

Among its many products, Wham’ O produces a potash and ammonium compound, called Quick-Gro, in 10,000-gallon batches from a raw material that costs $1 per gallon.

Total conversion costs (direct labor costs plus applied overhead costs) are $4,000. This compound can be sold as a fertilizer ingre-dient to a large agribusiness distributor for $3 per gallon. Alterna-tively, Wham-O can process Quik-Gro further into an industrial cleaner, called Quik-Kleen, which can be sold for $6 per gallon. Quik-Kleen production requires additional conversion costs of $7,000 per 10,000-gallon batch. Also, 30 percent of the gallons of Quik-Gro will evaporate during processing.

8. Chapter 6 introduced joint products and presented methods for allocating joint production costs incurred prior to the split-off point. Because joint processing costs are sunk and are not relevant to the decision about what to do with the joint products, joint production cost allocations to the products are not necessary and are also irrelevant to the decision.


products. It will always be profitable to continue processing a joint product after the split-off point so long as the incremental revenue from the processing exceeds the incre-mental processing costs. This is demonstrated in the UNR Ranch case and Exhibit 19-9.

The first decision point is at “Time 0." The decision alternatives are to sell the pig for $100 or process it further into quarters. The students, with the help of a management accounting major, decided to process further based on the following analysis:

The costs of raising the piglet, incurred prior to the decision point (Time 0), are irrelevant as they have already been incurred and are sunk.

The second decision faced by the students is whether to sell the quarters at the split-off point (Time 1) or further process each quarter into its final products. They performed the same incremental CVP analysis for each quarter:

Processing quarter 4 has an opportunity cost, so the students decided to sell that quarter of the pig instead of processing it further. They did decide to process the first two quar-ters further, realizing differential profits of $250 ($100 + $150). Since it was close to summer break and they had a lot of other school work to do, they decided to sell quarter

Exhibit 19-8 Wham-O’s sell-or-process-further decision

sell Quick-Gro

10 000 gallons x $3/gallon

process further into Quick-Kleen

further processing costs = $7 000

7 000 gallons x $6/gallon

Quick-Gro processingcosts = $14 000

$30 000

$42 000

[$10 000 + $4 000]


UNR Ranch Pig Production

The School of Agriculture at the University of Nevada, Reno (UNR) owns many farms and ranches. Among them is the Pig Farm. UNR's Agricultural Experimental Station provides high-grade feed, and students raise high-quality pigs.

At the end of the spring semester, the students are faced with a deci-sion about what to do with the pigs they raised. Raising a piglet costs $75. The pigs can be sold to a local meat-processing plant for $100 each or processed further. Further processing first results in the pig being slaughtered and quartered. Joint processing costs to this split-off point are $200. The quarters can be sold to local casinos for use in their restaurants or processed further into ham, pork chops, sausage, and other end products. The current market prices for pig quarters and final products, along with the costs for processing each quarter further into its final products, are presented in Exhibit 19-9.

Revenues from further processing ($325 - $100) +$225

Less incremental costs from further processing <200>

Profit from further processing +$ 25

CHAPTER 19


3 rather than processing it into sausage. There is no opportunity cost or benefit from pro-cessing this quarter further.

However, the agriculture class in the previous fall semester decided to process quarter 3 further. Students are paid an hourly wage to work at the Pig Farm. It was close to Christ-mas, and they wanted the extra money (instead of the extra time off) from producing sausage. In situations that have no differential profit, profit managers may want to leave the further processing decision to their workers. At certain times, the workers may want the extra work and wages. At other times, they may prefer the time off.

QUARTER 1:Revenues from further processing ($300 - $100) +$200


Profit from further processing +$100



Profit from further processing +$150



Profit from further processing $0



Profit from further processing <$30>

Exhibit 19-9 UNR pig farm’s joint processing decision

$300

$400

$150

$100

$100

Q1 = $100

Q2 = $100

Q3 = $76

Q4 = $50

process into ham

costs = $100

process into pork chopscosts = $150process into sausagecosts = $75

process into pickled pigsfeet, ham hocks, etc.costs = $80

revenues total $325split-off pointtime 1

time 0

joint processingcosts = $200

raise piglet

cost = $ 75

sell now

pig


DECISION MAKING UNDER CONDITIONS OF UNCERTAINTY AND RISKLEARNING OBJECTIVE 6

Describe how incremental CVP analysis is used for decision making under conditions of uncertainty and risk.

Most decision models are formulated and solved assuming the availability of perfect information. This situation is generally referred to as decision making under certainty. For example, if the sales price per unit is forecast at $10 and variable cost is budgeted at $4, then the contribution margin is $6-no more, no less. The availability of uncertain information about decision alternatives leads to two other categories of decision-making situations:• Decisions under risk• Decisions under uncertainty

Decision making under risk involves situations in which information can be expressed in terms of probabilities. Under risk conditions, management recognizes that the bud-geted CMU, sales volume, and similar data are not known with certainty. Rather, they are random variables that can be represented in terms of probability distributions, even though their exact values are unknown.

Decision making under uncertainty involves situations in which no probabilities can be determined because outcomes and events are not known. Thus, from the standpoint of the available information, certainty and uncertainty represent the two extreme situations, and risk is the in-between situation.

Consequently, all decisions are based on some point along the decision-making contin-uum shown in Exhibit 19-10. At the left of the continuum are decisions where the out-comes are uncertain and no, or very little, information is available to aid the decision maker. Moving along the continuum from decisions under uncertainty to decisions under risk, the management accountant can use probabilities for the likelihood of the occur-rence of a particular event or outcome. At the far right of the continuum are decisions under certainty. Although all decision makers would normally like to be totally certain about the results of a decision, this is rarely the case in practice. The role of the modern management accountant is to prepare and present all relevant information including dif-ferent events that may occur and their associated probabilities.

DECISION MAKING UNDER UNCERTAINTYBobbi's Boutique demonstrates some of the uncertainties commonly faced by new entre-preneurs. The payoff table (or matrix) for Bobbi's swimsuit decision is shown in Exhibit 19-11. In a payoff table, the actions are listed on the left as rows, and the events (sales volumes) are listed at the top as columns. The payoffs (incremental contribution mar-

Exhibit 19-10 The Decision-making Continuum

decisions underuncertainty

little or noinformation

decisions underrisk

information basedon probabilities

decisions undercertainty

perfect information

CHAPTER 19


gins) for each action-event outcome are listed in the matrix cells; one payoff is associ-ated with each action-event pair.

If the number of swimsuits that will be sold during the season (the event in this case) could be known with certainty before the order is placed, Bobbi would have an easy time making the decision. For example, if the demand will be 150, then she would merely look down column V2 in the payoff table and choose the action that yields the highest payoff (which is $2,100 for A1) and order 300 swimsuits. In real-world situations, how-ever, profit center managers will not know with certainty which events will occur. Choosing the optimal decision in the face of uncertainty is the essence of the decision maker's problem. Some common criteria for choosing the “best” course of action follow.

MAXIMIN CRITERION. The maximin criterion maximizes the minimum profit of the various alternatives. This decision-making strategy entails “picking the best of the worst.” In other words, choose the action that has the highest incremental contribution margin (CM) associated with its worst outcome. The action of ordering 100 swimsuits (A1) provides the “maximum minimum” (maximin) payoff of $700 (A2's minimum pay-off is $0 and A3's minimum payoff is $600). The maximin criterion is an ultraconserva-tive criterion because it hedges against the worst thing that can happen.9

MAXIMAX CRITERION. The maximax criterion maximizes the maximum profit. Where maximin is overly pessimistic, maximax is super optimistic. Maxi-max chooses the action that produces the “best of the best.” Using this criterion, Bobbi would pur-chase 300 swimsuits in order to take advantage of the price discount, sell 200 during the summer season, and sell 100 at year-end, thus realizing a maximum profit of $3,600.

Exhibit 19-11 Payoff Table for Bobbi's Boutique

CMU calculations:

Normal sales:

A1 = $10 per suit ($60 sales price - $50 purchase price) if 100 ordered

9. If the payoff table contained costs (or losses) instead of profits, the maximin criterion would have to be reversed to minimax; that is, minimize the maximum cost.


Bobbi’s Boutique

Bobbi Ayarbe, the owner of Bobbi's Boutique, must decide how many women's swimsuits of a certain style to order for the summer season. This particular style must be ordered in batches of 100. If the order is for 100, the cost is $50 per swimsuit. If the order is for 200, the cost is $45 per swim-suit. If the order is for 300 or more, the cost is $38 per swim-suit. During the summer season, the selling price is

$60. Any swimsuits left unsold at the end of the season can be sold for $30 in an “end-of-season clearance sale.” Bobbi, new to the business and unsure about her customers' demand for this style of swimsuit, cannot estimate sales volume or even estab-lish a probability distribution of potential sales. So, based on her judgment, Bobbi picked sales volume of 100, 150, and 200. Clearly, she cannot sell more swimsuits than she orders. Often, customers buying swimsuits also purchase related products, such as hats, matching beach shoes, and the like. If Bobbi orders less than is demanded, she projects she will lose $3 in contribution margin from the sales of these related products for each swimsuit a customer wants to buy but cannot because it is out of stock.


A2 = $15 per suit ($60 - $45 purchase price) if 200 ordered A3 = $22 per suit ($60 - $38 purchase price) if 300 ordered

Year-end sales:

A1 = no year-end sales since only 100 suits orderedA2 =<$15> per suit ($30 sales price - $45 purchase price) if 200 orderedA3 = <8> per suit ($30 - $39 purchase price) if 300 ordered

The maximax criterion may be used by enterprises that can absorb the worst outcomes or by enterprises that need to “go for broke” to survive. This criterion is a high-risk strategy, as the recommended course is to choose the action that can yield the best outcome regardless of the other potential outcomes.

MINIMAX REGRET CRITERION. The minimax regret criterion focuses on the opportunity cost (“regret”) that might result from choosing a particular course of action. Regret is measured for a specific outcome as the difference between the best possible payoff and the actual payoff for each event. Using the minimax regret criterion, the deci-sion maker selects the action that minimizes the maximum loss (or regret) or maximizes the minimum payoff.

An enterprise that is struggling to survive may employ this decision criterion in order to reduce the chance of failure. The minimax regret criterion may also be used as a hedging strategy when minimizing losses is more important than maximizing profits. Minimax regret is a risk-averse decision criterion.

To use the minimax regret decision rule, the payoff table is converted to a regret table, as illustrated in Exhibit 19-12. Each entry in the payoff table is subtracted from the largest entry in its column. The result is the opportunity cost of that outcome. It is entered into the corresponding cell of the regret table. To illustrate this for cell V1A3 of the regret table:

Events (Sales Volumes)Actions V1

100 V2150

V3200

A1: Order 100 Swimsuits $1,000 $ 850 $ 700A2: Order 200 Swimsuits -0- 1,500 3,000A3: Order 300 Swimsuits 600 2,100 3,600

Table 1: Cell value calculations: ACMA1V1: CMU = $10, volume = 100 $1,000

A1V2: ($10 x 100 suits) - ($3 CMU lost x 50 suits excess demand) 850

A1V3: ($10 x 100 suits) - ($3 CMU lost x 100 suits excess demand) 700

A2V1: ($15 x 100 suits) + (<$15> x 100 sold at year-end) -0-

A2V2: ($15 x 150 suits) + (<$15> x 50 sold at year-end) 1,500

A2V3: ($15 x 200 suits) 3,000

A3V1: ($22 x 100 suits) + (<$8> x 200 sold at year-end) 600



CHAPTER 19


The largest entry in a column will have zero regret. The action yielding the highest incremental contribution margin for each volume (event) is the most profitable alterna-tive for that event. Thus, it has an opportunity benefit rather than an opportunity cost.

If Bobbi Ayarbe orders 100 swimsuits and the demand is 200, then her regret is $2,900 because she could have made $2,900 more by ordering 300 swimsuits had she known beforehand that demand would actually be 200 swimsuits. If, however, she had ordered 100 swimsuits and demand is 100 swimsuits, her regret is zero.

The optimum action is to order 300 swimsuits, which minimizes her maximum regret. This is shown in the table entitled “Maximum Regrets for Each Action” in Exhibit 19-12.

Exhibit 19-12 Minimax Calculations for Bobbi's Boutique

DECISION MAKING UNDER RISKWhen probabilities for various demand levels can be estimated, managers move into that portion of the decision-making continuum designated as decision making under risk. The probabilities are used to calculate the expected value of each action. The expected

Largest entry in column V1 of the payoff table $1,000Less cell V1A3 value from the payoff table <600>

Regret Table value for cell V1A3 $400

Payoff TableEvents

V1 V2 V3

ACTIONS 100 150 200A1: ORDER 100 SWIMSUITS $1,000 $ 850 $ 700

A2: ORDER 200 SWIMSUITS -0- 1,500 3,000A3: ORDER 300 SWIMSUITS 600 2,100 3,600

REGRET TABLEEVENTS

ACTIONS V1

100

V2

150

V3

200A1: ORDER 100 SWIMSUITS - $1,250 $2,900

A2: ORDER 200 SWIMSUITS $1,000 600 600A3: ORDER 300 SWIMSUITS 400 - -

MAXIMUM REGRETS FOR EACH ACTION ACTIONS MAXIMUM REGRETA1: ORDER 100 SWIMSUITS $2,900A2: ORDER 200 SWIMSUITS 1,000A3: ORDER 300 SWIMSUITS 400


value of an action is the weighted average of the payoffs for that action, where the weights are the probabilities of the various mutually exclusive events that can occur.

EXPECTED VALUE CRITERION. The expected value criterion involves the follow-ing steps:• Assigning a probability to each event with the probabilities summing to one• Calculating the expected value of each action by multiplying each incremental• Contribution margin by its corresponding probability and summing the results• Choosing the action whose expected value is the largest

To illustrate the calculations, assume Bobbi assigns the following probability distribution to the events based on past data, experience, and judgment:

Bobbi's expected values (profits) for each action are shown in Exhibit 19-13.

Exhibit 19-13 Bobbi's Boutique Expected Profits

Using the expected value criterion, she should order 300 swimsuits with an expected incremental contribution margin and profit of $1,650.

DECISION-TREE ANALYSIS. The preceding examples presented decision criteria for evaluating single-stage alternatives. No future decisions depended on the decision taken now. This section considers a multistage decision process in which dependent decisions

EVENT PROBABILITYV1: demand = 100 0.5V2: demand = 150 0.3V3: demand = 200 0.2

1.0

Action A1: Order 100 Swimsuits

Event Probability Profit Weighted ProfitV1: demand = 100 0.5 $1,000 $500

V2: demand = 150 0.3 850 255V3: demand = 200 0.2 700 140

1.0 $895Expected profit = $895

Action A2: Order 200 Swimsuits Event Probability ProfitV1: demand = 100 0.5 $ -0- $ -0-

V2: demand = 150 0.3 1,500 450V3: demand = 200 0.2 3,000 600

1.0 $1,050Expected profit = $1,050

Action A3: Order 300 Swimsuits Event Probability ProfitV1: demand = 100 0.5 $ 600 $300

V2: demand = 150 0.3 2,100 630V3: demand = 200 0.2 3,600 720

1.0 $1,650Expected profit = $1,650

CHAPTER 19


are made in tandem. The decision tree is a graphical tool that facilitates a multistage decision process. Each event in the decision process is shown by a separate branch of the decision tree. This graphical approach often helps to clarify a complicated decision problem. The decision tree helps profit center managers examine all possible outcomes and facilitates an orderly, rational process.

The decision tree, which is normally drawn from left to right, shows actions, events, and their resulting payoffs (in the final branches of the decision tree). The value (outcome) of each branch is multiplied by its probability of occurrence to determine the expected payoff of that particular branch's outcome.

The decision tree shown in Exhibit 19-14 summarizes Telstar's alternatives presented in the Insights & Applications on page 901. Telstar management assumes that VSAT sales will be either high or low. Starting with node 1, a decision point, management must decide whether to build a large factory or a small factory. Node 2 is an event with two branches representing the high- and low-sales outcomes. Node 3 is also an event with two branches representing high and low sales.

Telstar management will consider possible future expansion of the small factory only if sales over the first two year turns out to be high. This is the reason node 4 represents a decision point with its two branches; that is, the “expansion” and “no expansion” deci-sions. Again, nodes 5 and 6 are events with the branches emanating from each represent-ing high and low sales. The numbers at the end of the terminal branches represent the corresponding profits.

Exhibit 19-14 Decision Tree for Telstar’s Factory Capital Project

1

2

3

4

5

6

high sales (.50)

low sales (.20)

high sales (.80)

low sales (.20)

high sales (.80)

low sales (.20)

phase 2 [8 years]phase 1 [2 years]

expand(-$8 000 000)

do notexpandhigh sales

($6 000 000/year)[.80]

low sales (.20)

build full size factory(-$10 000 000)

build small factory(-$2 000 000)

$2 000 000/year

$6 000 000

$1 800 000

$400 000

$600 000

$400 000

$400 000


The alternatives are evaluated using the expected value criterion. The decision analysis process is performed by backward induction, which starts with the payoffs at the far right side of the decision tree and works backward to a decision point. Moving backward to an event node from which the different branches emanate, the expected value of that particular node can be determined. Continuing to work backward through the decision tree, the expected value of making a specific decision is next determined. Therefore, the calculations start at the end of phase 2 and move backward to phase 1. For the last 8 years, the two alternatives at node 4 are calculated as follows:• Expected profit with expansion (node 5)

= {[($1,800,000 x .80) + ($400,000 x .20)] x 8 years} - $8,000,000 = $4,160,000• Expected profit with no expansion (node 6)

= [($600,000 x .80) + ($400,000 x .20)] x 8 years = $4,480,000

Consequently, at node 4, the decision calls for no expansion and the expected profit is $4,480,000. This is shown in Exhibit 19-15. A double line is drawn through the “expand” branch (leading to node 5) to indicate it has an opportunity cost and, thus, is not the preferred alternative.

The phase 1 calculations corresponding to node 1 are as follows:

Expected profit with full-size factory (node 2)

= {[($2,000,000 x .80) + ($600,000 x .20)] x 10 years} - $10,000,000 = $7,200,000

- Expected profit with small factory (node 3)

= {[$4,480,000 + ($600,000 per year x 2 years)] x .80} + [($400,000 per year x 10 years) x .20] - $2,000,000 = $3,344,000

Thus, the optimal decision at node 1 is to build a full-size factory now. Its expected opportunity benefit is $3,856,000 ($7,200,000 - $3,344,000).


Telstar's Capital Project Alternatives

Telstar is planning on making very small aperture terminals (VSATs) for telecommunication applications. The company has the option of building a full-size factory, or a small factory now and then deciding two years from now whether it should be expanded.The metaphase decision problem arises because if Tel-star decides to construct a small factory now, another decision must be made in two years regarding expansion.The decision therefore involves two phases: Phase 1. A decision must be made now regarding the size of the factory. Phase 2. A decision must be made two years from now regarding expansion, assuming that Tel-star decides to construct a small factory now. Telstar, as part of its strategic planning process, is interested in studying the capital project decision over a 10-year period. A market survey indicates that the probabilities of high and low sales over the next 10 years are .80 and .20, respectively.

The immediate construction of a full-size factory will cost $10 million and a small factory will cost $2 million.

The expansion of the small factory two years from now is expected to cost $8 million. Alternatives and estimates of their associated annual profits are as follows:

-A full-size factory and high sales will generate profits of $2,000,000 annually. If demand is low, profits will be $600,000 annually.

-If a small factory is built now, Telstar will consider expansion only if sales for the first two years are high.

-An expanded small factory with high sales will provide profits of $1,800,000 annually. If demand is low, profits will be $400,000 annually.

-A small factory with no expansion and high sales will yield a profit of $600,000 for each of the 10 years.

-A small factory with no expansion and high sales in the first two years followed by low sales will generate a profit of $400,000 in each of the remaining eight years.

-The market survey indicates that if sales are low for the first two years, with a small factory they will remain low for the remaining eight years, producing a profit of $400,000 annually.

CHAPTER 19


SUMMARY OF LEARNING OBJECTIVES

The major goals of this chapter were to enable you to achieve six learning objectives:

Learning objective 1. Identify the relevant profit elements for short-run profit manage-ment decision making.

All revenue and cost information is relevant for profit management decision making except sunk costs, and revenues and costs that will not differ among alternatives. A machine can manufacture product A, which will provide revenue of $200,000, or it can be used to manufacture product B, which will provide revenue of $275,000. The differ-ential, and thus relevant, revenue is $75,000. An opportunity benefit results if the machine is used to produce product B, and an opportunity cost results if product A is made.

On the cost side, if the standard direct labor cost to make 10,000 products without a new machine is $150, but is $10 with the new machine, the differential (relevant) cost is $1,400,000 [($150 - $10) x 10,000 products]. This is then compared to the machine's cost to determine its opportunity cost or benefit. If future fixed costs are $500,000 with or without the machine, then the $500,000 is irrelevant.

Although they do not represent actual dollar outlays, opportunity costs do represent eco-nomic benefits that are foregone as a result of pursuing some course of action. There-fore, they are relevant in decision making. Care must be exercised not to overlook these costs as they should be part of the quantitative analysis.

For a student, the cost of studying on Saturday night may be the sacrifice of not going to a social event. The student hopes that the opportunity benefits from studying will have a greater marginal utility than going to the social event.

Learning objective 2. Use incremental CVP analysis in special-order decisions, and discuss the qualitative and legal factors associated with setting prices.

Exhibit 19-15 Decision Tree for Telstar’s Plant Expansion Project with Expected Values

1

2

3

4

5

6

build full-size factory

build small factory

expected value = $3 344 000

do not expand

expand

$7 200 000

$4 160 000

$4 480 000

$4 000 000


In determining whether to accept additional sales at a special price, management must consider productive capacity and the difference in revenue and cost caused by the new business. If the enterprise is operating at full capacity, the additional production may increase both fixed and variable manufacturing costs, or it may require giving up some normal sales. But if the current production volume is below full capacity, additional busi-ness may be undertaken without increasing fixed manufacturing costs. Therefore, with surplus capacity available, variable costs are usually the only costs to consider in decid-ing whether to accept or reject an order at a special price below the regular price.

In other situations, a special order may require incremental fixed costs to be incurred. If so, these fixed costs are relevant. When normal sales have to be given up because suffi-cient surplus capacity is not available, then the contribution margin lost on the sales given up also becomes relevant to the special-order decision.

Assume that a bicycle manufacturer is operating at 60 percent capacity. The standard absorptive manufacturing cost of the bicycle is $80, composed of $55 in variable costs and a standard FOH cost of $25. The regular price in the domestic market is $150. The manufacturer receives an offer from an exporter for 10,000 bicycles at a special price of $75. If the manufacturer accepts the offer, it will still be operating below full capacity. Pricing policies in the domestic market will not be affected, and no pricing laws, such as the Robinson-Patman Act, will be broken. Should the manufacturer accept the offer? Yes, because each bicycle will generate an incremental CMU of $20 ($75 special sales price less $55 in incremental variable production costs). Of course, if the order involves special shipping costs, these are also relevant.

One of the dangers of pricing an item below its regular price is that regular customers may take their business elsewhere. Also, various countries have passed antidumping laws, which impose duties on imported products found to have been sold in a particular country at less than fair market value. If the special price of $75 per bicycle will be viewed as an unfair price subject to antidumping penalties, the company should consider these penalties as well.

Learning objective 3. Analyze scarce-resource situations.

Scarce-resource situations arise when an enterprise does not have enough of a certain direct material, class of labor, or direct technology to produce the expected volume of multiple products using that resource. In these situations, if only one product is to be pro-duced until the shortage is over, it should be the product that yields the highest contribu-tion margin per unit of the scarce resource. This is calculated by dividing each product's CMU by the standard quantity of the scarce resource it uses.

This analysis is only valid, though, when sales of one product do not affect sales of the other products, and only one product is to be produced during the shortage. Qualitative factors should also be considered in this decision. Will some normal business be lost if the other products are temporarily discontinued? Is this shortage expected to be a tempo-rary or permanent problem? Is the industry so competitive that if the company loses busi-ness to competitors, they will be able to lower their sales prices and thus attract even more business away from this company?

Learning objective 4. Perform incremental CVP analysis for the make-or-buy decision, and discuss the qualitative factors applicable to such decisions.

CHAPTER 19


The decision of whether to produce a component of the company's final product inter-nally or to buy the part from a supplier is called the make-or-buy decision. In a make-or-buy decision, management considers only the costs relevant to the decision. if the total relevant costs of production are less than the cost of buying the part, it should be pro-duced in-house.

To illustrate, a company has been purchasing a part for $4, but the company has excess capacity and feels it can produce 60,000 parts per period at the following costs:

Total $Fixed costs are expected to increase by $10,000 per year if the part is made. The company, however, has an opportunity to let a small fabricator use these idle facilities for annual rent of $30,000. Should the company make or buy the part?

Based on this quantitative analysis, a $4,000 opportunity cost is associated with making the part. The future, extra FOH is relevant because it is different under the two alterna-tives. Also, the company would lose the annual rent of $30,000 if it chooses to make the part. Therefore, the $30,000 is treated as an opportunity cost of making the part.

As with all decisions, the company should consider qualitative factors, such as the fol-lowing when considering a make-or-buy decision:• Quality of the component• Reliability of suppliers• Technical capability of suppliers• Financial strength and reputation of suppliers• Confidentiality of sensitive information• Impact on employees if the enterprise turns to outside suppliers

In this case, the company may choose to make the part because the extra $4,000 cost is not as important as the increased control it will have over part quality and availability if it makes the part. In other words, better control over quality and delivery from making the part is more important (has a greater marginal utility) than the $4,000 differential cost involved.

Learning objective 5. Apply incremental CVP analysis to the sell-or-process-further decision.

In some manufacturing firms, a product can be sold at a certain point in the process (e.g., at its split-off point), or it can be processed further into a final product and sold. If the

Direct materials $1.50Direct labor 1.00Variable overhead 0.90

$3.40

CMU if made ($4.00 - $3.40) +$ 0.60

x volume x 60,000Contribution margin +$36,000

Less fixed overhead <10,000>

Opportunity cost of renting idle facilities <30,000>Profit if made <$ 4,000>


increase in revenue generated from processing is more than the additional processing costs, then further processing is advisable.

A slaughterhouse can sell 40,000 raw hams per year at an average price of $20 per ham at the point where hogs are butchered and sold to meat distributors, or the slaughterhouse can cure, cut, and package the hams and sell them for an average price of $38 per ham. The additional processing costs are $480,000. Should the hams be processed further?

There is a $240,000 advantage (opportunity benefit) to processing the raw hams further.

Learning objective 6. Describe how incremental CVP analysis is used for decision mak-ing under conditions of uncertainty and risk.

Decision making can be thought of as taking place along a continuum and can be catego-rized into three types depending on the information available:• Decision making under uncertainty• Decision making under risk• Decision making under certainty

A number of criteria for making decisions under uncertainty exist based on the assump-tion that no probability distributions are available. It is usually assumed that payoffs (or outcomes) can be calculated for each of the alternatives. The following criteria are used under such conditions:• Maximin criterion• Maximax criterion• Minimax regret criterion

In decision making under risk, outcomes can be expressed probabilistically. The expected values of outcomes can be calculated and expressed within decision trees to provide a graphic picture of single-stage and multistage decision problems. Many deci-sion-making situations can use the expected value criterion with good results. Moreover, this criterion is analytically simple, which makes it particularly appealing to decision makers.

IMPORTANT TERMS

Backward induction A form of decision-tree analysis, which works backward from the end branches of the tree diagram to the first decision fork and carries forward only the best action, each step of the way, while eliminating all inferior ones.

Decision making under certainty A situation in which the decision maker has perfect information.

Decision making under risk A situation in which the degree of knowledge about out-comes is expressed in terms of probabilities.

Decision making under uncertainty A situation in which probabilities of outcomes are unknown or cannot be determined.

Differential cost and revenue The costs and revenues that are different between alterna-tives. Differential elements occurring in the future are relevant to profit manage-

Revenues if processed further [($38 - $20) x 40,000 hams] $720,000

Incremental processing costs <480,000>

Profits from further processing $240,000

CHAPTER 19


ment decisions.Incremental cost and revenue The additional costs incurred and revenue generated

because of a particular alternative. Incremental elements that differ between alter-natives are relevant to profit management decisions.

Long-run decisions Decisions that affect asset investments and the long-run profit-abil-ity of an enterprise.

Make-or-buy decision A decision that compares the cost of producing a component or providing a service internally with the cost of purchasing the component or service from an external supplier.

Opportunity benefit The differential profit of the best (most profitable) alternative over the second best alternative.

Opportunity cost A potential benefit that is foregone because one course of action is chosen over another. It is the difference between the incremental profit of that alter-native and the incremental profit of the best alternative.

Outsourcing When an organization decides to acquire a service from an external sup-plier rather than performing that service in-house.

Privatization To turn over public properties and services to private enterprise. Profit elements The items that effect profit, which are composed of sales volume, sales

price, variable costs, contribution margin, and fixed costs.Relevant A term used to describe those costs and revenues that are pertinent to the deci-

sion-making process. Relevant profit elements occur in the future and differ between alternatives.

Scarce-resource decision A decision to produce one product while temporarily sus-pending the production of other products because of a shortage in a resource used in manufacturing those products.

Sell-or-process-further decision A decision that involves choosing whether to sell a marketable product at some intermediate stage or process it further into a different form to be sold at a later stage.

Short-run decisions Operational decisions that involve selecting an action that will have an impact on the enterprise over a relatively short time period. These deci-sions are usually fairly routine and do not require significant and permanent resource commitments.

Special-order decision A situation in which management is considering accepting a onetime sales order at a price below its normal sales price.

Sunk cost A cost already incurred. Because it has already happened, it cannot be changed. Sunk costs are irrelevant in calculating the differential profitability of future alternatives.

DEMONSTRATION PROBLEMS

DEMONSTRATION PROBLEM 1 Determining relevant qualitative and quantitative factors.

Magna Company produces motors that fit into its main product line of landscaping equipment. Because material costs have steadily increased, management is reviewing


the decision to continue making these motors. The management accountant has identi-fied the following facts:

1. The equipment used to produce the motors has a book value of $400,000.2. The space now occupied by the motor manufacturing department could be used for

storage, thereby eliminating the current need to rent storage space.3. Management is planning on opening a market in Kansas.4. Comparable motors can be purchased from an outside supplier for $100.5. The outside supplier will sign a long-term contract and a nondisclosure agreement. 6. The people who work in the motor manufacturing department would be discharged

and given four weeks' severance pay.7. A $100,000 promissory note is still outstanding on the equipment used in producing

the motors.

Required: Indicate by number the relevant qualitative and quantitative factors.

Required: Calculate the expected value of the decision at node 1.

SOLUTION TO DEMONSTRATION PROBLEM 2

Expected value of making the parts (node 2)

= ($250,000 x .7) + ($150,000 x .3) - $130,000= $90,000

Expected value of buying the parts (node 3)

= ($120,000 x .7) + ($40,000 x .3)= $96,000

Solution To Demonstration Problem 1Relevant Qualitative Factors Relevant Quantitative Factors- 24 45 -6 6

decision events contribution margins

makeorbuy

make

buy

high (.70)

low (.30)

high (.70)

low (.30)

(-$130 000)

-0-

$250 000

$150 000

$120 000

$40 000

1

2

3

CHAPTER 19


The largest expected value (contribution margin) is achieved if the parts are bought from the outside supplier.

DEMONSTRATION PROBLEM 3 Sell-or-process-further decision.

Viking Processors makes three products from a single direct material input. Cost and revenue data are as follows:

Required:

Determine which products should be sold at the split-off point and which should be pro-cessed further.

SOLUTION TO DEMONSTRATION PROBLEM 3 Analysis of the sell-or-process-further decision:

This analysis shows that products A and C should both be processed further. Product B should be sold at the split-off point. Allocated joint costs are irrelevant because they are sunk.

DEMONSTRATION PROBLEM 4 Special-order decision.

Parker Company sells its product at a price of $30 per unit. Parker's standard absorptive manufacturing cost based on a capacity of 200,000 units is as follows:

Parker received a special order for 20,000 units from a foreign distributor. The only dif-ferential selling costs that would be incurred on this order would be $3 per unit for ship-ping. Parker has sufficient existing capacity to manufacture the additional units.

Required:

a. Determine the minimum selling price that Parker should set for the special order.b. Determine the selling price that should be set if Parker's targeted profit on the special

order is $100,000.

ProductA B C

Sales value at the split-off point $150,000 $120,000 $ 80,000Sales value after further processing 230,000 160,000 100,000Allocated joint costs 100,000 90,000 40,000Costs of further processing 60,000 50,000 10,000

ProductA B C

Sales value after further processing $230,000 $160,000 $100,000Less sales value at the split-off point <150,000> <120,000> <80,000>Incremental revenue from further processing $ 80,000 $ 40,000 $ 20,000Less cost of further processing <60,000> <50,000> <10,000>Incremental profit (loss) from further processing $ 20,000 <$ 10,000> $ 10,000

Direct materials $ 6Direct labor 4Overhead (60% is fixed) 10Cost per unit $20



a. The minimum selling price should be equal to the incremental costs associated with the special order. The incremental costs are as follows:

Thus, the minimum selling price is $17. Of the total overhead, only VOH is considered an incremental cost because the fixed overhead will be incurred regardless of whether the order is taken.

b. A target profit of $100,000 calls for an increase in the selling price of $5 ($100,000 20,000 units). Therefore, the selling price required to achieve the target profit of $100,000 is $22 ($17 + $5).

DEMONSTRATION PROBLEM 5 Decision making under uncertainty.

Margo Reed is the marketing manager for a large manufacturer of sporting equipment. She has proposed to top management that the company open some specialty stores in one of three cities: Los Angeles, San Diego, or San Francisco. Although she has some previ-ous experience in the specialty store business, the popularity of these stores is difficult to predict. She nevertheless categorizes the popularity into high, medium, and low and con-structs the following payoff table:

Profits (i.e., payoffs) are in millions of dollars. Under conditions of uncertainty, Margo cannot predict anything about which volumes (demands) will most likely occur. She can, however, use various criteria for choosing the “best” course of action.

Required:

a. Using the maximin criterion, determine the city in which the specialty stores should be located.

b. Using the maximax criterion, determine the city in which the specialty stores should be located.

c. Construct a regret table using the minimax regret criterion.


a. Management will choose to open specialty stores in the city that will have the largest profitability under the worst state of nature (outcome). From Margo's payoff table, it is clear San Diego would be chosen because it has a minimum profit of $6 million for its worst case event (low demand). The worst outcome for Los Angeles is $4 million, and for San Francisco, $5 million.

b. In this super optimistic scenario, management is adventuresome and attracted to large gains. San Francisco is chosen, with a $20 million profit, because this is the maxi-

Direct materials $ 6Direct labor 4Variable overhead (40% of $10) 4Shipping cost 3Incremental costs per unit $17

EventsActions High

Demand Medium Demand

Low Demand

Los Angeles $10 $ 6 $ 4San Diego 14 10 6San Francisco 20 12 5

CHAPTER 19


mum profit across all demand levels.c. Regret table:

Each column's regret figures are calculated by subtracting each payoff in a column from the highest payoff in that column. In other words, the opportunity costs of each action within each event (demand level) are the cells' values. Maximum regrets are as follows:

Demonstration Problem 6. Decision-making under risk.

Management at Corvair Aircraft Dealers is considering stocking heavy utility helicop-ters on consignment. They will order one of two helicopters for this season’s inventory, but no more or less. There is a $100,000 cost for carrying each excess helicopter and a $400,000 contribution margin for each helicopter sold. Following are the probabilities of the season’s demand:

Required:

a. Build a payoff table.b. Construct a decision tree, and through backward induction, calculate the appropriate

decision.

SOLUTION TO DEMONSTRATION PROBLEM 6 a.

EventsACTIONS High

DemandMedium Demand

Low Demand

Los Angeles $10 $6 $2San Diego 6 2 -San Francisco - - 1

Action Maximum RegretsLos Angeles $10San Diego 6San Francisco 1

probability demand0.1 00.5 10.4 2

DemandAction 0 1 2Order 1 helicopter <$100,000> $400,000 $400,000Order 2 helicopters <$200,000> $300,000 $800,000


Expected value of ordering 1 helicopter:

= (<$100,000> x .10) + ($400,000 x .50) + ($400,000 x .40) = $350,000

Expected value of ordering 2 helicopters:

= (<$200,000> x .10) + ($300,000 x .50) + ($800,000 x .40) = $450,000

Thus, the optimal decision at node 1 is to order two helicopters, with an expected value of $450,000.

REVIEW QUESTIONS

19.1 List and briefly describe four profit management decision-making situations.19.2 Distinguish between strategic long-run decisions and routine short-run decisions. 19.3 List the steps in a rational decision-making process.19.4 What are the five profit elements and when are they relevant to short-run profit

management decision making?19.5 Describe the two characteristics of relevant profit elements.19.6 Why are sunk costs irrelevant to short-run operational decisions?19.7 Distinguish between incremental and differential profit elements. Under what con-

ditions will they be the same? When will they be different?19.8 Why is the relevant range an important factor in operational profit management

decisions?19.9 What is meant by the term opportunity cost? Give an example of an opportunity

cost in decision making.19.10 Define opportunity benefit. Under what circumstances will an alternative have an

opportunity benefit instead of an opportunity cost?19.11 What are the formulas for calculating an opportunity cost and an opportunity bene-

fit?19.12 What is the relationship between opportunity cost and marginal utility?

1

2

3

decision events payoffsdemand = 0 [.10]

demand = 1 [.50]

demand = 2 [.40]

demand = 2 [.40]

demand = 1 [.50]

demand = 0 [.10]

-$100 000

$400 000

-$200 000

$300 000

$800 000

$400 000

order 1

order 2

CHAPTER 19


19.13 List three types of sales price-setting decisions.19.14 How does a special-order situation differ from a normal sales price setting deci-

sion for the sales used in the master budget?19.15 What is the minimum sales price for a special order that incurs no incremental

fixed costs when adequate surplus capacity exists to fill the order?19.16 Explain the relevance of plant capacity when a special-order decision is being

considered.19.17 What qualitative factors should be considered when a special order would require

normal sales to be given up?19.18 For special orders involving incremental fixed costs, how can a break-even sales

volume be determined?19.19 For special orders involving incremental fixed costs, how can a break-even sales

price be determined?19.20 Develop a simple cost-based price-setting model. Under what conditions can the

floor price be used? When should the ceiling price be used?19.21 What is the relationship between a full cost-based sales price and absorption cost-

ing?19.22 What is the relationship between a variable cost-based sales price and the contri-

bution margin approach?19.23 Under which five conditions is an absorptive cost-based sales price appropriate? 19.24 What qualitative and legal factors are involved in setting prices? 19.25 Explain a scarce-resource decision situation. 19.26 In a temporary scarce-resource situation, which product should be produced? 19.27 What qualitative factors should be considered in the scarce-resource decision? 19.28 Illustrate a make-or-buy decision.19.29 Are there any qualitative factors that should be considered in a make-or-buy deci-

sion?19.30 What quantitative factors are relevant in a make-or-buy decision? 19.31 How can margin of safety be applied to the make-or-buy decision?19.32 Explain how opportunity costs enter into the make-or-buy decision.19.33 Explain why outsourcing and privatization involve make-or-buy decisions. 19.34 Characterize the sell-or-process-further decision.19.35 “It will always be profitable to continue processing a joint product after the split-

off point so long as the incremental revenue from such processing exceeds the incremental costs.” Do you agree? Explain.

19.36 Distinguish between decision making under conditions of certainty, uncertainty, and risk.

19.37 What is the key difference between decision making under uncertainty and deci-sion making under risk?

19.38 What is a payoff table? Can it be used for decision making under uncertainty and decision making under risk?

19.39 Explain why the maximin criterion is appropriate for a risk-averse decision maker.19.40 Explain why the maximax criterion is appropriate for a risk-seeking, super opti-

mistic decision maker.19.41 Explain how the minimax regret criterion is used in decision making.


19.42 How is expected value calculated and used in decision making under risky situa-tions?

19.43 What is the nature of decision trees and how do they aid decision making?

CHAPTER-SPECIFIC PROBLEMS

These problems require responses based on concepts and techniques presented in the text.

19.44 Multiple-choice questions.

1. In a make-or-buy decision:

a. Only variable costs are relevant.b. Fixed costs that can be avoided in the future are relevant.c. Fixed costs that will continue regardless of the decision are relevant. d. Only conversion costs are relevant.

2. In a make-or-buy decision, which of the following qualitative factors is usually con-sidered?

a. Special technology.b. Reliability of delivery.c. Special skills and materials requirements. d. Quality control.e. All of the above.

3. Which of the following qualitative factors favor the buy choice in a make-or-buy deci-sion?

a. Maintaining a long-run relationship with suppliers. b. Quality control.c. Use of idle capacity.d. All of the above.

4. In considering a special order that will enable a company to make use of presently idle capacity, which of the following costs would be irrelevant?

a. Direct materials.b. Depreciation. c. Direct labor.d. Variable overhead.

5. From a long-run perspective, the major pitfall in the contribution margin approach to pricing is:

a. Its failure to recognize depreciation expense. b. Its failure to recognize fixed costs. c. Its inability to control administrative costs. d. Its inability to control waste.

6. Expected value in decision making is:

a. A standard deviation using the probabilities as weights.b. An arithmetic mean using the probabilities as weights.

CHAPTER 19


c. The square root of the squared deviations.d. The standard deviation divided by the coefficient of determination.

19.45 Make-or-buy decision. Marvel Company needs 10,000 units of a part to be used in the production of one of its products. If Marvel buys the part from Sterling Company instead of making it, Marvel could not use the released facilities in another manufactur-ing activity. Sixty percent of the fixed overhead applied will continue regardless of Mar-vel's decision. The following information is available:

Required:

a. Calculate Marvel's total relevant costs to make the part.b. Determine which alternative is more attractive to Marvel and by what amount.

19.46 Make-or-buy decision to maximize net benefits. [CMA adapted] Stewart Indus-tries has been producing two bearings, components B12 and B18, for use in production. Data regarding these two components follow:

* Variable manufacturing overhead is applied on the basis of direct labor hours. ** Fixed manufacturing overhead is applied on the basis of machine hours.

Stewart's annual requirement for these components is 8,000 units of B12 and 11,000 units of B18. Recently, Stewart's management decided to devote additional machine time to other product lines, with the result that only 41,000 machine hours per year can be dedicated to the production of the bearings. An outside company has offered to sell Stewart the annual supply of the bearings at prices of $11.25 per unit for B12 and $13.50 per unit for B18. Stewart wants to schedule the otherwise idle 41,000 machine hours to produce bearings so that the company can minimize its costs (maximize its net benefits).

Required:

a. What is the net benefit (loss) per machine hour that would result if Stewart Industries accepts the supplier's offer of $13.50 per unit for component B18?

b. Determine the combination of purchasing and manufacturing that will maximize ben-efits.

Cost to Marvel to make the part: Direct materials $25Direct labor 6Variable overhead 14Fixed overhead 15Total $60Cost to buy the part $56

B12 B18Machine hours required per unit 2.5 3.0Standard cost per unit: Direct materials $ 2.25 $ 3.75Direct labor 4.00 4.50Manufacturing overhead Variable* 2.00 2.25Fixed** 3.75 4.50

$12.00 $15.00


19.47 Profit from processing further. Isherwood Company manufactures three main products, F, G, and W, from a joint process. Joint costs are allocated on the basis of rela-tive sales value at split-off. Additional information for June production activity follows:

Required: What is the opportunity cost or benefit from further processing of each prod-uct? [AICPA adapted]

19.48 Profit from processing further. [AICPA adapted] Warfield Corporation manufac-tures products C, D, and E from a joint process. Joint costs are allocated on the basis of relative sales value at split-off. Additional information follows:

Required:

a. What is the opportunity cost or benefit from further processing of each product?b. Should product D be processed further and then sold?

19.49 Sell-or-process-further decision. The Yerrington Company has 1,000 obsolete water coolers at a manufacturing cost of $30,000. If the coolers are refurbished for $6,000, they could be sold for $10,000. If the coolers are scrapped, they could be sold for $2,000.

Required:

Determine which alternative is more attractive and indicate the total relevant costs for that alternative.

19.50 Sell-or-process-further decision. [AICPA adapted] Yardley Corporation uses a joint process to produce products A, B, and C. Each product may be sold at its split-off point or processed further. Additional processing costs are entirely variable and are trace-able to the respective products. Joint production costs were $50,000 and are allocated by Yardley using the relative sales value at the split-off point. Additional information fol-lows:

Required: To maximize profits, which products should Yardley process further?

19.51 Sell-or-process-further decision. Watkins Company produces three products, X, Y, and Z, from a particular joint process. Each product may be sold at the point of split-

F G W TOTALUnits produced 50,000 40,000 10,000 100,000Joint costs ? ? ? $450,000Sales value at split-off $420,000 $270,000 $60,000 $750,000Additional costs if processed further $88,000 $30,000 $12,000 $130,000Sales value if processed further $538,000 $320,000 $78,000 $936,000

C D E TOTALUnits produced 6,000 4,000 2,000 12,000Joint costs $72,000 ? ? $120,000Sales value at split-off ? ? $30,000 $200,000Additional costs if processed further $14,000 $10,000 $6,000 $30,000Sales value if processed further $140,000 $60,000 $40,000 $240,000

If Processed FurtherProduct Units Produced Sales Value At Split-off Sales Value Additional CostsA 20,000 $ 45,000 $60,000 $20,000B 15,000 75,000 98,000 20,000C 15,000 30,000 62,000 18,000

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off or processed further. Additional processing requires no special facilities, and produc-tion costs of further processing are entirely variable and traceable to the products involved. Last year all three products were processed beyond split-off. Joint production costs for the year were $60,000. Sales values and costs needed to evaluate Watkins' pro-duction policy follow:

Joint costs are allocated to the products in proportion to the relative physical volume of output.

Required:

a. For units of Z, what is the unit production cost most relevant to the sell-or-process-further decision?

b. To maximize profits, which products should Watkins process further? [AICPA adapted]

19.52 Special-order decision. Baxter Company manufactures soccer balls. The esti-mated income statement for the year before any special order is as follows:

Fixed costs included in the estimated income statement are $2,400,000 in cost of goods sold and $120,000 in administrative and selling expenses. Baxter received a special order for 60,000 soccer balls at $15 each. There will be no additional administrative and selling expenses if Baxter accepts. Baxter has sufficient capacity to manufacture 60,000 additional soccer balls.

Required: Calculate the unit relevant cost of the special order and state whether Baxter should accept it.

19.53 Decision making under uncertainty. Following is a payoff table of an investor:

Only three investment strategies are considered: defense stocks, junk bonds, and high-grade bonds. Also, only three states of nature are considered: war, peace, and depres-sion. Ignore all impacts of capital gains, taxes, and so on, and assume that the investor

If Processed FurtherProduct Units Produced Sales Value At Split-off Sales Value Additional costsX 6,000 $25,000 $42,000 $9,000Y 4,000 41,000 45,000 7,000Z 2,000 24,000 32,000 8,000

Amount Per UnitSales $8,000,000 $20.00Cost of goods sold <6,800,000> <17.00>Gross profit 1,200,000 3.00Administrative and selling <320,000> <0.80>Operating income $ 880,000 $ 2.20

Events States Of NatureActions War Peace DepressionDefense stocks 20 1 -6Junk bonds 9 8 0High-grade bonds 4 4 4


has determined her rate of return (in percent) for each of the nine action-event combina-tions as shown in the payoff table. Also, assume probabilities cannot be determined.

Required:

a. Calculate the optimal action using the maximin criterion.b. Calculate the optimal action using the maximax criterion.c. Calculate the optimal action using the minimax regret criterion.

19.54 Expected value criterion for introducing a new product and selecting a machine. [CMA adapted] A company is considering three alternative machines to produce a new product. The cost structures (unit variable costs plus avoidable fixed costs) for the three machines are shown below. The selling price is unaffected by the machine used.

The demand for units of the new product is described by the following probability distri-bution:

Required:

a. Calculate expected demand. Calculate the expected costs of using the semi-automatic machine.

b. Based on expected demand calculated in Requirement (a), which machine should be selected?

19.55 Expected value criterion. [AICPA adapted] Your client wants your advice on which of two alternatives he should choose. One alternative is to sell an investment now for $10,000. Another alternative is to hold the investment three days, after which he can sell it for a certain selling price based on the following probabilities:

Required: Using probability theory, which of the following is the most reasonable state-ment?

a. Hold the investment three days because the expected value of holding exceeds the cur-rent selling price.

b. Hold the investment three days because of the chance of getting $30,000 for it.c. Sell the investment now because the current selling price exceeds the expected value

of holding.d. Sell the investment now because there is a 60% chance that the selling price will fall in

three days.

Single-purpose machine $0.60 + $20,000Semiautomatic machine $0.40 + $50,000Automatic machine $0.20 + $120,000

Demand Probability200,000 0.4300,000 0.3400,000 0.2500,000 0.1

Selling Price Probability$ 5,000 0.4

8,000 0.212,000 0.330,000 0.1

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19.56 Expected profit. [CMA adapted] The Tyson Company is considering hiring sev-eral new employees to handle an overload from a new contract. If the new people are not hired, there will be delays in contract work. Based on past experience, the company expects to retain 75% of the new customers with no new hires. The following payoff matrix has been prepared for analyzing whether new people are needed:

Required: Calculate the expected profit for the “no hire” decision.

19.57 Expected value analysis used in the make-or-buy decision. The Unimat Com-pany manufactures a unique thermostat that yields dramatic cost savings from effective climatic control of large buildings. The efficiency of the thermostat is dependent upon the quality of a specialized thermocoupler. These thermocouplers are purchased from Cosmic Company for $15 each.

Since early 2003, an average of 10% of the thermocouplers purchased from Cosmic have not met Unimat's quality requirements. The number of unusable thermocouplers has ranged from 5% to 25% of the total number purchased and has resulted in failures to meet production schedules. In addition, Unimat has incurred additional costs to replace the defective units because the rejection rate of the units is within the range agreed upon in the contract.

Unimat is considering a proposal to manufacture the thermocouplers. The company has the facilities and equipment to produce the components. The Engineering Department has designed a manufacturing system that will produce the thermocouplers with a defec-tive rate of 4% of the number of units produced. The following schedule presents the engineer's estimates of the probabilities that different levels of variable manufacturing cost per thermocoupler will be incurred under this system. The variable manufacturing cost per unit includes a cost adjustment for the defective units at the 4% rate. Additional annual fixed costs incurred by Unimat if it manufactures the thermocoupler will amount to $32,500.

Unimat Company will need 18,000 thermocouplers to meet its annual demand require-ments.

Required: Prepare an expected value analysis to determine whether Unimat Company should manufacture the thermocouplers. [CMA adapted]

19.58 Scarce resources. Jumpin Jack Clothing manufactures three different lines of chil-dren's clothing. Bell-bottom jump suits (product 1), western cut jumpers (product 2), and

Hire New People Do Not Hire New PeopleRetain new customers $100,000 $75,000Lose new customers 25,000 50,000

Estimated Variable Manufacturing Cost Per Good Thermocoupler Unit

Probability Of Occurrence

$10 0.112 0.314 0.416 0.2

1.0


suspender jeans (product 3) all require the use of a special sewing machine. Information about the three products follows:

Not enough sewing machine hours are available to fill demand for all three product lines.

Required: Assuming only one product line will be produced, which one should it be? Are there any assumptions about your analysis that management should be aware of?

19.59 Scarce resources. Custom Manufacturing runs a job shop. It has orders for three custom jobs, each requiring very specialized labor. Only one employee has the skills to do this type of work. The following information is available about the three jobs:

Required: Assuming only one job can be accepted because of the limited amount of spe-cialized labor time available, which job is the most profitable?

19.60 Scarce resources. St. Mary's hospital performs three different types of blood tests for a certain disease. Each of these tests requires the use of a highly specialized molecu-lar separation machine. The lab is considering performing only one of the tests and dis-continuing the other two, because only one machine is currently available. The following information has been obtained from the accounting LAN:

Required: Which test should be performed, and which tests should be dropped? What ethical factors would you want the lab to consider in making this decision?

THINK-TANK PROBLEMS

Although these problems are based on chapter material, reading extra material, review-ing previous chapters, and using creativity may be required to develop workable solu-tions.

19.61 Make-or-buy decision. [AICPA adapted] When you completed your audit of the Scoopa Company, management asked for your assistance in deciding whether to con-tinue manufacturing a part or to buy it from an outside supplier. The part, which is named Faktron, is a component used in some of the finished products of the company.

From your audit working papers and from further investigation, you develop the follow-ing data as being typical of the company's operations:• The annual requirement for Faktrons is 5,000 units. The lowest quotation from a supplier was $8 per unit.• Faktrons have been manufactured in the Precision Machinery Department. If Faktrons are purchased

from an outside supplier, certain machinery will be sold and would realize its book value.

Product1 2 3

Sewing machine standard hours 5 4 2Contribution margin per unit $10 $12 $8

Product1 2 3

Standard direct labor hours 10 8 5Contribution margin per unit $10 $12 $8

TEST1 2 3

Machine time required (hours) 1.50 2.00 0.75Contribution margin per test $15 $20 $9

CHAPTER 19


• Following are the total costs of the Precision Machinery Department during the year under audit when 5,000 Faktrons were made:

• The following Precision Machinery Department costs apply to the manufacture of Fak-trons: direct materials, $17,500; direct labor, $28,000; indirect labor, $6,000; power, $300; other $500. The sale of the equipment used for Faktrons would reduce the follow-ing costs by the amounts indicated: depreciation, $2,000; property taxes and insurance, $1,000.

- The following additional Precision Machinery Department costs would be incurred if Faktrons were purchased from an outside supplier: freight, $0.50 per unit; indirect labor for receiving, materials handling, inspection, $5,000. The cost of the purchased Faktrons would be considered a Precision Machinery Department cost.

Required:

a. Prepare a schedule comparing the total costs of the Precision Machinery Department (1) when Faktrons are made and (2) when Faktrons are bought from an outsider supplier.

b. Discuss the considerations in addition to the cost factors that you would bring to the attention of managers in assisting them in deciding whether to make or buy Faktrons. Include in your discussion the considerations that might be applied to the evaluation of the outside supplier.

19.62 Make-or-buy decision.[CMA adapted] Leland Manufacturing uses 10 units of part number KJ37 each month in the production of radar equipment. The unit cost to manufacture one unit of KJ37 is as follows:

Materials handling represents the direct variable costs of the Receiving Department that are applied to direct materials and purchased components on the basis of their cost. This is a separate charge in addition to manufacturing overhead. Leland's annual manufactur-ing overhead budget is one-third variable and two-thirds fixed. Scott Supply, one of Leland's reliable vendors, has offered to supply part KJ37 at a unit price of $15,000.

Required:

a. If Leland purchases the KJ37 units from Scott, the capacity Leland used to manufac-

Direct materials $67,500Direct labor 50,000Indirect labor 20,000Light and heat 5,500Power 3,000Depreciation 10,000Property taxes and insurance 8,000Payroll taxes and other benefits 9,800Other 5,000

Direct materials $ 1,000Materials handling (20% of direct materials cost) 200Direct labor 8,000Overhead (150% of direct labor) 12,000Total manufacturing cost $21,200


ture these parts would remain idle. What would be the opportunity cost of KJ37 should Leland decide to purchase the parts from Scott?

b. Assume Leland is able to rent all idle capacity for $25,000 per month. If Leland decides to purchase the 10 units from Scott, what would be Leland's opportunity cost for KJ37?

c. Assume that Leland does not wish to commit to a rental agreement but would use idle capacity to manufacture another product that would contribute $52,000 per month. If Leland elects to manufacture KJ37 in order to maintain quality control, what would be Leland's opportunity cost?

19.63 Make-or-buy decision.[CMA adapted] Sarbec Company needs a total of 125 tons of sheet steel, 50 tons of 2-inch width and 75 tons of 4-inch width, for a customer's job. Sarbec can purchase the sheet steel in these widths directly from Jensteel Corporation, a steel manufacturer, or it can purchase sheet steel from Jensteel that is 24 inches wide and have it slit into the desired widths by Precut, Inc. Both vendors are local and have previ-ously supplied materials to Sarbec.

Precut specializes in slitting sheet steel that is provided by a customer into any desired width. When negotiating a contract, Precut tells its customers that there is a scrap loss in the slitting operation, but that this loss has never exceeded 2.5% of input tons. Precut rec-ommends that if a customer has a specific tonnage requirement, it should supply an ade-quate amount of steel to yield the desired quantity. Precut's charges for steel slitting are based on good output, not input handled.

The 24-inch wide sheet steel is a regular stock item of Jensteel and can be shipped to Pre-cut within five days after receipt of Sarbec's purchase order. If Jensteel is to do the slit-ting, shipment to Sarbec would be scheduled for 15 days after receipt of Sarbec's purchase order. Precut has quoted delivery at 10 days after receipt of the sheet steel. In prior dealings, Sarbec has found both Jensteel and Precut to be reliable vendors with high-quality products. Sarbec has received the following price quotations from Jensteel and Precut:

In addition, Precut has informed Sarbec that if it purchases 100 output tons of each width, the per-ton slitting rates would be reduced 12%. Sarbec knows that the same cus-

Jensteel Corporation RatesSize Gauge Quantity Cost Per Ton

2 inch 14 50 tons $2104 inch 14 75 tons 20024 inch 14 125 tons 180

Precut, Inc. Steel Slitting RatesSize Gauge Quantity Price / Ton Of Output2 inch 14 50 tons $184 inch 14 75 tons 15

Freight And Handling chargesDestination Cost Per TonJensteel to Sarbec $10.00Jensteel to Precut 5.00Precut to Sarbec 7.50

CHAPTER 19


tomer will be placing a new order in the near future for the same material and estimates it would have to store the additional tonnage for an average of two months at a carrying cost of $1.50 per month for each ton. There would be no change in Jensteel's prices for additional tons delivered to Precut.

Required:

a. Prepare an analysis that will show whether Sarbec Company should:1 Purchase the required slit steel directly from Jensteel Corporation.2 Purchase the 24-inch wide sheet steel from Jensteel and have it slit by Precut into 50 output tons 2 inches wide and 75 output tons 4 inches wide.3 Take advantage of Precut's reduced slitting rates by purchasing 100 output tons of each width.

b. Without prejudice to your answer to Requirement (a), present three qualitative argu-ments why Sarbec Company may favor the purchase of the slit steel directly from Jen-steel Corporation.

19.64 Sell-or-process-further decision. Gossett Chemical Company uses comprehen-sive annual profit planning procedures to evaluate pricing policies, finalize production decisions, and estimate unit costs for its various products. One particular product group involves two joint products and two by-products. This product group is analyzed sepa-rately each year to establish appropriate production and marketing policies.

The two joint products-ALCHEM-X and CHEM-P-emerge at the end of processing in Department 20. Both chemicals can be sold at this split-off point-ALCHEM-X for $2.50 per unit, and CHEM-P for $3.00 per unit. By-product BY-D20 also emerges at the split-off point in Department 20 and is salable without further processing for $0.50 per unit. Unit costs of preparing this by-product for market are $0.03 for freight and $0.12 for packaging.

CHEM-P is sold without further processing, but ALCHEM-X is transferred to Depart-ment 22 for additional processing into a refined chemical labelled as ALCHEM-XF. No additional raw materials are added in Department 22.

ALCHEM-XF is sold for $5.00 per unit. By-product BY-D22 is created by the additional processing in Department 22, and it can be sold for $0.70 per unit. Unit marketing costs for BY-D22 are $0.05 for freight and $0.15 for packaging.

Gossett Chemical Company accounts for by-product production by crediting the net realizable value of by-products produced to production costs of the main products. The relative sales value method is used to allocate net joint production costs for inventory valuation purposes.

A portion of the 19X5 profit plan established in September 19X4 is presented next: Units Of Production

CHEM-P ALCHEM-XFEstimated sales 400,000 210,000Planned inventory change -8,000 -6,000Required production Minimum production based upon 392,000 204,000joint output ratio 392,000 210,000By-product output BY-D20 90,000 BY-D22 60,000


CHEM-P ALCHEM-XF

Budgeted marketing costs $196,000 $105,000

Shortly after this budget was compiled, the company learned that a chemical that would compete with ALCHEM-XF was to be introduced. The Marketing Department estimated that a permanent price reduction to $3.50 a unit would be required for ALCHEM-XF to be sold in present quantities. Gossett must now reevaluate the decision to process ALCHEM-X further.

The market for ALCHEM-X will not be affected by the introduction of this new chemi-cal. Consequently, the quantities of ALCHEM-X that are usually processed into ALCHEM-XF can be sold at the regular price of $2.50 per unit. The costs for marketing ALCHEM-X are estimated to be $105,000. If the further processing is terminated, Department 22 will be dismantled, and all costs will be eliminated except equipment depreciation, $18,400; supervisory salaries, $21,200; and general overhead, $35,200.

Required:

a. Should Gossett sell ALCHEM-X at the split-off point or continue to process it further in Department 22? Prepare a schedule of relevant costs and revenues to support your answer.

b. During discussions of the possible dropping of ALCHEM-XF, one person noted that the manufacturing margin for ALCHEM-X would be 57.2% [(2.50 -1.07)12.50] and 57.3% for CHEM-P. The normal markup for products sold in the market with ALCHEM-X is 72%. For the CHEM-P portion of the line, the markup is 47%. He argues that the company's unit costs must be incorrect because the margins differ from the typical rates. Briefly explain why Gossett’s rates for the two products are almost identical when “nor-mal” rates are not.[CMA adapted]

CostsBudgeted Production Costs Department 20 Department 22Raw material $160,000 -Costs transferred from 20* - $225,000Hourly direct labor 170,000 120,000Variable overhead 180,000 140,800Fixed overhead 247,500 188,000

$757,500 $673,800

* The cost transferred to Department 22 is calculated as follows:

Sales value of output: ALCHEM-X (210,000 x $2.50) $ 525,000 31%CHEM-P (392,000 x $3.00) 1,176,000 69%

$1,701,000 100%Department 20 costs $ 757,500Less BY-D20 (90,000 x $0.35) <31,500>Net costs: $ 726,000ALCHEM-X 31% $ 225,000 or $1.07 per unitCHEM-P 69% 501,000 or $1.28 per unitAllocated net costs 100% $ 726,000

CHAPTER 19


19.65 Special-order decision. [CMA adapted] Anchor Company manufactures several different styles of jewelry cases. Management estimates that during the third quarter of 19X6 the company will be operating at 80% of normal capacity. Because Anchor desires a higher utilization of plant capacity, the company will consider a special order.

Anchor has received special-order inquiries from two companies. The first order is from JCP, Inc., which would like to market a jewelry case similar to one of Anchor's cases. The JCP jewelry case would be marketed under JCP's own label. JCP, Inc., has offered Anchor $5.75 per jewelry case for 2,000 cases to be shipped by October 1, 19X6. The cost data for the Anchor jewelry case, which would be similar to the specifications of the JCP special order, are as follows:

According to the specifications provided by JCP Inc., the special-order case requires less expensive raw materials. Consequently, the raw materials will cost only $2.25 per case. Management has estimated that the remaining costs, labor time, and machine time will be the same as for the Anchor jewelry case.

The second special order was submitted by the Krage Company for 7,500 jewelry cases at $7.50 per case. Like the JCP cases, these jewelry cases would be marketed under the Krage label and have to be shipped by October 1, 19X6. However, the Krage jewelry case is different from any jewelry case in the Anchor line. The estimated per-unit costs of this case are as follows:

In addition, Anchor will incur $1,500 in additional setup costs and will have to purchase a $2,500 special device to manufacture these cases; this device will be discarded once the special order is completed.

The Anchor manufacturing capabilities are limited to the total machine hours available. The plant capacity under normal operations is 90,000 machine hours per year or 7,500 machine hours per month. The budgeted fixed overhead for 19X6 amounts to $216,000. All manufacturing overhead costs are applied to production on the basis of machine hours at $4.00 per hour.

Anchor will have the entire third quarter to work on the special orders. Management does not expect any repeat sales to be generated from either special order. Company practice precludes Anchor from subcontracting any portion of an order when special orders are not expected to generate repeat sales.

Required: Should Anchor Company accept either special order? Justify your answer and show your calculations.

Regular selling price per unit $9.00Costs per unit: Raw materials $2.50Direct labor 0.5 hours @ $6.00 3.00Overhead 0.25 machine hours @ $4.00 1.00Total costs $6.50

Raw materials $3.25Direct labor 0.5 hours @ $6.00 3.00Overhead 0.5 machine hours @ $4.00 2.00Total costs $8.25


19.66 Emphasizing the contribution margin approach in price setting for a special order. [CMA adapted] E. Berg and Sons build custom-made pleasure boats that range in price from $10,000 to $250,000. For the past 30 years, Mr. Berg, Sr., has determined the selling price of each boat by estimating the cost of material, labor, and a prorated portion of overhead and adding 20% to these estimated costs.

For example, a recent price quotation was determined as follows:

The overhead figure was determined by estimating total overhead costs for the year and allocating them at 25% of direct labor.

If a customer rejected the price and business was slack, Mr. Berg, Sr., would often be willing to reduce his markup to as little at 5% over estimated costs. Thus, average markup for the year is estimated at 15%.

Mr. Ed Berg, Jr., has just completed a course on pricing and believes the firm could use some of the techniques discussed in the course. The course emphasized the contribution margin approach to pricing, and Mr. Berg, Jr., feels such an approach would be helpful in determining the selling prices of their boats.

Total overhead, which includes selling and administrative expenses for the year, has been estimated at $150,000, of which $90,000 is fixed and the remainder is variable in direct proportion to direct labor.

Required:

a. Assume the customer in the example rejected the $18,000 quotation and also rejected a $15,750 quotation (5% markup) during a slack period. The customer countered with a $15,000 offer.

1. What is the difference in net income for the year between accepting or rejecting the customer's offer?2. What is the minimum selling price Mr. Berg, Jr., could have quoted with out

reducing or increasing net income?

b. What advantages does the contribution margin approach to pricing have over the approach used by Mr. Berg, Sr.?

c. What pitfalls, if any, are there to contribution margin pricing?

19.67 Special-order decision. [CMA adapted] George Jackson operates a small machine shop. He manufactures one standard product available from many other similar busi-nesses, and he also manufactures products to customer order. His accountant prepared the following annual income statement:

The depreciation charges are for machines used in the respective product lines. The power charge is apportioned on the estimate of power consumed. The rent is for the building space, which has been leased for 10 years at $7,000 per year. The rent and heat and light are apportioned to the product lines based on the amount of floor space occu-pied. All other costs are current expenses identified with the product line incurring them.

Direct materials $ 5,000Direct labor 8,000Overhead 2,000

15,000Plus 20% 3,000Selling price $18,000

CHAPTER 19


A valued custom parts customer has asked Jackson to manufacture 5,000 special units for him. Jackson is working at capacity and would have to give up some other business to take this order. He cannot renege on custom orders already agreed to, but he could reduce the output of his standard product by about one-half for one year while producing the specially requested custom part. The customer is willing to pay $7.00 for each part. The material cost will be about $2.00 per unit, and the labor will be $3.60 per unit. Jack-son will have to spend $2,000 for a special device that will be discarded when the job is done.

Required:

a. What is the incremental cost of the 5,000-unit order?b. What are the total fixed costs of the order?c. What is the full cost of the special order?d. What is the opportunity cost of taking the order?e. What would be the cash advantage (disadvantage) if Jackson accepts the order?

19.68 Selection of the least-cost alternative. [CMA adapted] Video Recreation, Inc. (VRI), is a supplier of video games and video equipment such as large-screen televisions and video-cassette recorders. The company has recently concluded a major contract with Sunview Hotels to supply games for the hotel video lounges. Under this contract, a total of 4,000 games will be delivered to Sunview Hotels throughout the western United States, and all of the games will have a warranty period of one year for both parts and labor. The number of service calls required to repair these games during the first year after installation is estimated as follows:

VRI's Customer Service Department has developed three alternatives for providing the warranty service to Sunview:• Plan 1. VRI would contract with local firms to perform the repair services. It is estimated that six such

vendors would be needed to cover the appropriate areas and that each of these vendors would charge an annual fee of $15,000 to have personnel available and to stock the appropriate parts. In addition to the annual fee, VRI would be billed $250 for each service call and would be billed for parts used at cost plus

Custom Sales Standard Sales TotalSales $50,000 $25,000 $75,000Material $10,000 $ 8,000 $18,000Labor 20,000 9,000 29,000Depreciation 6,300 3,600 9,900Power 700 400 1,100Rent 6,000 1,000 7,000Heat and light 600 100 700Other 400 900 1,300

<$44,000> <$23,000> <$67,000>$ 6,000 $ 2,000 $ 8,000

Number O service Calls Probability400 0.1700 0.3900 0.4

1,200 0.2


a 10% surcharge.• Plan 2. VRI would allow the management of each hotel to arrange for repair service when needed and

then would reimburse the hotel for the expenses incurred. It is estimated that 60% of the service calls would be for hotels located in urban areas where the charge for a service call would average $450. At the remaining hotels, the charge would be $350. In addition to these service charges, parts would be billed at cost.

• Plan 3. VRI would hire its own personnel to perform repair services and to do preventive maintenance. Nine employees, located in the appropriate geographical areas, would be required to fulfill these respon-sibilities, and their average salary would be $24,000 annually. The fringe benefit expense for these employees would amount to 35% of their wages. Each employee would be scheduled to make an average of 200 preventive maintenance calls during the year; each of these calls would require $15 worth of parts. Because of this preventive maintenance, it is estimated that the expected number of hotel calls for repair service would decline 30%, and the cost of parts required for each repair service call would be reduced by 20%.

VRI's Accounting Department has reviewed the historical data on repair costs for equip-ment installations similar to those proposed for Sunview Hotels and found that the cost of parts required for each repair occurred in the following proportions:

Required: VRI wishes to select the least-cost alternative to fulfill its warranty obligations to Sunview Hotels. Recommend which of the three plans VRI should adopt. Support your recommendation with appropriate calculations and analysis.

19.69 Payoff and expected value. [CMA adapted] The Wentworth Company manufac-tures modular furniture for the home and uses a monthly variance system to control costs of the manufacturing departments. Edward Collins is the supervisor of the Assembly Department and is reviewing the monthly variance analysis for November:

Collins has gathered the following information to assist him in deciding whether or not to investigate the unfavorable materials quantity variance:

Required:

a. Recommend whether or not Wentworth Company should investigate the unfavorable materials quantity variance. Support your recommendation by: 1. Preparing a pay-off table for use in making the decision. 2. Computing the expected value of the cost of each possible action.

b. Edward Collins is uncertain about the probability estimate of 90% for proper operation

Parts Cost

Per Repair Proportion$30 15%40 1560 4590 25

Standard cost of production materials $275,000Materials price variance -0-Materials quantity variance, unfavorable 19,000Total $294,000

Estimated cost to investigate the variance $ 4,000Estimated probability that the Assembly Department is operating properly 90%If the Assembly Department is operating improperly: Estimated cost to make the necessary changes $ 8,000Estimated present value of future unfavorable variances that would be saved by making the necessary changes

$40,000

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of the Assembly Department. Determine the probability estimate of the Assembly Department operating properly that would cause Collins to be indifferent between the two possible actions.

19.70 Payoff table and the decision process. [CMA adapted] Jackston, Inc., manufac-tures and distributes a line of Christmas toys. The company has neglected to keep its dollhouse line current. As a result, sales have decreased to approximately 10,000 units per year from a previous high of 50,000 units. The dollhouse has been redesigned recently and is considered by company officials to be comparable to its competitors' models. The company plans to redesign the dollhouse each year in order to compete effectively. Joan Blocke, the sales manager, is not sure how many units can be sold next year, but she is willing to place probabilities on her estimates. Blocke's estimates of the number of units that can be sold during the next year and the related probabilities are as follows:

The units would be sold for $20 each.

The inability to estimate the sales more precisely is a problem for Jackston. The number of units of this product is small enough to schedule the entire year's sales in one produc-tion run. If the demand is greater than the number of units manufactured, then sales will be lost. If demand is below supply, the extra units cannot be carried over to the next sea-son and would be given away to various charitable organizations. The production and distribution cost estimates follow:

The company intends to analyze the data to facilitate making a decision as to the proper size of the production run.

Required:

a. Prepare a payoff table for the different sizes of production runs required to meet the four sales estimates prepared by Joan Blocke for Jackston Inc. If Jackston relied solely on the expected monetary value approach to make decisions, what size of production run would be selected?

b. identify the basic steps that are taken in any decision process. Explain each step by reference to the situation presented in the problem and your answer for Require-ment (a).

19.71 Introduction of a new product using the contribution margin approach based on most likely outcomes and expected value.[CMA adapted] Sofak Company is a man-

Estimated Sales In Units Probability20,000 0.130,000 0.440,000 0.350,000 0.2

Units Manufactured20,000 30,000 40,000 50,000

Variable costs $180,000 $270,000 $360,000 $450,000Fixed costs 140,000 140,000 160,000 160,000Total costs $320,000 $410,000 $520,000 $610,000


ufacturer of precision sensing equipment. Jerry Adams, one of Sofak's project engineers, has developed a prototype of an automatic testing kit that could continually evaluate water quality and chemical content in hot tubs. Adams believes that this kit will permit domestic tub owners to control water quality better at substantially reduced costs and with less time invested. The management of Sofak is convinced that the kit will have strong market acceptance. Furthermore, this new equipment uses the same technology that Sofak employs in manufacturing some of its other equipment. Therefore, Sofak can use existing facilities to produce the product.

Adams is ready to proceed with developing cost and profit plans for the testing kit. He asked the Marketing Department to develop a suggested selling price and estimate the sales volume. The Marketing Department contracted with Statico, a marketing research company, to develop price and volume estimates.

Based on an analysis of the market, Statico considered unit prices between $80 and $120. Within this price range, it recommended a price of $100 per kit. The frequency distribu-tion of the unit sales volume that Sofak could expect at this selling price is as follows:

Sofak's Profit Planning Department accumulated cost data that Adams had requested. The new product will require direct materials costing $25 per unit and will require two hours of direct labor time to manufacture. Sofak is currently in contract negotiations with its union, making any projections of labor costs difficult. The current direct labor cost is $8 per direct labor hour (DLhr). Representatives of management who are negotiating with the union have estimated the following possible settlements and related probabili-ties:

Sofak applies manufacturing overhead to its products using a plantwide rate of $15 per DLhr. This rate was based on a planned activity level of 900,000 DLhr that represents 75% of practical capacity. The budgeted manufacturing overhead costs for the current fiscal year are as follows:

Estimated Unit Sales Volume At $100Annual Unit Sales Volume Probability

50,000 0.2560,000 0.4570,000 0.2080,000 0.10

Direct Labor Cost Per Hour Probability Of Settlement Amounts$8.50 0.30$8.80 0.50$9.00 0.20

Sofak Company Schedule Of Budgeted Overhead Costs For The Fiscal Year Ended

Manufacturing November 30, Budgeted Annual Cost

19x6 cost per DLHr

Variable: Supplies $ 360,000 $ 0.40Materials handling 315,000 0.35Heat, light, power 1,125,000 1.25Fixed: Supervisory salaries 1,440,000 1.60Depreciation, building 4,410,000 4.90Depreciation, equipment 3,420,000 3.80Property taxes on factory 1,620,000 1.80Insurance 810,000 0.90Total budgeted costs $13,500,000 $15.00

CHAPTER 19


The introduction of the new product will require some changes in the manufacturing plant. Although the plant is below capacity and current facilities can be used, a new pro-duction line requiring a supervisor would be opened. The annual cost of the supervisor would be $28,000. In addition, one piece of equipment that Sofak does not own would have to be obtained under an operating lease at an annual cost of $150,000.

Sofak has already paid Statico $132,000 for the marketing study that was mentioned pre-viously. Statico has agreed to conduct the promotion and distribution of the new product for a fee of $6 per unit once Sofak introduces it.

Required: Determine the annual pretax advantage (disadvantage) that Sofak Company could expect from the introduction of the new product by using:

a. A deterministic approach based on the most likely outcomes.b. An expected value approach.

19.72 Introduction of a new product and decision-tree analysis. Brandon Appliance Corporation, a predominant producer of microwave ovens, is considering the introduc-tion of a new product-a microwave oven that will defrost, cook, brown, and broil food as well as sense when the food is done.

Brandon must decide on a course of action for implementing this new product line. An initial decision must be made whether or not to (1) market the product at all, (2) intro-duce the product in a marketing test, or (3) nationally distribute the product from the onset. If a marketing test is conducted, Brandon must then decide whether it wishes to abandon the product line or make it available for national distribution.

The Finance Department has provided some cost information and probability estimates relating to this decision. The preliminary costs for research and development have already been incurred and are considered irrelevant to the marketing decision. A success nationally will increase profits by $5,000,000, and a failure will reduce them by $1,000,000, while abandoning the product will not affect profits. The test market analy-sis will cost Brandon an additional $100,000.

If a market test is not performed, the probability of success in a national campaign is estimated to be 45%. If the market test is performed, the probability of a favorable test result is 60%. With favorable test results, the probability for national success is esti-mated to be 80%. However, if the test results are unfavorable, the national success prob-ability is only 10%.

Required: Determine the course of action Brandon Appliance Corporation should follow for the introduction of its new product line by:

a. Constructing a decision-tree diagram that analyzes all the alternatives presented above.

b. Performing backward induction to determine the optimal course of action using the new change in profits as the payoff. [CMA adapted]

19.73 Choosing the best product model. [CMA adapted] Steven Company has been pro-ducing component parts and assemblies for use in the manufacture of microcomputers and microcomputer peripheral equipment since 2002. The company plans to introduce a


magnetic tape cartridge backup unit for IBM-compatible microcomputers in the near future.

Steven's Research and Development (R&D) and Market Research Departments have been working on this project for an extended period, and the combined development costs incurred to date amount to $1,500,000. R&D produced several alternative designs for the backup units. Three of the designs were approved for development into proto-types, and from these only one will be manufactured and sold. Market Research has determined that the appropriate selling price would be $400 per unit, regardless of the model selected.

The estimated demand schedule for three different market situations is shown. These three demand levels are the only ones the company considers feasible, and other demand levels are not expected to occur. Steven can meet all demand levels because its fixed plant currently is below full capacity.

Steven's accounting and engineering staffs have worked together to develop manufactur-ing cost estimates for each of the three model designs. Costs for the three models follow. Manufacturing overhead, 40% of which is variable, is applied to Steven's products using a plantwide application rate of 250% of direct labor dollars.

Steven has decided to employ an expected value model in its analysis to reach a decision as to which of the three prototypes it will manufacture and sell.

Required:

a. Develop a payoff table to determine the expected monetary value for each of the three models Steven Company could manufacture. Based on your analysis, identify the proto-type model Steven should manufacture and sell.

b. Steven Company's costs for a backup unit design that was not developed into a proto-type were estimated as follows:

If this design had been developed by Steven into a viable model, it would have sold for $400 and had the same expected demand as the other models. Steven's management eliminated this model from consideration because it was considered an inadmissible act,

Unit Sales Probability Of OccurrenceLight demand 20,000 0.25Moderate demand 80,000 0.60Heavy demand 120,000 0.15

Model A Model B Model CUnit costs: Direct materials $150 $100 $114Direct labor 40 50 48Manufacturing overhead 100 125 120

Total unit costs $290 $275 $282Other costs: Tooling and advertising $3,000,000 $4,500,000 $4,100,000Incurred development costs 1,500,000 1,500,000 1,500,000

Unit costs: Direct materials $130Direct labor 46Manufacturing overhead 115Total unit costs $291Other costs: Tooling and advertising $4,000,000Incurred development costs 1,500,000

CHAPTER 19


i.e., the calculation of its payoff would have been irrelevant. Explain why the model design was considered an inadmissible act, thus making the calculation of its payoff irrelevant.

c. Steven Company could have employed a decision-tree model in this situation. Explain how the decision-tree model could have been employed in making this decision (no cal-culations are required).

19.74 Decision-tree analysis. [CMA adapted] Global Credit Corporation (GCC) pro-vides retail and banking institutions throughout the United States and Canada with credit histories of individuals who are seeking various types of financing such as home mort-gages, car loans, and retail store credit cards. GCC has branch offices in most major cit-ies in order to provide rapid service to its customers. GCC employs a database system, and the database is maintained at the home office in Kansas City for security purposes. Each branch office is equipped with computer terminals that provide direct access to the database for information retrieval. However, all data entry is completed in Kansas City.

GCC employs a staff of approximately 500 data-entry clerks at the home office. The company hires inexperienced personnel and provides a training course immediately upon hiring. Hiring inexperienced personnel allows GCC to realize an average savings of $3,000 per new employee. Glen Webster, director of human resources, has just com-pleted a review of the employment records of the data-entry clerks and has discovered that only 50% of the trainees complete the training course satisfactorily and continue their employment with GCC. The remaining 50% are found lacking in aptitude for the job and are dismissed. While Webster is aware that the turnover rate for this type of posi-tion is typically high, this particular problem indicates a failure in the selection process.

Because the full training course for each data-entry clerk costs GCC $600 and the reten-tion rate is so poor, Webster is considering using a battery of tests to assist in determin-ing which individuals should be hired and trained. The testing program would cost $200 per applicant to administer. Webster estimates that 75% of the applicants would score at or above the minimum cutoff, i.e., achieve an acceptable score. Those applicants who achieve an acceptable score and are hired would be given an abbreviated training course at a cost of $300. Those applicants who would be hired despite scoring below the cutoff point would still be given the full training course so there would be no savings in train-ing costs.

After the results of the testing program are known, the Human Resource Department would consider other employee attributes before making a decision. As a result of this additional screening, Webster estimates that 90% of the high-scoring applicants would be hired and sent to the abbreviated training course, and 10% of the low-scoring appli-cants would be hired and sent to the full training course. The remaining applicants would not be hired.

To assist in his decision regarding the testing program, Webster has assigned probabili-ties to satisfactory and unsatisfactory training course completion under varying condi-tions. These probabilities are presented as follows:

Required:


a. Glen Webster has decided to use decision-tree analysis to determine whether or not GCC should initiate a testing program for the applicants for the data entry positions.

1. Explain why decision-tree analysis can be employed in this situation.2. Discuss the disadvantages associated with decision-tree analysis.

b. Formulate the decision-tree framework for analyzing whether GCC should initiate a testing program or continue with its current employment practices.

c. Using the backward induction method, determine whether GCC should select the test-ing program. Support your decision with appropriate calculations.

19.75 Steps in a rational decision-making process. [CMA adapted] During the early 1990s, ProSoft Corporation developed and marketed business applications software for mini-computers, achieving a significant market share and a secure position in the indus-try. After maturing at this level of success, the company's mission became less clear. Fur-ther software development for minicomputers was seen as costly with little value to the company, as the market for major business applications was saturated and the minor applications had limited markets.

In order to maintain ProSoft's market share, management decided to enter the growing personal computer field. While major programming would be required to make the com-pany's existing software compatible with personal computers (PCs), management viewed the commitment of all personnel to this project as critical to the continued growth of Pro-Soft. The emphasis was to be placed on product development, with minimal effort directed toward market analysis.

After weeks of executive strategy sessions regarding product specifications, manage-ment imposed the task deadlines and set the date for the introduction of its first PC prod-uct, an accounting package for general ledger, accounts payable, and accounts receivable applications. Three months prior to the introduction date, ProSoft began an advertising and dealer promotion campaign announcing the new product and setting the introduction date. Several technical problems arose during development, but the staff believed that a few time-saving measures would enable them to complete the package in time to meet the announced date. Management felt considerable pressure to meet this date as ProSoft had previously missed an announced date and suffered the consequences.

Two weeks before the announced date, ProSoft's marketing personnel learned that an updated version of the PC operating software that ProSoft's new package was designed to interact with was to be released shortly. The marketing staff knew that features could quickly be added to ProSoft's new product to take advantage of the new features in the operating software; however, there would not be time to field test the program changes. The technical personnel warned the marketing staff of the dangers of releasing a product without proper field testing, but these warnings were not heeded. Management, with encouragement from the marketing staff, made the decision to incorporate the features necessary to take advantage of the new operating software and introduce the product on the scheduled date.

Training Course CompletionTesting/ Non testing Satisfactory UnsatisfactoryTest acceptable .7 .3Test not acceptable .2 .8No test .5 .5

CHAPTER 19


Not long after ProSoft made the first shipments of its new software, customers began to complain about processing problems in the accounts payable and accounts receivable modules. Very quickly, it was determined that portions of ProSoft's new package were not compatible with the updated operating software. To correct the problem, the com-pany had to rewrite the software and manuals and replace all existing product. The tech-nical personnel were not dedicated to the development of the next PC product, and this problem fragmented their efforts. The revised product was not available for three months, causing a loss of sales. The financial impact of the $1.7 million error on the company with annual profits of $1.1 million was devastating.

Required:

a. Identify the steps in the general decision-making process.b. Using the steps identified in Requirement (a), describe the weaknesses in ProSoft's

decision-making process.c. Recommend changes to correct the weaknesses identified in Requirement (b).

19.76 Rational decision-making process. [CMA adapted] Sally Hamm, business man-ager of the Parkside School District, is preparing for the upcoming meeting of the Dis-trict School Board. In addition to presenting reports on the routine operations of the district, Hamm will be expected to make recommendations on two special agenda items. The first item addresses the number of high school classroom teachers for the upcoming school year; the second involves the inclusion of computer courses in the adult educa-tion program. Both of these items have budget implications that must be addressed. Hamm is responsible for developing the district's budget under the direction of, and within the guidelines, established by the School Board. Once the board approves the budget, it is voted on by the citizens in the school district, i.e., the citizens accept or reject the district's budget.

Hamm must determine the number of teachers that will be needed to teach grades 10, 11, and 12 at Parkside Regional High School next year. The salary line is always the largest single item in the school budget and will be the subject of intense discussion before it is voted on by the citizens. To aid in making her recommendation, Hamm has the follow-ing information available: the current high school enrollment, the current ninth grade enrollment, historical data on students transferring in and out of the district, and statis-tics on the number of students that can be expected to drop out of Parkside Regional High School. The Parkside School District has always maintained a teacher-student ratio that is at or above the state average.

The administrators at Parkside Regional High School have proposed that the computer facilities at the high school be utilized in the evenings to conduct adult education courses to gain increased benefits from the investment in these facilities. Hamm has been given little information about this program although she has been told that additional materials would be required (e.g., additional software and training manual) which could be expen-sive. There is little formal information available about local interest in a program of this nature, and Hamm is not sure that the program will generate enough revenue to defray the costs. Based on Hamm's recommendation, a decision about this program will be reached at the upcoming meeting.


Required:

a. Identify the steps in the general decision-making process under rational and objective conditions.

b. Citing examples from the situation given above, differentiate between decision mak-ing under conditions of risk and decision making under conditions of uncertainty.

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