Short-Run Decision Making; Relevant

Costing and Inventory Management

Management Accounting: The Cornerstone for

Business Decisions

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Learning Objectives

1. Describe the short-run decision-making model and explain how cost behavior affects the information used to make decisions.

2. Apply relevant costing and decision-making concepts in a variety of business situations.

3. Choose the optimal product mix when faced with one constrained resource.

Learning Objectives

4. Explain the impact of cost on pricing decisions.

5. Discuss inventory management under the economic order quantity and JIT models.

Illustrate Make or Buy Decision

What are the steps of the decision model?

How to structure a make or buy problem.

Buttons Manufacturing needed to determine if it would be cheaper to make 12,000 units of a component in house or purchase them from an outside supplier for $4.80 each. Absorption-costing information for internal production includes the following :

Total Cost Unit CostDirect materials $12,000 $1.00Direct labor 24,000 2.00Variable overhead 10,200 0.85Fixed overhead 52,800 4.40 Total $89,000 $8.25Fixed overhead will continue whether the component

is produced internally or externally. No additional cost of purchasing will be incurred beyond the purchase price.

12-1

REQUIRED: 1. What are the alternatives for Buttons

Manufacturing?2. List the relevant cost(s) of the internal

production and external purchase.3. Which alternative is more cost effective and

by how much?4. Now assume that the fixed overhead includes

$12,000 of cost that can be avoided if the component is purchased externally. Which alternative is more cost effective, and by how much?

Calculation:1.

How to structure a make or buy problem.12-1

2.

3.

How to structure a make or buy problem.12-1

4.

How to structure a make or buy problem12-1

Illustrate Accept a Special Order Decision

How to structure a special-order problem.12-2

Leibnitz Company has an offer by a new customer to purchase 22,000 units of model BL7 for $8 each. The new customer is geographically separated from the company’s other customers, and existing sales would not be affected. Leibnitz normally produces 100,000 units of BL7 per year but only plans to produce and sell 75,000 in the coming year. The normal sales price is $14 per unit. Unit cost information is as follows:

Direct material $2.50Direct labor 2.30Variable overhead 1.50Fixed overhead 2.00 Total $8.30

Fixed overhead will not be affected whether or not the special order is accepted.

REQUIRED:1. What are the relevant costs and

benefits of the two alternatives (accept or reject the special order)?

2. By how much will operating income increase or decrease if the order is accepted?

Calculations:

How to structure a special-order problem.12-2

2. If the problem is done on the unit basis:

How to structure a special-order problem.12-2

How to structure a keep-or-drop product

line problem.The roofing tile line has a contribution margin of

$15,000 (sales of $160,000 less variable expense of $145,000). All variable costs are relevant. Relevant fixed costs associated with this line include $15,000 in advertising and $35,000 in supervision.

REQUIRED: 1. List the alternatives being considered.2. List the relevant benefits and costs for each

alternative.3. Which alternative is more cost efficient and

by how much?

Calculation:1.

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2.

3.

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How to structure a keep-or-drop product

line problem.

Dropping the product line reduces sales of blocks by 8% and sales of bricks by 10%. All other information remains the same.

REQUIRED:1. If the roofing tile line is dropped, what

is the contribution margin for the block line? For the brick line?

2. Now which alternative (keep or drop the roofing tile line) is more cost effective, by how much?

12-4

How to structure a keep-or-drop product line problem

with complementary effects.

Calculation:

12-4

How to structure a keep-or-drop product line problem

with complementary effects.

2.

12-4

How to structure a keep-or-drop product line problem

with complementary effects.

How to structure the sell-or-process further

decision.Appletime must decide to whether to sell Grade B

pears at the split-off or process further for pear sauce. The company normally sells Grade B pears in units of 120 5lb bags at a net price of $1.20 per bag. If the pears are processed further the result would be 500 cans of sauce with an additional cost of $0.19 per can. The buyer will pay $0.85 per can.

REQUIRED:1.What is the contribution margin from selling the

Grade B pears in the 5lb bag?2.What is the contribution to income from

processing the the Grade B pears in to pear sauce?

3.Should they sell the pears in bags or process them further?

12-5

Calculation:

How to structure the sell-or-process further

decision.12-5

Illustrate Further Processing Decision

How to determine the optimal product mix with one constrained resource.

Jorgeson Company produces two types of gearboxes, X2 and Y3 with unit contribution margins of $50 and $20, respectively. Each gearbox must stamped by a special machine. The company owns four machines that provide 20,000 hours of machine time per year. Gearbox X2 requires 1 hour of machine time, while gearbox Y3 requires 0.25 hour of machine time. There are no other constraints.

REQUIRED:1. What is the contribution margin per hour of

machine time per gearbox?2. What is the optimal mix of gearboxes?3. What is the total contribution margin for the

optimal mix?

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Calculation:

How to determine the optimal product mix with one constrained resource.

12-6

Everything is exactly the same as Cornerstone 12-6 with the addition that only a maximum of 50,000 units of either gearbox can be sold.

REQUIRED:1. What is the contribution margin per

hour of machine time per gearbox?2. What is the optimal mix of gearboxes?3. What is the total contribution margin

for the optimal mix?Calculation:

How to determine the optimal product mix with one constrained resource

and a sales constraint.12-7

How to determine the optimal product mix with one constrained resource

and a sales constraint.12-7

How to determine the optimal product mix with one constrained resource

and a sales constraint.12-7

3.

How to calculate price by applying a markup percentage to cost.

Elvin Company assembles and installs computers to customer specifications. Elvin had decided to price its jobs at the cost of direct materials and direct labor plus 20%. The job for a local middle school included the following costs:Direct materials $150,000Direct labor 10,000

REQUIRED: Calculate the price charged by Elvin Company to the middle school.

Calculation:

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How to calculate a target cost.

Digitime’s new pocket watch plus PDA has a target price $175. Management requires a 20% profit on new products.

REQUIRED:1. Calculate the amount of desired

profits.2. Calculate the target cost.

Calculation:1. Desired profit =

2. Target cost =

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Match Definitions

Ordering Costs

Carrying Costs

The costs of having inventory on hand

The cost of placing and receiving an order of inventory

EOQ

StockoutCosts

A mathematical model to determine how much inventory should be ordered and when

The costs of not have a product available when a customer demands it

How to calculate ordering cost, carrying cost, & total

inventory-related cost.Mall-o-Cars, Inc., sells a number of automotive brands

and provides service after the sale of those brands. Part Z9T is used in the repair of window switches ( the part is purchased from external suppliers). Each year 5,000 Z9T are used; they are currently purchased in lots of 500 units. It costs Mall-o-Cars $25 to place the order and the carrying cost is $2 per part per year.

REQUIRED:1. How many orders for Part Z9T are placed per year?2. What is the total ordering cost of Part Z9T per year?3. What is the total carrying cost of Part Z9T per year?4. What is the total cost of Mall-o-Car’s inventory for

Part Z9T per year?

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Calculation:1.

2.

3.

4.

How to calculate ordering cost, carrying cost, & total

inventory-related cost.12-10

How to calculate the EOQ, ordering cost, carrying cost, and total inventory-related

cost.Mall-o-Cars, Inc., sells a number of automotive

brands and provides service after the sale of those brands. Part Q6B is used in the repair of window trim. Each year 20,000 Q6B are used; they are currently purchased in lots of 2,000 units. It costs $40 to place the order and the carrying cost is $2.50 per part per year.

REQUIRED:1. What is the EOQ for Part Q6B?2. How many orders for Part Q6B does Mall-o-Cars

place per year?3. What is the total ordering cost of Part Q6B per

year?4. What is the total carrying cost of Part Q6B per

year?5. What is the total cost of Mall-o-Car’s inventory

for Part Q6B per year?

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Calculation:1.

2.

3.

4.

5.

How to calculate ordering cost, carrying cost, & total

inventory-related cost.12-11