Chapter 13

Relevant Costs and Product Planning Decisions

Concept Questions

1. (LO 1—Special order decisions)

A special order will increase net income when the additional revenue from the
special order is greater than the additional costs of producing the special order,
including any opportunity costs.

2. (LO 1—Special order decisions: relevant costs)

In a special order decision with excess capacity, the relevant costs are likely to
include the variable costs (direct material, direct labor, variable overhead and
perhaps variable selling and administrative costs) of producing the special order.
There are not likely to be any opportunity costs.

3. (LO 2—Make or buy decision: relevant costs)

The relevant costs are typically the costs of buying the product from an outside
source, the variable costs of making the product that can be avoided by buying,
any avoidable fixed costs, and the opportunity costs incurred by foregoing the
production of another product.

4. (LO 2—Make or buy decision: qualitative factors)

In a make or buy decision, the quality of product, reliability of the vendor and the
impact of changing technology on the product are all important qualitative factors.

5. (LO 2—Outsourcing: disadvantages)

Disadvantages of outsourcing the production of a component part include:

perceived lack of stability within the company, lack of loyalty in the workforce,
and a loss of a highly trained and skilled workforce.

6. (LO 2—Make or buy decision: relevant costs)

Fixed costs that are unavoidable would be irrelevant as well as any sunk costs
for facilities and equipment. For example, rent on the factory building is likely to
be unavoidable and thus not relevant if it must be used to make other parts and
products.
7. (LO 3—Dropping a product line)

The decision to drop a product should be based on many factors. From a

quantitative perspective, a product should be discontinued if the contribution
margin lost by dropping the product is less than the fixed costs avoided by
dropping the product. Other qualitative factors should be considered. For
example, dropping a product may result in a decline in sales of another company
product or a loss of customers that purchase other products.

8. (LO 4—Limited resources)

The goal should be to maximize the contribution margin per unit of the scarce
resource.

9. (LO 5—Bottlenecks and the theory of constraints)

Management should focus its time and resources to alleviate the bottleneck by
improving the efficiency of the bottleneck process through the purchase of new
equipment, the cross-training of employees, scheduling overtime, or perhaps
even outsourcing.

10. (LO 6—Sell or process further)

The rule is simple: a product should be processed further if the additional

revenue is greater than the additional cost.

Brief Exercises
1. (LO1—Special-order pricing decision)

The only relevant cost is the variable cost of Rs.750. The fixed costs are not
relevant and there are no opportunity costs. Therefore, the minimum price should
be Rs.750.

2. (LO 2—Make or buy decision)

The relevant costs of making the product are the variable costs of ₹2,350 per
unit. If Switzer buys the units for ₹2,500, the company can only avoid the ₹2,350
of relevant variable costs. If Switzer accepts the offer and buys the part for
₹2,500, income will decrease by ₹1,50,000 (1,000 units  ₹150.00 in additional
cost per unit).

3. (LO3—Basic drop-a-segment decision)

If the Portland segment is eliminated, the company’s overall income will decrease
by Rs.10,00,000 as follows:

Decrease in overall contribution margin Rs.(12,50,000)

 Decrease in fixed costs* 2,50,000
Overall decrease in operating income Rs.(10,00,000)

* A decrease in fixed costs equates to an increase in profit

Because the contribution margin lost is greater than the avoidable fixed costs,
overall profit will decrease.

4. (LO2—Resource utilization decisions and constraints)

a. False
b. False
c. True
d. False
e. False

5. (LO6—Decision to sell or process further)

If smoked hams can be sold for Rs.112.50 per pound, the hams should be
processed further because the incremental revenue of Rs.37.50 (Rs.112.50 –
Rs.75) is greater than the incremental cost of Rs.25. Profit would go up by
Rs.12.50 per pound with further processing. The joint processing cost of Rs.50
per pound is a sunk cost that is not relevant to the decision. If the smoked hams
can be sold for Rs.87.50, they should not be processed further. In that case, the
incremental costs are greater than the incremental revenue and would result in
an overall decrease in profits of Rs.12.50 per pound.

Exercises

6. (LO 1—Special order pricing decision)

The relevant cost per chair is ₹550 for direct materials, ₹350 for direct labor,
₹100 for variable overhead, and ₹300 (₹15,000/50) for the special equipment
rental for a total of ₹1,300. The minimum profit per chair is ₹500.00 (₹25,000 ÷
50 chairs). Therefore, the minimum sales price should be ₹1,800 (₹1,300+
₹500).

7. (LO 1—Special order decision: Relevant costs)

The relevant unit cost is ₹275 per unit (₹11,00,00,000/400,000 units).

 The total relevant costs include ₹10,00,00,000 of variable manufacturing costs
(₹16,00,00,000 – ₹6,00,00,000 fixed costs) and ₹1,00,00,000 of variable selling
expenses (₹1,50,00,000 – ₹50,00,000 of fixed costs).
8. (LO1—Special-order pricing decision)

The minimum acceptable selling price is Rs.400 (the amount of the relevant
variable costs). Note that this is true as long as total production is within the
relevant range of 50,000 to 300,000 cases.

9. (LO1—Special order: Effect on income)

The only relevant cost is the variable cost of Rs.1,000 per lacrosse stick. The
Rs.1,000 fixed cost is not relevant. Likewise, because there is excess capacity,
there is no opportunity cost. If the order is accepted, income will increase by
Rs.10,50,000 [(Rs.2,500 – Rs.1,000) x 700 units].

10. (LO 2—Make or buy: Effect on income)

Relevant cost to make themselves:

Variable costs:
Direct materials ₹ 150
Direct labor 150
Variable overhead 100
Relevant VC to make (per unit) ₹ 400
 10,000 lbs
Total relevant VC to make ₹ 40,00,000

Add: Relevant FC to make 16,00,000

(new supervisor)
Total relevant costs to make ₹ 56,00,000

vs. Total cost to buy (₹550  55,00,000

10,000)
Increase in cost if make themselves ₹ 1,00,000

Therefore, if they make the component themselves, income will decrease

₹100,000.

11. (LO2—Basic make-or-buy decision)

The only relevant cost of making the product is the variable cost of Rs.2,800 per
unit. If Ice Cold buys the units for Rs.3,000, the company can avoid just that
Rs.2,800. If Ice Cold accepts the offer and buys the part for Rs.3,000, income will
decrease by Rs.2,00,000 (1,000 units × Rs.200.00 additional cost per unit).
12. (LO2—Outsourcing decision)

The company should accept the offer of Rs.62,50,000. Outsourcing will allow the
company to avoid Rs.75,00,000 of labor costs. The depreciation and allocated
overhead costs are neither avoidable nor relevant to the decision.

Relevant cost of outsourcing:

Amount paid to Robyn Maintenance Rs.62,50,000

Relevant cost of doing the job itself:

Current cost Rs.75,00,000
Less: Unavoidable fixed costs (10,00,000) 65,00,000
Incremental cost of doing the job itself Rs.2,50,000

13. (LO2—Outsourcing decision)

The company should accept the offer of Rs.75,00,000. Outsourcing will allow the
hospital to avoid Rs.1,00,00,000 of labor costs. The depreciation and allocated
overhead costs are neither avoidable nor relevant to the decision.

14. (LO 3—Impact of dropping a product line)

If Product C is dropped, operating profit will decrease an additional ₹7,50,000

calculated as follows:

Decrease in overall CM ₹(7,50,000)

Decrease in FC —
Overall decrease in operating income ₹(7,50,000)

Since the contribution margin lost by dropping Product C is greater than the fixed
costs avoided, the company should not drop the product.

15. (LO 3—Impact of dropping a product line)

If painted rockers are dropped, overall operating profit will not be affected as
follows:

Decrease in overall CM ₹(7,50,000)

Decrease in FC * 7,50,000
Overall decrease in operating income ₹ 0

* A decrease in FC equates to an increase in profit.

 Since the contribution margin lost is exactly equal to the avoidable fixed costs,
overall profit will not change.

16. (LO 4—Limited resource decision)

To maximize profits, the company should produce the product with the highest
contribution margin per unit of limited resource. In this case, they should produce
Compact Disc 1, which has a CM/machine hour of ₹200.

Compact Disc 1 Compact Disc 2

Selling price ₹ 500 ₹ 1,000
Variable cost (100) (200)
Contribution margin ₹ 400 ₹ 800
÷ machine hours per disc ÷ 2 ÷ 5
CM per machine hour ₹200.00 ₹160

Although not required to answer the problem, notice that the maximum net
income Kerrie would be able to have is ₹80,00,000.

Sales [(100,000 mach. hrs./2 hrs.)  ₹2,50,00,00

₹500] 0
Less: Variable costs (50,000  ₹100) (50,00,000)
Less: Fixed costs (1,20,00,000)
Maximum net income ₹80,00,000

17. (LO 4—Maximizing contribution margin given a limited resource)

A. The contribution margin for queen beds is ₹3,750 per unit (₹26,250 sales
price less the variable costs of ₹22,500). The contribution margin for king
beds is ₹7,500 per unit (₹31,750 sales price less the variable costs of
₹24,250).

B. Given the limited resource of stuffing hours, Soft Mattress, Inc., should
make the product that maximizes the contribution margin per unit of
limited resource. Each queen bed generates a contribution margin of
₹3,750 per stuffing hour (₹3,750 CM/1 hour) while each king bed
generates a contribution margin of only ₹2,500 per stuffing hour (₹7,500
CM/3 hours). Accordingly, Soft Mattress, Inc., will maximize its profits by
making only queen mattresses. Students should note that qualitative
factors (such as the impact on customers of not making king mattresses)
should also be considered in this decision.

18. (LO4—Maximizing contribution margin given a limited resource)

 A. The contribution margin per limited resource for pigskin
footballs is Rs.6,875 (Rs.25,000 sales price less the variable cost of
Rs.11,250 = Rs.13,750/2 hr = Rs.6,875). The contribution margin per
limited resource for artificial leather footballs is Rs.7,000 (Rs.12,500 sales
price less the variable cost of Rs.5,500 = Rs.7,000/1 = Rs.7,000).

B. Given the limited resource of hours required to stitch the football

(stitching hours), Footballs Galore should make the product that
maximizes the contribution margin per unit of limited resource. Each
batch of pigskin footballs generates a contribution margin of Rs.6,875 per
stitching hour (Rs.13,750 CM/2 hours), whereas each batch of artificial
leather footballs generates a contribution margin of Rs.7,000 per stitching
hour Rs.7,000CM/1 hour). Accordingly, Footballs Galore will maximize its
profits by making only artificial leather footballs. Note that qualitative
factors (such as the impact on customers of not making pigskin footballs)
should also be considered in this decision.

19. (LO 6—Sell or process further decision)

The company should sell the units “as is” because all previous costs of
production are sunk costs and irrelevant. The incremental revenue of ₹1,500
realized by reworking the defective units is less than the additional costs of
₹2,100 incurred. Therefore, the company should sell them “as is.”

20. (LO 6—Sell or process further decision)

Based on the computations below, DePaulis should finish the chairs since the
incremental revenue is greater than the incremental costs.

With further processing:

Incremental revenue per chair (₹6,250 – ₹2,000

₹4,250)
Incremental cost per chair (₹4,500 – ₹3,250) 1,250
Incremental profit per chair ₹750

Problems

21. (LO 1—Special order decision: Qualitative factors)

A. Expected level of operating profit:

Sales ₹2,50,00,000
 Variable manufacturing costs (20,000  ₹500) 1,00,00,000
Fixed manufacturing costs 90,00,000
Variable marketing & admin. costs (20,000  ₹250) 50,00,000
Fixed marketing & admin. costs 10,00,000
Net income ₹ 0

B. Yes, accepting the special order would increase profits by ₹4,00,000:

Increase in incremental revenue (1,000  ₹10,00,000
₹1,000)
Increase in incremental costs (1,000  6,00,000
₹600*)
Increase in profit ₹ 4,00,000

*VC per unit = ₹500 + ₹100

C. Accepting this special order would increase profits by ₹13,50,000 as

follows:
Incremental revenue (3,000  ₹950) ₹28,50,000
Incremental costs (3,000  ₹500) 15,00,000
Incremental profit ₹13,50,000

D. Considering the impact of special orders on existing customers is always

an important qualitative consideration. If regular customers are aware that
others are buying at a lower price, they may become angry and take their
business elsewhere.

22. (LO1—Special-order decision: Qualitative factors)

A. The company should accept the special order. The incremental profit is
Rs.75,000, calculated as follows:

Incremental revenues (500  Rs.400) Rs.2,00,000

Incremental costs: Variable manufacturing (500  Rs.250)
1,25,000
Incremental profit Rs. 75,000

B. Paying the setup costs of Rs.50,000 would increase the incremental costs to
Rs.1,75,000, reducing the profit to Rs.25,000. However, the special order
should still be accepted.
C. Other factors include the possibility of repeat business from this customer,
whether he or she will expect the same price, and the reaction of other
customers if they find out that this special order was sold at a lower price.

D. If regular sales would be affected by the acceptance of the special order, the
company must consider the opportunity cost incurred by accepting
 the order. In this case, the company would lose the contribution margin of
Rs.700 (Rs.1,000 – Rs.300) on outside sales. The contribution margin lost
would total Rs.1,40,000 (200  Rs.700). Because the special order
increased profits only by Rs.75.000, the overall profit would decrease by
Rs.65,000. Therefore, the special order should now be rejected.

23. (LO 2—Make or buy decision: Relevant costs and qualitative factors)

A. The total relevant costs of making the part are ₹2,400 per unit or
₹2,40,00,000 in total which includes direct materials, direct labor, variable
overhead, and 40 percent of the ₹750 of fixed overhead (the other 60
percent will continue regardless of the decision and is therefore not
avoidable).

B. Jain Simmons should continue to make the part. The cost of buying the
part from Sullivan Company (₹2,650) is ₹250 higher than the costs that
can be avoided by stopping production (₹2400). Making the part will be
more advantageous by ₹25,00,000.

C. This is a qualitative factor that should further encourage Jain Simmons to

continue making the part. The company will want to have a positive image
in the community.

24. (LO2—Make-or-buy decision: Relevant costs and qualitative factors)

A. The total relevant cost of making the part is Rs.2,400 per unit, or
Rs.2,88,00,000, which includes the costs of direct materials, direct labor,
and variable overhead, as well as 40 percent of the Rs.750 of fixed
overhead. (The other 60 percent will continue regardless of the decision
and is therefore not avoidable.)

B. From a quantitative perspective, Tony’s Electronics should buy the part

from the external supplier and stop manufacturing the part. The cost of
buying the part from Scott Company (Rs.2,250) is Rs.150 less than the
cost that can be avoided by stopping production (Rs.2,400). Buying the
part will be more advantageous by Rs.18,00,000.

C. In making the decision, the company should consider the impact on

stakeholders, including displaced workers. This is a qualitative factor
that should encourage Tony’s Electronics to continue making the
part—particularly given the relatively small cost savings that the company
would receive from outsourcing the part.

25. (LO2—Make-or-buy decision: Qualitative factors)

 A. From a quantitative perspective, the rope should not be purchased from
the outsider supplier. Making the rope will save the company Rs.1,25,000.

The outside purchase price of Rs.62.50 per unit, or Rs.6,25,000 for 10,000
units of rope, is higher than the variable cost of Rs.50 per unit
(Rs.5,00,000 in variable cost ÷ 10,000 units sold) that can be avoided if
the rope is not produced internally. Only the variable cost of Rs.5,00,000
for 10,000 units of rope is an avoidable cost.

B. If the Hemp Division is at full capacity and cannot produce any more
rope, it should continue to manufacture rope for Hammock Products and
purchase 10,000 feet of additional rope at Rs.62.50 per unit from an
outside supplier. This rope can be sold to outsiders at the current price of
Rs.100.00 per unit, resulting in a net benefit of Rs.3,75,000.

C. Hemp should consider whether the lower quality rope would have an
impact on customers and on the company’s future sales. However,
because the rope is still of satisfactory quality, the company might choose
to buy it and pass on the savings (or part of the savings) to its customers.

D. At Rs.50.00 per unit, the outsider purchase price is still just equal to the
avoidable costs of producing the rope internally. Although Hemp would not
purchase the rope if its sales to outsiders were limited, if sufficient demand
exists to sell all production to outsiders at present prices, the division
might consider the purchase. An analysis of qualitative factors is once
again paramount.

26. (LO 3—Temporary suspension of operations: Qualitative factors)

A. Some fixed costs will continue to be incurred despite the temporary

closing of the mine. Key employees probably cannot be discharged. A
small staff would be needed to continue certain administrative functions.
The maintenance of the building and equipment would need to continue to
prevent damage that could be costly to repair. Taxes and insurance would
continue to be paid during the shut-down period.

B. Suspension of operations would be desirable when sales volume drops

below 6,000 units.

Each ton of ore sold contributes ₹50 of contribution margin (₹150 revenue
– ₹100 variable costs).

If the mine is closed down, fixed costs are ₹2,00,000 per month while
fixed costs are ₹5,00,000 per month if the mine continues to operate. The
additional ₹3,00,000 of fixed costs requires the sale of 6,000 tons of ore.
 C. Shutting down operations gives the company a bad image. Attempts to
rehire former employees may prove futile. By the time the company is able
to start up again, prices in the market may have changed. The local
economy will be adversely affected also.

27. (LO3—Decision focus: Eliminating unprofitable segments)

A. The current profit for the company as a whole is Rs.1,050 million

(Rs.450 + Rs.1,000 – Rs.350 – Rs.50).

B. If the East and West segments are eliminated, the new operating profit
would be Rs.1,000 million. Although the company would increase its
contribution margin by Rs.50 million if the East segment is eliminated,
elimination of the West segment would result in a loss of Rs.100 million in
contribution margin. However, none of the fixed costs associated with
either segment are avoidable. The remaining segments (North and South)
would have to be allocated Rs.450 million of fixed costs now being
allocated to the East and West segments.

C. Eliminating the East segment with its negative contribution margin is one
option. Although its allocated fixed costs of Rs.300 million will still need to
be allocated elsewhere, total profits of the remaining three segments will
increase to Rs.1,100 million (Rs.2,600 million of contribution margin –
Rs.1,500 million of fixed costs).

D. Qualitative factors include loss of sales and the potential negative impact
on the remaining segments. A discontinued segment may have been
supplying goods or services to the other divisions, and a replacement
would have to be found. The local economy may be adversely affected by
the shutdown. Finally, there may be implications of not having a presence
in one part of the country.

28. (LO3—Decision focus: Eliminating unprofitable segments)

A. The current operating profit for the company as a whole is Rs.1,400 million

(Rs.250 + Rs.750 – Rs.100 + Rs.500).

B. The new operating profit would be Rs.1,100 million. Dropping the craps
segment would result in a reduction in contribution margin of Rs.300
million, and because none of the fixed costs would be avoidable and the
remaining segments (card tables, slots, and roulette) would have to be
allocated to theRs.400 million of fixed costs now being allocated to craps,
the company’s profit would go down by Rs.300 million.
 C. Increasing revenues by bringing more people into the casino will help
maximize profits. Although variable costs would be expected to rise as
gambling revenue increases, fixed costs would not. Because all the
segments have positive contribution margins, increasing revenues will
increase the profitability of the company.

D. Qualitative factors include a loss of customers and gambling revenue and

the potential negative impact on the remaining segments. Gamblers may
stop coming to the casino if craps is not offered. Finally, there are other
stakeholders, such as employees, who would likely lose jobs if the
segment is eliminated.

29. (LO 4 and 5—Limited resource decision)

A. This decision should be based on the contribution margin per hour of

machine time.

Contribution margin per pair of boots:

Men’s Women’s
CM ₹ 650 ₹ 650
÷ Machine time 0.25 hr 0.50 hr
CM per hour ₹ 2,600 ₹ 1,300

To maximize profitability, the men’s boot should be produced first.

B. The company can sell 1,000 pairs of each product each month.

Manufacturing 1,000 pairs of men’s boots requires 250 hours of machine

time (1,000 pairs  0.25 hours per pair). The remaining 390 hours can be
used for the production of the women’s boots. Since each pair of women’s
boots requires 0.50 hour, 780 pairs of women’s boots can be produced.

C. The company should consider the impact of limiting the production of

women’s boots to 780 pairs when the demand is 1,000 pairs per month. If
women can’t find the boots that they want in stock, might that impact sales
of men’s boots as well?

30. (LO4 and 5—Limited-resource decision)

If all bottles of salsa displayed can be sold and all of the salsas are given
the same amount of shelf space, the new salsa would generate the most
revenue, followed by salsa #1, and salsa #2. Salsa #3 would be ranked
last.
 A. Salsa #1 would generate Rs.12,500 of revenue (Rs.125  10 bottles per
foot  10 feet).

Salsa #2 would generate Rs.12,375 of revenue (Rs.137.5  9 bottles per

foot  10 feet).

Salsa #3 would generate Rs.10,500 of revenue (Rs.150  7 bottles per

foot  10 feet).

The new salsa would generate Rs.24,000 of revenue (Rs.200.00  12

bottles per foot  10 feet).

B. Rather than giving each salsa the same amount of shelf space, the salsa
that generates the highest CM per foot of shelf space should be given the
most space. Thus, we have the following calculations:

Salsa #1 Salsa #2 Salsa #3 New Salsa

CM per bottle Rs. 62.50 Rs.70 Rs.75 Rs.40
 bottles per foot  10  9  7  12
CM per foot* Rs.625 Rs.630 Rs.525 Rs.480

* Alternatively, the contribution margin per foot of shelf space may be calculated by
dividing the contribution margin per bottle of salsa by the amount of shelf space taken
up by each bottle. For example, each bottle of salsa #1 takes up 0.1 foot of shelf space
(1 foot/10 bottles per foot) and each bottle of salsa #2 takes up 0.111 foot of shelf space
(1 foot/9 bottles per foot).

Salsa #2 is the most profitable per foot of shelf space and should get the
most shelf space, followed by salsa #1, salsa #3, and the new salsa.

C. Qualitative factors include the demand for each product and the loss of
sales that might occur if any of the salsas are removed from the shelf if
square footage is limited. The unique packaging of the new salsa may
make the other products seem inferior and may “water down” sales of
those products.

31. (LO4 and 5—Limited-resource decision)

A. This decision should be based on the contribution margin per hour of

machine time.

Following is the contribution margin per carton of balls:

Pro Model Tour Model
Contribution margin Rs.10,000 Rs.10,000
÷ Machine time 0.25 hr 0.50 hr
 CM per hour Rs.40,000 Rs.20,000

To maximize profitability, the Pro Model should be produced in the largest

quantity.

B. The maximum sales of each ball are 300 cartons (108,000 balls/360 balls
per carton).

Manufacturing 300 cartons of Pro Model balls requires approximately

75 hours of machine time (300 cartons  0.025 hour per carton). The
remaining 35 hours can be used for the production of the Tour Model.
Because each carton of Tour Model balls requires 0.50 hour, it follows
that 70 cartons, or 25,200 Tour Model balls, can be produced (35 machine
hours/0.50 hour per carton  360 balls per carton).

C. One other factor to be considered is how limiting the number of Tour Balls
in the market to 25,200 (when the demand is 108,000) will affect sales of
the Pro Model ball.

32. (LO 6—Sell or process further decision)

A. No, it would not be advantageous to smoke the salmon. The incremental

cost of ₹62.5 per pound (₹162.50 – ₹100.00) is greater than the
incremental revenue of ₹50.00 (₹325 – ₹275).

B. If the incremental costs are reduced to ₹37.5, it would be profitable to

smoke the salmon. The incremental revenues of ₹50.00 would exceed the
incremental costs by ₹12.5.

C. Qualitative factors to be considered are the reliability and longevity of the

smoke house, the quality of the smoked fish, whether the Fish House has
the facilities to store and serve additional products, whether the new
product will attract new customers, and whether the new product will have
a positive or negative impact on the sales of other products.

33. (Special Orders)

1. Statement Showing Profitability of the Special Order

Rs. Rs.
Sales (2,500 medals @ Rs.100) 250,000
Deduct: Variable costs
Direct materials (2,500 medals @ Rs.35) 87,500
Direct labor (2,500 medals @ Rs.40) 100,000
Set-ups, etc. (25 batches @Rs.500) 12,500
 ------------ 200,000
------------
Contribution 50,000
------------
The special order should be accepted because it gives a contribution of Rs.50, 000.

2. When Plant Capacity is 9,000 medals

Rs. Rs.
Present contribution on 7,500 medals:
Sales (7,500 medals @ Rs.150) 1,125,000
Deduct: Variable costs
Direct materials (7,500 medals @ Rs.35) 262,500
Direct labor (7,500 medals @ Rs.40) 300,000
Set-ups, etc. (150 batches @Rs.500) 75,000
------------ 637,500
------------
Contribution 487,500
------------

Rs. Rs.
Contribution on 6,500 medals
Sales (6,500 medals @ Rs.150) 975,000
Deduct: Variable costs
Direct materials (6,500 medals @ Rs.35) 227,500
Direct labor (6,500 medals @ Rs.40) 260,000
Set-ups, etc. (130 batches @Rs.500) 65,000
------------ 552,500
-------------
Contribution 422,500
-------------

Loss in contribution due to acceptance of special order (Rs. 487,500-422,500) Rs.65, 000
Gain in contribution from acceptance of special order 50,000
------------
Net loss in contribution 15,000
-----------
When the plant capacity is 9,000 medals, the special order should not be accepted because it
results in loss of contribution of Rs.15,000.

34. (Make or Buy Decisions)

1. Relevant cost of making the component

Rs.
Direct material cost 500,000
Direct labor cost 800,000
 Variable factory overhead 600,000
--------------
Relevant cost to make 1,900,000
---------------

Relevant cost of buying the component

Rs.
Purchase price of the component @ Rs.22 2,200,000
Deduct: Reduction in fixed cost 200,000
--------------
Relevant cost to buy 2,000,000
---------------
The cost to make the component is less than the cost to buy. Therefore, it is advisable to make
the component.
(2) When the released capacity is rented out, there will be no change in the relevant cost of
making the component. However, the cost to buy the component will further reduce by the
amount rental income. The cost to buy will be:
Rs.
Purchase price of the component @ Rs.22 2,200,000
Deduct: Reduction in fixed cost 200,000
Rental income 150,000
--------------
Relevant cost to buy 1,850,000
---------------
In this case, as the cost to buy is less than the cost of making, it is advisable to buy the
component.

35. (Discontinuance of a Product)

Statement of Profitability
Product A B C
Rs. Rs. Rs.
Sales (A) 45,000 225,000 30,000
----------- ---------- -----------
Variable cost:
Variable manufacturing cost 24,000 144,000 12,000
Variable selling and distribution cost 8,100 8,100 7,800
--------- ----------
----------
Total Variable cost (B) 32,100 152,100 19,800
Contribution margin C= (A-B) 12,900 72,900 10,200
Fixed cost:
Fixed manufacturing overhead 3,000 48,000 9,000
Fixed selling and distribution cost 2,100 1,800 2,100
----------- ----------- -----------
 Total fixed cost (D) 5,100 49,800 11,100

Net profit /(loss) (C-D) 7,800 23,100 (900)

Profit/ Volume ratio (C/A) 28.7% 32.4% 34%
Ratio of fixed cost to total cost 13.7% 24.7% 36%

Ratio of selling and distribution cost to sales 22.7% 4% 33%

Product C should not be discontinued because:
(a) Product C appears unprofitable because of a heavy apportionment of fixed manufacturing
cost to it. Fixed manufacturing cost as a percentage of total cost is very
high at 36% compared to only 13.7% for product A and 24.7% for product B.
(b) P/V ratio of product B (34%) is higher than that of product A (28.7%) and product B
(32.4%).
(c) Sales of product C are much less than that of product A and product B. Still, it has been
charged with highest amount of selling and distribution cost.
(d) Discontinuance of product C will entail a contribution loss of Rs.10, 200. With fixed costs
remaining at the same level, the overall profit of the concern will decrease by that amount.

36. (Resource Utilization Decisions)

Statement of Profitability
Products
---------------------------------------------
A B C
Rs. Rs. Rs.
Selling price per unit 20 16 10
----- ----- -----
Variable costs:
Materials 6 4 2
Labor 3 3 1.5
Variable overhead 2 1 1
------ ----- -----
Variable cost per unit 11 8 4.5
Contribution per unit 9 8 5.5
P/V ratio 45% 50% 55%
Ranking III II I
Ranking of products when raw materials are in short supply
Raw materials required per unit (kg) 0.60 0.4 0.2
Contribution per kg of raw materials (Rs.) 15 20 27.5
Ranking III II I

Ranking of products when labor is in short supply

Labor hours required per unit 0.2 0.2 0.1
Contribution per kg of raw materials (Rs.) 45 40 55
 Ranking II III I
Product mix and profit when raw materials availability is limited to 12,100 kg
Product Number of Raw materials Contribution Total
units required (kg) per unit Contribution
Rs. Rs.
C 20,000 4,000 5.5 110,000
B 12,000 4,800 8 96,000
A 5,500 3,300 9 49,500
(balance)
-----------
Total contribution 255,500
Deduct: Fixed expenses (10000*Rs.5+12,000*Rs.4+ 20,000*Rs.2) 138,000
------------
Profit 117,500
------------

Product mix and profit when labor availability is limited to 5000 hours
Product Number of Labor hours Contribution Total
units required per unit Contribution
Rs. Rs.
C 20,000 2,000 5.5 110,000
A 10,000 2,000 9 90,000
B 5,000 1,000 8 40,000
(balance)
-----------
Total contribution 240,000
Deduct: Fixed expenses 138,000
------------
Profit 102,000
------------

Product mix and profit when there is no shortage of raw materials or labor hours
As C is the most profitable product, its sales should be increased by spending Rs.20,000 on
advertisement. The product mix and profit will be as shown below:

Product Number of Contribution Total

units per unit Contribution
Rs. Rs.
A 10,000 9 90,000
B 12,000 8 96,000
C 25,000 5.5 137,500
-----------
Total contribution 323,500
Deduct: Fixed expenses 138,000
Advertisement 20,000
----------- 158,000
 ------------
Profit 165,500
------------

37.. (Sell or Process Further Decisions)

Apportionment of pre-separation costs

Pre-separation costs Rs. ‘000
Raw materials cost 268
Initial processing cost 464
------
Total 732
-----
Apportionment of Pre-separation costs on the basis of Net Sales Value (Rs.’000)
Product Sales Further Net sales value Pre-separation
processing costs
Q 768 160 608 456
R 232 128 104 78
S 32 - 32 24
T 240 8 232 174
------- -------
Total 976 732
-------- -------
(a) Statement Showing Budgeted profit and Loss for each Product and in Total
Rs. ‘000
Products
-------------------------------------------------------------------------------
Q R S T Total
Sales 768 232 32 240 1,272
Less: Pre-separation costs 456 78 24 174 732
------ ------ ------ ----- -------
312 154 8 66 540
Less: Additional processing 160 128 - 8 296
------ ------ ------- ------ --------
Profit 152 26 8 58 244
------ ------ ------- ------ --------

(b) Statement showing Profit or Loss when Products are sold at Split-off Point
Rs. ‘000
 Products
-------------------------------------------------------------------------------
Q R S T Total
Sales 512 144 32 180 868
Less: Pre-separation costs 456 78 24 174 732
------ ------ ------ ----- -------
Profit 56 66 8 6 136
------ ------ ------ ------ ------
By adopting alternative (b) the profit has come down from Rs. 244,000 to Rs.136, 000.
Therefore, alternative (a) should be adopted.

(c) Statement showing Differential Cost and Incremental Income of the Existing Alternatives

(Rs. ‘000)
Product Sales Revenue Incremental Differential Profit/(Loss)
---------------------------- cost income from
Fully At split further
processed off point processing
-----------------------------------------------------------------------------------------------------------
Q 768 512 160 256 96
R 232 144 128 88 (40)
T 240 180 8 60 52
------------------------------------------------------------------------------------------------------------
If R is not processed further, the profits will increase by Rs.40,000. The overall profit would
increase to Rs. 284,000 from Rs.240,000 under alternative (a). The company should, therefore,
sell products R and S at split-off point and further process products Q and T.

38. Determination of Minimum Value of Special Order (Considering relevant costs)

Cost Element Details Amount Remarks

Material A 4000 kg x `18.75 ` 75,000 Realisable value is

relevant

Material B 10,000 kg x `20 `2,00,000 Cost is relevant as it

has to be purchased

Other materials ` 15,000 Cost is relevant as it

has to be incurred

Processing cost

Dept X 4 men x 1 month Cost is relevant as

x `8,750 ` 35,000 fresh labor is to be
hired
 Dept Y ----- Cost not relevant as
spare capacity is
available

Other expenses ` 8,000 Relevant cost is cost

net of resale value
--------------
Minimum value of Special Order `3,33,000
__________

39. (LO1—Comprehensive make-or-buy decision)

A. Under normal conditions, plant capacity is 75,000 machine hours per

month, or 225,000 hours per quarter. The company has estimated that it
will be operating at 80 percent of capacity for the quarter. The excess
capacity is 45,000 hours (225,000  0.20).

B. The total overhead per hour is Rs.200, with a fixed portion of Rs.120
(Rs.10,80,00,000 of total fixed overhead divided by 900,000 machine
hours). The variable portion is therefore Rs.80 per budgeted machine
hour, or Rs.200 per unit.

C. In examining the special order from CCR, Foggy Mountain should

consider the differential costs of making the extra banjos and any
opportunity costs.

The relevant costs would include a cost of Rs.1,100 (not Rs.1,250) for
direct materials, Rs.1,500 for direct labor, and Rs.200 for variable
overhead (Rs.80 variable overhead rate  2.5 hours), for a total of
Rs.2,[Link] Mountain would also incur an opportunity cost equal to
Rs.155 per banjo, calculated as follows:

Producing 20,000 banjos will require 50,000 machine hours. However,

Foggy Mountain expects to have only 45,000 excess machine hours in the
second quarter (see Requirement A). Therefore, in order to accept the
special order, Foggy Mountain would have to reduce its regular sales by
2,000 banjos.

Consequently, if Foggy Mountain accepts the special order, the company

will incur an opportunity cost equal to the contribution margin lost on
regular sales.

At a sales price of Rs.4,500 per unit, the contribution margin on lost sales
would be Rs.1,550 per unit (Rs.4,500 sales price – Rs.1,250 raw material
cost – Rs.1,500 labor cost – Rs.200 variable overhead cost).
 Hence, the total contribution margin lost would be Rs.31,00,000 (2,000
banjos  Rs.1,550 contribution margin per unit). This increases the
relevant costs of the special order by Rs.155 per banjo (Rs.31,00,000
contribution margin/20,000 banjos in the special order).

The total cost of the special order would thus be Rs.2,800 + Rs.155 =
Rs.2,955. Because CCR will pay Foggy Mountain Rs.2,875 per unit for the
order, Foggy Mountain should reject the special order.
D. The unit contribution is computed as follows:

Selling price Rs.3,750

Raw materials (1,625)
Direct labor (1,500)
Overhead (5  Rs.80) (400)
Machine setup (Rs.7,50,000/7,500 units) (100)
Special machine (Rs.11,25,000/7,500 units) (150)
Contribution margin Rs. (25)

E. The company would lose Rs.25 per unit, for a total loss of Rs.1,87,500
(Rs.25  7,500 units), because of the additional machine setup costs and
the purchase of special equipment. Foggy Mountain would have to charge
Seager and Buffet at least Rs.3,775 to accept the special order.

40. (LO2 and 4—Decision focus: Comprehensive make-or-buy)

A. The problem for Avery is really twofold. The first problem is whether tackle
boxes should be manufactured or purchased from the outside supplier.
The second is whether the company should use any idle capacity to
manufacture skateboards or some combination of skateboards and tackle
boxes. The problems are linked and must be considered together.

B. Avery has several options. First, the company can continue to

manufacture 8,000 tackle boxes. Second, the company can manufacture
8,000 tackle boxes and buy an additional 4,000 tackle boxes. Third, the
company can manufacture 17,500 skateboards and buy 9,000 tackle
boxes. Finally, the company can manufacture 17,500 skateboards,
manufacture 1,000 tackle boxes, and purchase an additional 9,000 tackle
boxes.

C. The best option from a quantitative perspective is to manufacture 17,500

skateboards, an option that involves utilizing 8,750 direct labor hours,
manufacturing an additional 1,000 tackle boxes (utilizing the remaining
1,250 direct labor hours), and purchasing 9,000 tackle boxes from the
outside supplier. The contribution margin of each product is calculated as
follows:
 Purchased
Tackle Manufactured Manufactured
Boxes Tackle Boxes Skateboards
Selling Price Rs.4,300 Rs.4,300 Rs.2,250
Less:
Material 3,400 850 625
Direct Labor N/A 937.50 375
VMOH N/A *312.50 **125
Selling & Admin. 200 ***550 ****150
CM Rs.700 Rs.1,650 Rs.975
CM per direct N/A Rs.1,320 Rs.1,950
labor hour (Rs.1,650/1.25 (Rs.975/0.5 hr)
hr)

* Each tackle box takes 1.25 hours to make (Rs.937.50/Rs.750 per hour) and overhead is
applied at the rate of Rs.500 per direct labor hour (Rs.625 applied overhead/1.25 hours).
The total direct labor hours expected at a capacity of 8,000 tackle boxes is 10,000
(8,000  1.25 hours). Total overhead is therefore estimated to be Rs.50,00,000.
Rs.25,00,000 of this overhead is fixed, leaving Rs.25,00,000 of variable overhead. The
variable overhead rate is therefore Rs.250 per labor hour, and the applied variable
overhead per tackle box is Rs.312.50 (Rs.250  1.25 hours).

** Each skateboard takes 0.5 hour to make (Rs.375/Rs.750 per hour). The variable
overhead rate is Rs.250 per direct labor hour (see above).

*** Rs.850 total selling and administrative cost, less Rs.300 per unit of fixed distribution
costs.

**** Rs.450 total selling and administrative cost, less Rs.300 per unit of fixed distribution
costs.

On the basis of this analysis, the most profitable product is the

manufactured skateboard, followed by the manufactured tackle box.
Purchased tackle boxes are the least profitable product. Producing 17,500
skateboards will require 8,750 direct labor hours (17,500  0.5 hour per
board). Because 10,000 labor hours are available, Avery can manufacture
an additional 1,000 tackle boxes requiring 1,250 direct labor hours. Avery
should then purchase 9,000 tackle boxes (the maximum number that
Craig Products will sell).

D. Qualitative factors include the quality of the product bought from the
outside source, the continuing availability of the product, and the ability of
the company to retrain and rehire all persons now working in the tackle
box process and staff them in the skateboard operation.

E. Responses to this question will vary. The question can be used to talk
about the ethical responsibilities of companies and how different
companies react to the production of products that may be dangerous.
Note that there may be real costs involved in the decision, including the
possibility of future lawsuits. However, note also that most products
(automobiles, lawn mowers, etc.) are dangerous to some extent. As long
as the product is not defective, the imminent danger of using many
different products should not preclude one’s desire to manufacture and
sell the product.