CHAPTER 27

INCREMENTAL ANALYSIS AND CAPITAL BUDGETING

SUMMARY OF QUESTIONS BY OBJECTIVES AND BLOOM’S TAXONOMY

Item SO BT Item SO BT Item SO BT Item SO BT Item SO BT
True-False Statements
1. 1 K 9. 3 C 17. 6 C 25. 9 K 33. 3
2. 2 K 10. 4 C 18. 7 C 26. 9 C 34. 5
3. 2 C 11. 4 K 19. 7 C 27. 9 C 35. 7
4. 2 K 12. 4 C 20. 8 C 28. 10 C 36. 9
5. 2 K 13. 5 C 21. 8 C 29. 10 C 37. 10
6. 2 C 14. 5 C 22. 9 C 30. 10 K
7. 3 C 15. 6 C 23. 9 K 31. 1
8. 3 C 16. 6 C 24. 9 K 32. 2
Multiple Choice Questions
38. 1 K 57. 3 C 76. 5 AP 95. 9 C 114. 10 AP
39. 1 K 58. 3 C 77. 5 C 96. 9 AP 115. 10 AP
40. 1 K 59. 3 C 78. 5 AN 97. 9 C 116. 10 AP
41. 1 K 60. 3 C 79. 6 C 98. 9 AP 117. 10 AP
42. 2 K 61. 4 K 80. 6 C 99. 9 K 118. 10 C
43. 2 C 62. 4 K 81. 6 C 100. 9 K 119. 10 C
44. 2 K 63. 4 C 82. 6 C 101. 9 K 120. 1
45. 2 C 64. 4 C 83. 6 C 102. 9 C 121. 3
46. 2 C 65. 4 C 84. 6 C 103. 9 K 122. 4
47. 2 K 66. 4 C 85. 7 C 104. 9 AP 123. 4
48. 2 K 67. 4 AN 86. 7 AN 105. 9 K 124. 6
49. 2 C 68. 4 AN 87. 7 C 106. 9 C 125. 7
50. 2 C 69. 4 AN 88. 7 AN 107. 9 AP 126. 7
51. 2 C 70. 4 AN 89. 8 AN 108. 9 C 127. 8
52. 2 C 71. 4 AN 90. 8 AN 109. 9 K 128. 9
53. 3 AN 72. 5 AP 91. 8 C 110. 9,10 K 129. 9
54. 3 AN 73. 5 AN 92. 8 AN 111. 10 C 130. 9
55. 3 C 74. 5 C 93. 8 K 112. 10 AN 131. 10
56. 3 C 75. 5 AN 94. 9 K 113. 10 AN 132. 10
Exercises
133. 3 AN 138. 4 AP 143. 6 E 148. 8 E 153. 10 E
134. 3 AN 139. 4 AN 144. 7 AP 149. 8 AP 154. 10 E
135. 3 E 140. 5 E 145. 7 E 150. 9 AP 155. 10 AP
136. 3,4 AP 141. 5 AP 146. 7 AP 151. 9 AP
137. 4 E 142. 6 AN 147. 7 E 152. 10 AP
Completion Statements
156. 1 K 159. 4 K 162. 8 K 165. 9 K 168. 10 K
157. 2 K 160. 5 K 163. 9 K 166. 9 K 169. 10 K
158. 3 K 161. 6 K 164. 9 K 167. 10 K 170. 10 K
27 - 2 Test Bank for Accounting Principles, Seventh Edition

SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE

Item Type Item Type Item Type Item Type Item Type Item Type Item Type
Study Objective 1
1. TF 38. MC 40. MC 120. MC
31. TF 39. MC 41. MC 156. C
Study Objective 2
2. TF 5. TF 42. MC 45. MC 48. MC 51. MC
3. TF 6. TF 43. MC 46. MC 49. MC 52. MC
4. TF 32. TF 44. MC 47. MC 50. MC 157. C
Study Objective 3
7. TF 33. TF 55. MC 58. MC 121. MC 135. Ex
8. TF 53. MC 56. MC 59. MC 133. Ex 136. Ex
9. TF 54. MC 57. MC 60. MC 134. Ex 158. C
Study Objective 4
10. TF 61. MC 64. MC 67. MC 70. MC 123. MC 138. Ex
11. TF 62. MC 65. MC 68. MC 71. MC 136. Ex 139. Ex
12. TF 63. MC 66. MC 69. MC 122. MC 137. Ex 159. C
Study Objective 5
13. TF 34. TF 73. MC 75. MC 77. MC 140. Ex 160. C
14. TF 72. MC 74. MC 76. MC 78. MC 141. Ex
Study Objective 6
15. TF 17. TF 80. MC 82. MC 84. MC 142. Ex 161. C
16. TF 79. MC 81. MC 83. MC 124. MC 143. Ex
Study Objective 7
18. TF 35. TF 86. MC 88. MC 126. MC 145. Ex 147. Ex
19. TF 85. MC 87. MC 125. MC 144. Ex 146. Ex
Study Objective 8
20. TF 89. MC 91. MC 93. MC 148. Ex 162. C
21. TF 90. MC 92. MC 127. MC 149. Ex
Study Objective 9
22. TF 27. TF 97. MC 102. MC 107. MC 129. MC 164. C
23. TF 36. TF 98. MC 103. MC 108. MC 130. MC 165. C
24. TF 94. MC 99. MC 104. MC 109. MC 150. Ex 166. C
25. TF 95. MC 100. MC 105. MC 110. MC 151. Ex
26. TF 96. MC 101. MC 106. MC 128. MC 163. C
Study Objective 10
28. TF 110. MC 114. MC 118. MC 152. Ex 167. C
29. TF 111. MC 115. MC 119. MC 153. Ex 168. C
30. TF 112. MC 116. MC 131. MC 154. Ex 169. C
37. TF 113. MC 117. MC 132. MC 155. Ex 170. C
Note: TF = True-False C = Completion
MC = Multiple Choice Ex = Exercise

The chapter also contains one set of ten Matching questions and four Short-Answer Essay
questions.
 Incremental Analysis and Capital Budgeting 27 - 3

CHAPTER STUDY OBJECTIVES

1. Identify the steps in management's decision-making process. Management's decision-
making process consists of (a) identifying the problem or opportunity, (b) assigning
responsibility for the decision, (c) determining possible courses of action, (d) developing data
relevant to each course of action, (e) making the decision, and (f) reviewing the results of the
decision.
2. Describe the concept of incremental analysis. Incremental analysis is the process used to
identify financial data that change under alternative courses of action. These data are
relevant to the decision because they will vary in the future among the possible alternatives.
3. Identify the relevant costs in accepting an order at a special price. The relevant
information in accepting an order at a special price is the difference between the variable
manufacturing costs to produce the special order and expected revenues.
4. Identify the relevant costs in a make-or-buy decision. In a make-or-buy decision, the
relevant costs are (a) the variable manufacturing costs that will be saved, (b) the purchase
price, and (c) opportunity costs.
5. Give the decision rule for whether to sell or process materials further. The decision rule
for whether to sell or process materials further is: Process further as long as the incremental
revenue from processing exceeds the incremental processing costs.
6. Identify the factors to be considered in retaining or replacing equipment. The factors to
be considered in determining whether equipment should be retained or replaced are the
effects on variable costs and the cost of the new equipment. Also, any disposal value of the
existing asset must be considered.
7. Explain relevant factors in deciding whether to eliminate an unprofitable segment. In
deciding whether to eliminate an unprofitable segment, it is necessary to determine the
contribution margin, if any, produced by the segment and the disposition of the segment's
fixed expenses.
8. Determine which products to make and sell when resources are limited. When a
company has limited resources, it is necessary to find the contribution margin per unit of
limited resource. Then multiply this amount by the units of limited resource to determine
which product maximizes net income.
9. Contrast the annual rate of return and cash payback techniques in capital budgeting.
The annual rate of return is obtained by dividing expected annual net income by the average
investment. The higher the rate of return, the more attractive the investment. The cash
payback technique identifies the time period to recover the cost of the investment. The
formula is: Cost of capital expenditure divided by estimated annual cash inflow equals cash
payback period. The shorter the payback period, the more attractive the investment.
10. Distinguish between the net present value and internal rate of return methods. Under
the net present value method, the present value of future cash inflows is compared with the
capital investment to determine net present value. The decision rule is: Accept the project if
net present value is zero or positive. Reject the investment if net present value is negative.
Under the internal rate of return method, the objective is to find the interest yield of the
potential investment. The decision rule is: Accept the project when the internal rate of return
is equal to or greater than the required rate of return. Reject the project when the internal
rate of return is less than the required rate.
27 - 4 Test Bank for Accounting Principles, Seventh Edition

TRUE-FALSE STATEMENTS
1. An important step in management's decision-making process is to determine and evaluate
possible courses of action.

2. In making decisions, management ordinarily considers both financial and nonfinancial

information.

3. In incremental analysis, total variable costs will always change under alternative courses
of action, and total fixed costs will always remain constant.

4. Accountants are mainly involved in developing nonfinancial information for management's

consideration in choosing among alternatives.

5. Decision-making involves choosing among alternative courses of action.

6. Financial data are developed for a course of action under an incremental basis and then it
is compared to data developed under a differential basis before a decision is made.

7. A special one-time order should never be accepted if the unit sales price is less than the
unit variable cost.

8. If a company has excess capacity and present markets will not be affected, it would be
profitable to accept an order at a special unit price even though the price is less than the
unit variable cost to manufacture the item.

9. A company should never accept an order for its product at less than its regular sales
price.

10. A decision whether to continue to make a product or buy it externally, depends on the
external price and the amount of variable and fixed costs that can be eliminated assuming
no alternative uses of resources.

11. An opportunity cost is the potential benefit obtained by using resources in an alternative
course of action.

12. If an incremental make or buy analysis indicates that it is cheaper to buy rather than make
an item, management should always make the decision to choose the lowest cost
alternative.

13. In a sell or process further decision, management should process further as long as the
incremental revenues from additional processing exceed the incremental variable costs.

14. It is always better to sell now rather than process further because of the time value of
money.

15. In a decision concerning replacing old equipment with new equipment, the book value of
the old equipment can be considered a sunk cost.

16. In a decision to retain or replace old equipment, the salvage value of the old equipment is
relevant in incremental analysis.
 Incremental Analysis and Capital Budgeting 27 - 5

17. It is better not to replace old equipment if it is not fully depreciated.

18. From a quantitative standpoint, a segment should be eliminated if its contribution margin
is less than the fixed costs that can be eliminated.

19. The elimination of an unprofitable product line may adversely affect the remaining product
lines.

20. When a company has limited resources to manufacture products, it should manufacture
those products which have the highest contribution margin per unit of limited resource.

21. If a company has only a certain number of machine hours available for production, it is
generally more profitable to produce and sell the product with the highest unit contribution
margin.

22. Capital budgeting decisions usually involve large investments and can have a significant
impact on a company's future profitability.

23. The annual rate of return technique requires dividing a project's annual cash inflows by
the economic life of the project.

24. A hurdle rate is the rate of return set by applying ideal standards.

25. A major advantage of the annual rate of return technique is that it considers the time value
of money.

26. The cash payback capital budgeting technique is a quick way to calculate a project's net
present value.

27. The cash payback method is frequently used as a screening tool but it does not take into
consideration the profitability of a project.

28. Using the net present value method, a net present value of zero indicates that the project
would be acceptable.

29. The net present value method can only be used in capital budgeting if the expected cash
flows from a project are an equal amount each year.

30. The interest rate yielded by a project is a rate that will cause the present value of the
proposed capital expenditure to equal the present value of the expected annual cash
inflows.

Additional True-False Questions

31. Accounting contributes to management's decision-making process through internal

reports that review the actual impact of the decision.

32. The process used to identify the financial data that change under alternative courses of
action is called allocation of limited resources.

33. If a company is operating at full capacity, the incremental costs of a special order will likely
include fixed manufacturing costs.
27 - 6 Test Bank for Accounting Principles, Seventh Edition

34. The basic decision rule in a sell or process further decision is: sell without further
processing as long as the incremental revenue from processing exceeds the incremental
processing costs.

35. In deciding on the future status of an unprofitable segment, management should

recognize that net income could decrease by eliminating the unprofitable segment.

36. The annual rate of return is computed by dividing expected annual net income by average
investment.

37. The discounted cash flow technique considers estimated total cash inflows from the
investment but not the time value of money.

Answers to True-False Statements

Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
1. T 7. T 13. F 19. T 25. F 31. T 37. F
2. T 8. F 14. F 20. T 26. F 32. F
3. F 9. F 15. T 21. F 27. T 33. T
4. F 10. T 16. T 22. T 28. T 34. F
5. T 11. T 17. F 23. F 29. F 35. T
6. F 12. F 18. T 24. F 30. T 36. T

MULTIPLE CHOICE QUESTIONS

38. A major accounting contribution to the managerial decision-making process in evaluating
possible courses of action is to
a. assign responsibility for the decision.
b. provide relevant revenue and cost data about each course of action.
c. determine the amount of money that should be spent on a project.
d. decide which actions that management should consider.

39. Which of the following stages of the management decision-making process is improperly
sequenced?
a. Evaluate possible courses of action Æ Make decision.
b. Assign responsibility for the decision Æ Identify the problem.
c. Identify the problem Æ Determine possible courses of action.
d. Assign responsibility for decision Æ Determine possible courses of action.

40. Internal reports that review the actual impact of decisions are prepared by
a. department heads.
b. the controller.
c. management accountants.
d. factory workers.

41. Which of the following steps in the management decision-making process does not
generally involve the managerial accountant?
a. Determine possible courses of action
b. Make the appropriate decision based on relevant data
c. Prepare internal reports that review the impact of decisions
d. None of these
 Incremental Analysis and Capital Budgeting 27 - 7

42. The process of evaluating financial data that change under alternative courses of action is
called
a. double entry analysis.
b. contribution margin analysis.
c. incremental analysis.
d. cost-benefit analysis.

43. Nonfinancial information that management might evaluate in making a decision would not
include
a. employee turnover.
b. contribution margin.
c. the environment.
d. the corporate profile in the community.

44. Incremental analysis is synonymous with

a. difficult analysis.
b. differential analysis.
c. gross profit analysis.
d. derivative analysis.

45. In incremental analysis,

a. only costs are analyzed.
b. only revenues are analyzed.
c. both costs and revenues may be analyzed.
d. both costs and revenues that stay the same between alternate courses of action will
be analyzed.

46. Incremental analysis is most useful

a. in developing relevant information for management decisions.
b. in choosing between the net present value method and the internal rate of return
method.
c. in evaluating the master budget.
d. as a replacement technique for variance analysis.

47. The source of data to serve as inputs in incremental analysis is generated by

a. market analysts.
b. engineers.
c. accountants.
d. all of these.

48. Which of the following is not a true statement?

a. Incremental analysis might also be referred to as differential analysis.
b. Incremental analysis is the same as CVP analysis.
c. Incremental analysis is useful in making decisions.
d. Incremental analysis focuses on decisions that involve a choice among alternative
courses of action.

49. Incremental analysis would not be appropriate for

a. a make or buy decision.
b. an allocation of limited resource decision.
c. elimination of an unprofitable segment.
d. analysis of manufacturing variances.
27 - 8 Test Bank for Accounting Principles, Seventh Edition

50. Incremental analysis would be appropriate for

a. acceptance of an order at a special price.
b. a retain or replace equipment decision.
c. a sell or process further decision.
d. all of these.

51. Which of the following is a true statement about cost behaviors in incremental analysis?
1. Fixed costs will not change between alternatives.
2. Fixed costs may change between alternatives.
3. Variable costs will always change between alternatives.
a. 1
b. 2
c. 3
d. 2 and 3

52. A company is considering the following alternatives:

Alternative 1 Alternative 2
Revenues $120,000 $120,000
Variable costs 60,000 70,000
Fixed costs 35,000 35,000
Which of the following are relevant in choosing between the alternatives?
a. Variable costs
b. Revenues
c. Fixed costs
d. Variable costs and fixed costs

53. It costs Fortune Company $12 of variable and $5 of fixed costs to produce one bathroom
scale which normally sells for $35. A foreign wholesaler offers to purchase 1,000 scales at
$15 each. Fortune would incur special shipping costs of $1 per scale if the order were
accepted. Fortune has sufficient unused capacity to produce the 1,000 scales. If the
special order is accepted, what will be the effect on net income?
a. $2,000 increase
b. $2,000 decrease
c. $3,000 decrease
d. $15,000 increase

54. Adler Company manufactures a product with a unit variable cost of $50 and a unit sales
price of $88. Fixed manufacturing costs were $240,000 when 10,000 units were produced
and sold. The company has a one-time opportunity to sell an additional 2,000 units at $70
each in a foreign market which would not affect its present sales. If the company has
sufficient capacity to produce the additional units, acceptance of the special order would
affect net income as follows:
a. Income would decrease by $8,000.
b. Income would increase by $8,000.
c. Income would increase by $140,000.
d. Income would increase by $40,000.

55. In incremental analysis,

a. costs are not relevant if they change between alternatives.
b. all costs are relevant if they change between alternatives.
c. only fixed costs are relevant.
d. only variable costs are relevant.
 Incremental Analysis and Capital Budgeting 27 - 9

56. If a plant is operating at full capacity and receives a one-time opportunity to accept an
order at a special price below its usual price, then
a. only variable costs are relevant.
b. fixed costs are not relevant.
c. the order will likely be accepted.
d. the order will likely be rejected.

57. Diggs, Inc. has excess capacity. Under what situations should the company accept a
special order for less than the current selling price?
a. Never
b. When additional fixed costs must be incurred to accommodate the order
c. When the company thinks it can use the cheaper materials without the customer's
knowledge
d. When incremental revenues exceed incremental costs

58. If a company must expand capacity to accept a special order, it is likely that there will be
a. an increase in unit variable costs.
b. no increase in fixed costs.
c. an increase in variable and fixed costs per unit.
d. an increase in fixed costs.

59. Which of the following is true if a company can accept a special order without affecting its
regular sales and is within plant capacity?
a. Net income will not be affected.
b. Net income will increase if the special sales price per unit exceeds the unit variable
costs.
c. Net income will decrease.
d. Additional fixed costs will probably be incurred.

60. If a company anticipates that other sales will be affected by the acceptance of a special
order, then
a. lost sales should be considered in the incremental analysis.
b. lost sales should not be considered in the incremental analysis.
c. the order should not be accepted.
d. the order will only be accepted if the plant is below capacity.

61. Which decision will involve no incremental revenues?

a. Make or buy decision
b. Drop a product line
c. Accept a special order
d. Additional processing decision

62. An opportunity cost

a. should be initially recorded as an asset.
b. is the cost of a new product proposal.
c. is the potential benefit that may be obtained by following an alternative course of
action.
d. is classified as manufacturing overhead.
27 - 10 Test Bank for Accounting Principles, Seventh Edition

63. Opportunity cost must be considered in decisions involving

a. budgeting.
b. financial accounting.
c. CVP analysis.
d. resources that have alternative uses.

64. The opportunity cost of an alternate course of action that is relevant to a make or buy
decision is
a. subtracted from the "Make" costs.
b. added to the "Make" costs.
c. added to the "Buy" costs.
d. none of these.

65. Opportunity cost is usually

a. a standard cost.
b. a potential benefit.
c. a sunk cost.
d. included as part of cost of goods sold.

66. Which one of the following is not a disadvantage of buying rather than making a
component of a company's product?
a. Quality control specifications may not be met.
b. The outside supplier could increase prices significantly in the future.
c. Profitable product lines may be dropped.
d. The supplier may not deliver on time.

Use the following information for questions 67–68.

Sam's Manufacturing Company can make 100 units of a necessary component part with the
following costs:

Direct Materials $70,000

Direct Labor 13,000
Variable Overhead 40,000
Fixed Overhead 27,000

67. If Sam's Manufacturing Company purchases the component externally, $20,000 of the
fixed costs can be avoided. At what external price for the 100 units is the company
indifferent between making or buying?
a. $150,000.
b. $103,000.
c. $143,000.
d. $123,000.

68. If Sam's Manufacturing Company can purchase the component externally for $135,000
and only $8,000 of the fixed costs can be avoided, what is the correct "make or buy
decision"?
a. Make and save $8,000
b. Buy and save $8,000
c. Make and save $20,000
d. Buy and save $20,000
 Incremental Analysis and Capital Budgeting 27 - 11

69. Cole's Shop can make 1,000 units of a necessary component with the following costs:
Direct Materials $128,000
Direct Labor 32,000
Variable Overhead 16,000
Fixed Overhead ?
The company can purchase the 1,000 units externally for $208,000. The avoidable fixed
costs are $10,000 if the units are purchased externally. An analysis shows that at this
external price, the company is indifferent between making or buying the part. What are the
fixed overhead costs of making the component?
a. $42,000.
b. $32,000.
c. $22,000.
d. Cannot be determined.

Use the following information for questions 70–71.

Noth Company produces 1,000 units of a necessary component with the following costs:

Direct Materials $72,000

Direct Labor 48,000
Variable Overhead 12,000
Fixed Overhead 21,000

70. Noth Company could avoid $9,000 in fixed overhead costs if it acquires the components
externally. If cost minimization is the major consideration and the company would prefer to
buy the components, what is the maximum external price that Noth Company would
accept to acquire the 1,000 units externally?
a. $153,000.
b. $141,000.
c. $144,000.
d. $132,000.

71. None of Noth Company's fixed overhead costs can be reduced, but another product could
be made that would increase profit contribution by $24,000 if the components were
acquired externally. If cost minimization is the major consideration and the company
would prefer to buy the components, what is the maximum external price that Noth
Company would be willing to accept to acquire the 1,000 units externally?
a. $129,000.
b. $165,000.
c. $144,000.
d. $156,000.

72. Gruedin Company has old inventory on hand that cost $12,000. Its scrap value is
$16,000. The inventory could be sold for $40,000 if manufactured further at an additional
cost of $12,000. What should Gruedin do?
a. Sell the inventory for $16,000 scrap value
b. Dispose of the inventory to avoid any further decline in value
c. Hold the inventory at its $12,000 cost
d. Manufacture further and sell it for $40,000.
27 - 12 Test Bank for Accounting Principles, Seventh Edition

73. A company has a process that results in 12,000 pounds of Product A that can be sold for
$8 per pound. An alternative would be to process Product A further at a cost of $80,000
and then sell it for $14 per pound. Should management sell Product A now or should
Product A be processed further and then sold? What is the effect of the action?
a. Process further, the company will be better off by $8,000.
b. Sell now, the company will be better off by $8,000.
c. Process further, the company will be better off by $72,000.
d. Sell now, the company will be better off by $80,000.

74. The decision rule on whether to sell or process further

a. varies from situation to situation.
b. is process further as long as total revenue exceeds present revenues.
c. is process further if incremental revenue from such processing exceeds incremental
fixed costs.
d. is process further if incremental revenue from such processing exceeds the
incremental processing costs.

75. Cole Company is starting business and is unsure of whether to sell its product assembled
or unassembled. The unit cost of the unassembled product is $60 and Cole Company
would sell it for $135. The cost to assemble the product is estimated at $27 per unit and
Cole Company believes the market would support a price of $174 on the assembled unit.
What is the correct decision using the sell or process further decision rule?
a. Sell before assembly, the company will be better off by $27 per unit.
b. Sell before assembly, the company will be better off by $39 per unit.
c. Process further, the company will be better off by $39 per unit.
d. Process further, the company will be better off by $12 per unit.

76. Chapman Company manufactures widgets. Embree Company has approached Chapman
with a proposal to sell the company widgets at a price of $60,000 for 100,000 units.
Chapman is currently making these components in its own factory. The following costs are
associated with this part of the process when 100,000 units are produced:
Direct material $23,000
Direct labor 22,000
Manufacturing overhead 30,000
Total $75,000
The manufacturing overhead consists of $12,000 of costs that will be eliminated if the
components are no longer produced by Chapman. From Chapman's point of view, how
much is the incremental cost or savings if the widgets are bought instead of made?
a. $15,000 incremental savings
b. $3,000 incremental cost
c. $3,000 incremental savings
d. $15,000 incremental cost

77. The focus of a sell or process further decision is

a. incremental revenue.
b. incremental cost.
c. both incremental revenue and incremental cost.
d. neither incremental revenue nor incremental cost.
 Incremental Analysis and Capital Budgeting 27 - 13

78. Kimble Company gathered the following data about the three products that it produces:
Present Estimated Additional Estimated Sales
Product Sales Value Processing Costs if Processed Further
A $ 9,000 $ 6,000 $ 16,000
B 15,000 5,000 18,000
C 11,000 3,000 16,000
Which of the products should not be processed further?
a. Product A
b. Product B
c. Product C
d. Products A and C

79. A company decided to replace an old machine with a new machine. Which of the following
is considered a relevant cost?
a. The book value of the old equipment
b. Depreciation expense on the old equipment
c. The loss on the disposal of the old equipment
d. The current disposal price of the old equipment

80. Which of the following is not relevant information in a decision whether old equipment
presently being used should be replaced by new equipment?
a. The cash price of the new equipment
b. The salvage value of the old equipment
c. The book value of the old equipment
d. The cost savings if the new equipment is purchased

81. Book value of old equipment is considered to be a

a. relevant cost.
b. semi-relevant cost.
c. sunk cost.
d. cost that can be changed by a present or future decision.

82. A company is deciding on whether to replace some old equipment with new equipment.
Which of the following is not a relevant cost for incremental analysis?
a. Annual operating cost of the new equipment
b. Annual operating cost of the old equipment
c. Net cost of the new equipment
d. Accumulated depreciation on the old equipment

83. A company is considering replacing old equipment with new equipment. Which of the
following is a relevant cost for incremental analysis?
a. Annual depreciation charge on the old equipment
b. Book value of the old equipment
c. Estimated annual depreciation of the new equipment
d. Cost of the new equipment

84. In a retain or replace equipment decision, trade-in allowance available on old equipment
a. increases the cost of the new equipment.
b. is relevant because it will not be realized if the old equipment is retained.
c. is not relevant to the decision.
d. reduces the cost of the old equipment.
27 - 14 Test Bank for Accounting Principles, Seventh Edition

85. What will most likely occur if a company eliminates an unprofitable segment when a
portion of fixed costs are unavoidable?
a. All expenses of the eliminated segment will be eliminated.
b. Net income will decrease.
c. Net income will increase.
d. The company's variable costs will increase.

86. A company has three product lines, one of which reflects the following results:
Sales $340,000
Variable expenses 200,000
Contribution margin 140,000
Fixed expenses 220,000
Net loss $(80,000)
If this product line is eliminated, 60% of the fixed expenses can be eliminated and the
other 40% will be allocated to other product lines. If management decides to eliminate this
product line, the company's net income will
a. increase by $80,000.
b. decrease by $140,000.
c. decrease by $8,000.
d. increase by $8,000.

87. A company is considering eliminating a product line. The fixed costs currently allocated to
the product line will be allocated to other product lines upon discontinuance. If the product
line is discontinued,
a. total net income will increase by the amount of the product line's fixed costs.
b. total net income will decrease by the amount of the product line's fixed costs.
c. the contribution margin of the product line will indicate the net income increase or
decrease.
d. the company's total fixed costs will decrease.

88. A segment has the following data:

Sales $560,000
Variable expenses 240,000
Fixed expenses 440,000
What will be the incremental effect on net income if this segment is eliminated, assuming
the fixed expenses will be allocated to profitable segments?
a. $320,000 increase
b. $320,000 decrease
c. $440,000 decrease
d. Cannot be determined from the data provided.

89. Stuart Company expects income of $2,400 per year over the life of an investment that will
cost $25,000. The calculation of the accounting rate of return is .192. The rate of return
indicates that
a. Stuart expects to earn 19.2% of $2,400 as profit each year the asset is used.
b. Stuart expects to earn 19.2% of its investment annually.
c. Stuart expects to earn 19.2% of its cash outlay back over the life of the asset.
d. Stuart expects the asset will earn 19.2 times as much profit as its cost.
 Incremental Analysis and Capital Budgeting 27 - 15

90. A company can sell all the units it can produce of either Product A or Product B but not
both. Product A has a unit contribution margin of $36 and takes two machine hours to make
and Product B has a unit contribution margin of $45 and takes three machine hours to
make. If there are 1,000 machine hours available to manufacture a product, income will be
a. $3,000 more if Product A is made.
b. $3,000 less if Product B is made.
c. $3,000 less if Product A is made.
d. the same if either product is made.

91. If a company has limited resources, the key factor in performing incremental analysis is
a. contribution margin.
b. limited resources required.
c. contribution margin per unit of limited resource.
d. none of these.

92. A company can produce and sell only one of the following two products:
Machine Contribution
Hours Required Margin Per Unit
Product 1 3 $30
Product 2 2 $25
If the company has machine capacity of 6,000 hours, what is the total contribution margin
of the product it should produce to maximize net income?
a. $60,000.
b. $72,000.
c. $75,000.
d. $48,000.

93. The following are all quantitative capital budgeting techniques except
a. annual rate of return technique.
b. cost-volume-profit technique.
c. discounted cash flow technique.
d. cash payback technique.

94. A company's cost of capital refers to the

a. rate management expects to pay on all borrowed and equity funds.
b. total cost of a capital project.
c. cost of printing and registering common stock shares.
d. rate of return earned on total assets.

95. How is annual cash inflow determined?

a. Depreciation is subtracted from net income because it is an expense.
b. Depreciation is added back to net income because it is not an outflow of cash.
c. Depreciation is subtracted from net income because it is an outflow of cash.
d. Depreciation is added back to net income because it is an inflow of cash.

96. If an asset cost $70,000 and is expected to have a $10,000 salvage value at the end of its
ten-year life, and generates annual net cash inflows of $10,000 each year, the cash
payback period is
a. 8 years.
b. 7 years.
c. 6 years.
d. 5 years.
27 - 16 Test Bank for Accounting Principles, Seventh Edition

97. If the payback period for a project is greater than its economic life, the
a. project will always be profitable.
b. entire initial investment will never be recovered.
c. project would only be acceptable if the company's cost of capital was low.
d. project's return will always exceed the company's cost of capital.

98. A company is considering purchasing factory equipment which costs $480,000 and is
estimated to have no salvage value at the end of its 8-year useful life. If the equipment is
purchased, annual revenues are expected to be $135,000 and annual operating expenses
exclusive of depreciation expense are expected to be $57,000. The straight-line method of
depreciation would be used. If the equipment is purchased, the annual rate of return
expected on this project is
a. 32.5%.
b. 3.8%.
c. 7.5%.
d. 16.3%.

99. Capital budgeting is the process

a. used in sell or process further decisions.
b. of determining how much capital stock to issue.
c. of making capital expenditure decisions.
d. of eliminating unprofitable product lines.

100. Which of the following is not a common method of capital budgeting?

a. Gross profit method
b. Payback method
c. Discounted cash flow method
d. Annual rate of return method

101. The rate that management expects to pay on borrowed or equity funds is known as
a. the hurdle rate.
b. the cost of capital.
c. the cutoff rate.
d. all of these.

102. The higher the rate of return for a given risk, the
a. more attractive the investment.
b. less attractive the investment.
c. higher the cost of capital.
d. higher the hurdle rate.

103. The annual rate of return method is based on

a. accounting data.
b. time value of money data.
c. market values.
d. replacement values.
 Incremental Analysis and Capital Budgeting 27 - 17

104. A company projects an increase in net income of $180,000 each year for the next five
years if it invests $900,000 in new equipment. The equipment has a five-year life and an
estimated salvage value of $300,000. What is the annual rate of return on this
investment?
a. 20%
b. 30%
c. 25%
d. 50%

105. When using the payback method, payback is expressed in terms of

a. a percent.
b. dollars.
c. time.
d. a discount factor.

106. The payback method is criticized on the grounds that it

a. ignores obsolescence factors.
b. ignores the cost of an investment.
c. is complicated to use.
d. ignores the time value of money.

107. Laird Company is considering buying a machine for $90,000 with an estimated life of ten
years and no salvage value. The straight-line method of depreciation will be used. The
machine is expected to generate net income of $3,000 each year. The cash payback on
this investment is
a. 30 years.
b. 10 years.
c. 7.5 years.
d. 3.8 years.

108. Colaw Company is considering buying equipment for $160,000 with a useful life of five
years and an estimated salvage value of $8,000. If annual expected income is $14,000,
the denominator in computing the annual rate of return is
a. $160,000.
b. $80,000.
c. $84,000.
d. $168,000.

109. A capital budgeting technique which takes into consideration the time value of money is
the
a. annual rate of return approach.
b. return on stockholders' equity approach.
c. payback approach.
d. net present value method.

110. Which one of the following is correct?

a. Cash flows are used to calculate the internal rate of return.
b. Accrual income is used to calculate the payback period.
c. Cash flows are used to calculate the annual rate of return.
d. Accrual income is used to calculate the net present value.
27 - 18 Test Bank for Accounting Principles, Seventh Edition

111. If a company's required minimum rate of return is 10%, and in using the net present value
method, a project's net present value is zero, this indicates that the
a. project's rate of return exceeds 10%.
b. project's rate of return is less than the minimum rate required.
c. project earns a rate of return of 10%.
d. project earns a rate of return of 0%.

112. Using the net present value method, the total present value of cash inflows for Project A is
$30,000 and the total present value of cash inflows of Project B is $36,000. If Project A
and Project B both require an initial investment of $30,000 and have the same economic
life, the project that should be accepted is
a. Project A.
b. Project B.
c. neither; they are both the same.
d. not capable of being calculated.

113. Mock Plumbing used the net present value method and determined that project 34 had a
zero net present value. What does this tell management about the project?
a. The return from this project is equal to the cost of capital.
b. The project guarantees company profitability.
c. The project's cash inflows will equal its cash outflows.
d. The project earns the company's desired minimum rate of return.

114. In using the internal rate of return method, the internal rate of return factor was 4.0 and
the equal annual cash inflows were $20,000. The initial investment in the project must
have been
a. $20,000.
b. $5,000.
c. $80,000.
d. an amount which cannot be determined.

Use the following table for questions 115–117.

Present value of an Annuity of 1

Periods 8% 9% 10%
1 .926 .917 .909
2 1.783 1.759 1.736
3 2.577 2.531 2.487

115. A company has a minimum required rate of return of 9%. It is considering investing in a
project which costs $140,000 and is expected to generate cash inflows of $56,000 at the
end of each year for three years. The net present value of this project is
a. $141,736.
b. $84,000.
c. $14,172.
d. $1,736.
 Incremental Analysis and Capital Budgeting 27 - 19

116. A company has a minimum required rate of return of 8%. It is considering investing in a
project that costs $75,930 and is expected to generate cash inflows of $30,000 each year
for three years. The approximate internal rate of return on this project is
a. 8%.
b. 9%.
c. 10%.
d. cannot be approximated.

117. A company has a minimum required rate of return of 10%. It is considering investing in a
project that requires an investment of $70,000 and is expected to generate cash inflows of
$30,000 at the end of each year for 3 years. The present value of future cash inflows for
this project is
a. $70,000.
b. $74,610.
c. $82,070.
d. $4,610.

118. The conceptually superior approach to capital budgeting is

a. a discounted cash flow method.
b. the payback method.
c. the annual rate of return method.
d. none of these.

119. The appropriate table to use when an investment promises to return unequal cash flows is
the
a. future value of 1 table.
b. future value of annuity table.
c. present value of 1 table.
d. present value of annuity table.

Additional Multiple Choice Questions

120. Accounting's contribution to the decision-making process occurs in all of the following
steps except to
a. identify the problem and assign responsibility.
b. determine possible courses of action.
c. review results of the decision.
d. Accounting’s contribution occurs in all of these steps.

121. It costs Dryer Company $26 per unit ($18 variable and $8 fixed) to produce its product,
which normally sells for $38 per unit. A foreign wholesaler offers to purchase 3,000 units
at $21 each. Dryer would incur special shipping costs of $2 per unit if the order were
accepted. Dryer has sufficient unused capacity to produce the 3,000 units. If the special
order is accepted, what will be the effect on net income?
a. $3,000 decrease
b. $3,000 increase
c. $9,000 increase
d. $54,000 increase
27 - 20 Test Bank for Accounting Principles, Seventh Edition

122. In a make or buy decision, opportunity costs are

a. added to the make total cost.
b. deducted from the make total cost.
c. added to the buy total cost.
d. ignored.

123. Which of the following would generally not affect a make or buy decision?
a. Selling expenses
b. Direct labor
c. Variable manufacturing costs
d. Opportunity cost

124. A cost that cannot be changed by any present or future decision is a(n)
a. fixed cost.
b. opportunity cost.
c. sunk cost.
d. variable cost.

125. If an unprofitable segment is eliminated

a. it is impossible for net income to decrease.
b. fixed expenses allocated to the eliminated segment will be eliminated.
c. variable expenses of the eliminated segment will be eliminated.
d. it is impossible for net income to increase.

126. All of the following are relevant in deciding whether to eliminate an unprofitable segment
except the segment's
a. sales.
b. variable expenses.
c. contribution margin.
d. fixed expenses.

127. In the Rossetto Company, contribution margin per unit is $12 for Product X and $20 for
Product Y. Product X requires 4 machine hours and Product Y requires 8 machine hours.
What is the contribution margin per unit of limited resource for each product?
X Y
a. $3.00 $2.50
b. $5.00 $3.00
c. $2.50 $1.50
d. $5.00 $1.50

128. The rate of return that management expects to pay on all borrowed and equity funds is the
a. cost of capital.
b. cutoff rate.
c. hurdle rate.
d. minimum rate.

129. The cash payback formula is

a. Cost of capital investment ÷ Net income.
b. Cost of capital investment ÷ Annual cash inflow.
c. Average investment ÷ Net income.
d. Average investment ÷ Annual cash inflow.
 Incremental Analysis and Capital Budgeting 27 - 21

130. To determine annual cash inflow, depreciation is

a. subtracted from net income because it is an expense.
b. subtracted from net income because it is an outflow of cash.
c. added back to net income because it is an inflow of cash.
d. added back to net income because it is not an outflow of cash.

131. Net present value is the difference between the

a. future cash inflows and the capital investment.
b. future cash inflows and the present value of the capital investment.
c. present value of future cash inflows and the capital investment.
d. present value of future net income and the capital investment.

132. A negative net present value means that the

a. project's rate of return exceeds the required rate of return.
b. project's rate of return is less than the required rate of return.
c. project's rate of return equals the required rate of return.
d. project is acceptable.

Answers to Multiple Choice Questions

Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
38. b 52. a 66. c 80. c 94. a 108. c 122. a
39. b 53. a 67. c 81. c 95. b 109. d 123. a
40. c 54. d 68. a 82. d 96. b 110. a 124. c
41. b 55. b 69. a 83. d 97. b 111. c 125. c
42. c 56. d 70. b 84. b 98. c 112. b 126. d
43. b 57. d 71. d 85. b 99. c 113. d 127. a
44. b 58. d 72. d 86. c 100. a 114. c 128. a
45. c 59. b 73. b 87. c 101. b 115. d 129. b
46. a 60. a 74. d 88. b 102. a 116. b 130. d
47. d 61. a 75. d 89. b 103. a 117. b 131. c
48. b 62. c 76. b 90. a 104. b 118. a 132. b
49. d 63. d 77. c 91. c 105. c 119. c
50. d 64. b 78. b 92. c 106. d 120. a
51. b 65. b 79. d 93. b 107. c 121. b
27 - 22 Test Bank for Accounting Principles, Seventh Edition

EXERCISES
Ex. 133
Bailey Company produced and sold 50,000 units of product and is operating at 80% of plant
capacity. Unit information about its product is as follows:
Sales Price $70
Variable manufacturing cost $45
Fixed manufacturing cost ($500,000 ÷ 50,000) 10 55
Profit per unit $15
The company received a proposal from a foreign company to buy 10,000 units of Bailey
Company's product for $50 per unit. This is a one-time only order and acceptance of this proposal
will not affect the company's regular sales. The president of Bailey Company is reluctant to
accept the proposal because he is concerned that the company will lose money on the special
order.

Instructions
Prepare a schedule reflecting an incremental analysis of this proposal and indicate the effect the
acceptance of this order might have on the company's income.

Solution 133 (9–13 min.)

BAILEY COMPANY
Incremental Analysis
Proposal to buy 10,000 units at $50

Net Income
Reject Order Accept Order Increase (Decrease)
Revenues (10,000 × $50) $ -0- $500,000 $500,000
Costs (10,000 × $45) -0- (450,000) (450,000)
Net Income $ -0- $ 50,000 $ 50,000

Bailey Company would increase its income by $50,000 in accepting the special order.

Ex. 134
Cutter Company manufactures cappuccino makers. For the first eight months of 2005, the
company reported the following operating results while operating at 80% of plant capacity:

Sales (500,000 units) $90,000,000

Cost of goods sold 54,000,000
Gross profit 36,000,000
Operating expenses 24,000,000
Net income $12,000,000

An analysis of costs and expenses reveals that variable cost of goods sold is $95 per unit and
variable operating expenses are $35 per unit.
 Incremental Analysis and Capital Budgeting 27 - 23

Ex. 134 (cont.)

In September, Cutter Company receives a special order for 20,000 machines at $145 each from a
major coffee shop franchise. Acceptance of the order would result in $10,000 of shipping costs
but no increase in fixed expenses.

Instructions
(a) Prepare an incremental analysis for the special order.
(b) Should Cutter Company accept the special order? Justify your answer.

Solution 134 (12–17 min.)

(a) Net Income
Reject Order Accept Order Increase (Decrease)
Revenues $ -0- $2,900,000 $2,900,000
Cost of Goods Sold -0- 1,900,000* (1,900,000)
Operating Expense -0- 710,000** (710,000)
Net Income $ -0- $ 290,000 $ 290,000

*Variable cost of goods sold = 20,000 × $95 = $1,900,000.

**Variable operating expenses = 20,000 × $35 = $700,000 + $10,000 = $710,000.

(b) The incremental analysis shows Cutter Company should accept the special order because
incremental revenues exceed incremental costs. This recommendation assumes that
acceptance of the special order will not affect relations with existing customers.

Ex. 135
Walker Company supplies schools with floor mattresses to use in physical education classes.
Walker has received a special order from a large school district to buy 800 mats at $45 each.
Acceptance of the special order will not affect fixed costs but will result in $1,200 of shipping
costs.

For the first 6 months of 2005, the company reported the following operating results while
operating at 80% capacity:
Sales (100,000 units) $7,000,000
Cost of goods sold 4,200,000
Gross profit 2,800,000
Operating expenses 2,000,000
Net income $ 800,000
Cost of goods sold was 80% variable and 20% fixed; operating expenses were 75% variable and
25% fixed.

Instructions
(a) Prepare an incremental analysis for the special order.
(b) Should Walker Company accept the special order? Justify your answer.
27 - 24 Test Bank for Accounting Principles, Seventh Edition

Solution 135 (13–18 min.)

(a) Net Income
Reject Order Accept Order Increase (Decrease)
Revenues $ -0- $36,000 $36,000
Cost of Goods Sold -0- 26,880 (26,880)
Operating Expense -0- 13,200 (13,200)
Net Income $ -0- $(4,080) $(4,080)

Variable cost of goods sold = $4,200,000 × 80% = $3,360,000.

Variable cost of goods sold per unit = $3,360,000 ÷ 100,000 = $33.60.
Variable cost of goods sold for the special order = 800 × $33.60 = $26,880.
Variable operating expenses = $2,000,000 × 75% = $1,500,000
Variable operating expenses per unit = $1,500,000 ÷ 100,000 = $15.00
Variable operating expenses for the special order = 800 × $15.00 = $12,000 + $1,200
= $13,200

(b) The incremental analysis shows Walker Company should not accept the special order
because incremental costs exceed incremental revenues.

Ex. 136
Hodges, Inc. budgeted 10,000 widgets for production during 2005. Hodges has capacity to
produce 12,000 units. Fixed factory overhead is allocated to production. The following estimated
costs were provided:
Direct material ($7/unit) $ 70,000
Direct labor ($15/hr. × 2 hrs./unit) 300,000
Variable manufacturing overhead ($3/unit) 30,000
Fixed factory overhead costs ($4/unit) 40,000
Total $440,000
Cost per unit = $44

Instructions
Answer each of the following independent questions:
1. Hodges received an order for 1,000 units from a new customer in a country in which Hodges
has never done business. This customer has offered $41 per widget. Should Hodges accept
the order?

2. Hodges received an offer from another company to manufacture the same quality widgets for
$38. Should Hodges let someone else manufacture all 10,000 widgets and focus only on
distribution?

Solution 136 (10–12 min.)

1. Yes, it can make an extra $1,000.
Incremental revenue per widget $41
Incremental cost per widget: $7 + ($15 × 2) + $3 = 40
Incremental profit per unit $1
Total incremental profit = $1 × 1,000 = $1,000
 Incremental Analysis and Capital Budgeting 27 - 25

Solution 136 (cont.)

2. Yes, Hodges will save $20,000 if it buys instead of makes.
Cost to buy per widget $38
Cost to make per widget: $7 + ($15 × 2) + $3 = 40
Incremental savings per widget if purchased $ 2
Total incremental savings if purchased = $2 × 10,000 = $20,000

Ex. 137
Doyle Company manufactured 6,000 units of a component part that is used in its product and
incurred the following costs:

Direct materials $ 70,000

Direct labor 30,000
Variable manufacturing overhead 20,000
Fixed manufacturing overhead 40,000
$160,000

Another company has offered to sell the same component part to the company for $22.00 per
unit. The fixed manufacturing overhead consists mainly of depreciation on the equipment used to
manufacture the part and would not be reduced if the component part was purchased from the
outside firm. If the component part is purchased from the outside firm, Doyle Company has the
opportunity to use the factory equipment to produce another product which is estimated to have a
contribution margin of $20,000.

Instructions
Prepare an incremental analysis report for Doyle Company which can serve as informational
input into this make or buy decision.

Solution 137 (13–18 min.)

Make Buy Increase (Decrease)
Direct materials $ 70,000 $ -0- $ 70,000
Direct labor 30,000 -0- 30,000
Variable manufacturing overhead 20,000 -0- 20,000
Fixed manufacturing overhead 40,000 40,000 -0-
Purchase price (6,000 × $22.00) -0- 132,000 (132,000)
Total annual cost 160,000 172,000 (12,000)
Opportunity cost 20,000 -0- 20,000
Total cost $180,000 $172,000 $ 8,000

Income is expected to increase by $8,000 if the component part is purchased from the outside
firm and the new product is manufactured.
27 - 26 Test Bank for Accounting Principles, Seventh Edition

Ex. 138
Barry Corporation currently manufactures a subassembly for its main product. The costs per unit
are as follows:

Direct materials $ 1
Direct labor 10
Variable overhead 5
Fixed overhead 8
Total $24

Funkhouser Company has contacted Barry with an offer to sell it 5,000 of the subassemblies for
$18 each. If Barry makes the subassemblies, $5 of the fixed overhead per unit will be allocated to
other products.

Instructions
Should Barry make or buy the subassemblies? Explain your answer.

Solution 138 (6 min.)

Cost to make - cost to buy = incremental cost
($24 – $3) – $18 = $3
Incremental cost to make = $3 × 5,000 units = $15,000

Barry should buy to save $3 per unit.

Ex. 139
Kuhn Bicycle Company has been manufacturing its own seats for its bicycles. The company is
currently operating at 100% capacity, and variable manufacturing overhead is charged to
production at the rate of 70% of direct labor cost. The direct materials and direct labor cost per
unit to make the bicycle seats are $5.00 and $6.00, respectively. Normal production is 50,000
bicycles per year.

A supplier offers to make the bicycle seats at a price of $14 each. If the bicycle company accepts
this offer, all variable manufacturing costs will be eliminated, but the $20,000 of fixed
manufacturing overhead currently being charged to the bicycle seats will have to be absorbed by
other products.

Instructions
(a) Prepare the incremental analysis for the decision to make or buy the bicycle seats.
(b) Should Kuhn Bicycle Company buy the seats from the outside supplier? Justify your answer.
 Incremental Analysis and Capital Budgeting 27 - 27

Solution 139 (15–20 min.)

(a) Net Income
Make Buy Increase (Decrease)
Direct Materials (50,000 × $5) $250,000 $ -0- $250,000
Direct Labor (50,000 × $6) 300,000 -0- 300,000
Variable Manufacturing Costs
($300,000 × 70%) 210,000 -0- 210,000
Fixed Manufacturing Costs 20,000 20,000 -0-
Purchase Price (50,000 × $14) -0- 700,000 (700,000)
Total annual cost $780,000 $720,000 $ 60,000

(b) The seats should be purchased from the outside supplier. As indicated, the company's net
income would increase $60,000 by purchasing the seats.

Ex. 140
United Chemical Corporation produces an oil-based chemical product which it sells to paint
manufacturers. In 2005, the company incurred $450,000 of costs to produce 40,000 gallons of the
chemical. The selling price of the chemical is $14.00 per gallon. The costs per unit to
manufacture a gallon of the chemical are presented below:
Direct materials $ 7.50
Direct labor 2.00
Variable manufacturing overhead 1.00
Fixed manufacturing overhead .75
Total manufacturing costs $11.25

The company is considering manufacturing the paint itself. If the company processes the
chemical further and manufactures the paint itself, the following additional costs per gallon will be
incurred: Direct materials $2.10, Direct labor $1.00, Variable manufacturing overhead $.60. No
increase in fixed manufacturing overhead is expected. The company can sell the paint at $19.00
per gallon.

Instructions
Determine the incremental per gallon increase in net income and the total increase in net income
if the company manufactures the paint.

Solution 140 (15–20 min.)

Net Income
Sell Chemical Process Further Increase (Decrease)
Sales price per unit $14.00 $19.00 $5.00
Cost per unit:
Direct materials (A) 7.50 9.60 (2.10)
Direct labor (B) 2.00 3.00 (1.00)
Variable manufacturing overhead (C) 1.00 1.60 (.60)
Fixed manufacturing overhead .75 .75 —
Total 11.25 14.95 (3.70)
Net income per unit $ 2.75 $ 4.05 $1.30
27 - 28 Test Bank for Accounting Principles, Seventh Edition

Solution 140 (cont.)

(A) $7.50 + $2.10
(B) $2.00 + $1.00
(C) $1.00 + $.60

Assuming the company sells all 40,000 gallons that it produces, the incremental net income
would be $52,000 (40,000 gallons × $1.30).

Ex. 141
Alves, Inc. produces milk at a total cost of $66,000. The production generates 60,000 gallons of
milk which can be sold for $1 per gallon to a pasteurization company, or the milk can be
processed further into ice cream and then sold for $2.25 per gallon. It costs $55,000 more to turn
the annual milk supply into ice cream.

Instructions
If Alves processes the milk into ice cream, how much is the incremental profit or loss? Should
Alves process the milk into ice cream or sell it as is?

Solution 141 (6 min.)

Incremental revenues: ($2.25 – $1.00) x 60,000 gallons = $75,000
Incremental costs: given as $55,000
Incremental profits: $75,000 – $55,000 = $20,000 profit

Alves should process into ice cream.

Ex. 142
Franke Timber Corporation uses a machine that removes the bark from cut timber. The machine
is unreliable and results in a significant amount of downtime and excessive labor costs. The
management is considering replacing the machine with a more efficient one which will minimize
downtime and excessive labor costs. Data are presented below for the two machines:
Old Machine New Machine
Original purchase cost $410,000 $520,000
Accumulated depreciation 280,000 —
Estimated life 5 years 5 years
It is estimated that the new machine will produce annual cost savings of $110,000. The old
machine can be sold to a scrap dealer for $10,000. Both machines will have a salvage value of
zero if operated for the remainder of their useful lives.

Instructions
Determine whether the company should purchase the new machine.
 Incremental Analysis and Capital Budgeting 27 - 29

Solution 142 (11–16 min.)

Retain Replace Net Income
Equipment Equipment Increase/(Decrease)
Cost savings $ -0- $550,000 (A) $550,000
New machine cost -0- (520,000) (520,000)
Proceeds from sale of old machine $ -0- 10,000 10,000
Net incremental net income $ -0- $ 40,000 $ 40,000
(A) $110,000 × 5 = $550,000.
The company should purchase the new machine because there will be an increase in net income
of $40,000.

Ex. 143
Munroe Enterprises relies heavily on a copier machine to process its paperwork. Recently the
copy clerk has not been able to process all the necessary copies within the regular work week.
Management is considering updating the copier machine with a faster model.
Current Copier New Model
Original purchase cost $8,000 $15,000
Accumulated depreciation 6,000 —
Estimated operating costs (annual) 7,000 3,800
Useful life 5 years 5 years
If sold now, the current copier would have a salvage value of $1,000. If operated for the
remainder of its useful life, the current machine would have zero salvage value. The new machine
is expected to have zero salvage value after five years.

Instructions
Prepare an analysis to show whether the company should retain or replace the machine.

Solution 143 (12–16 min.)

Net Income
Retain Machine Replace Machine Increase (Decrease)
Operating costs $35,000 $19,000 $16,000
New machine cost -0- 15,000 (15,000)
Salvage value -0- (1,000) 1,000
Totals $35,000 $33,000 $ 2,000
The current copier should be replaced. The incremental analysis shows that net income for the
five-year period will be $2,000 higher by replacing the current copier.
27 - 30 Test Bank for Accounting Principles, Seventh Edition

Ex. 144
Anheiser, Inc. has three divisions: Bud, Wise, and Er. The results of May, 2005 are presented
below.
Bud Wise Er Total
Units sold 3,000 5,000 2,000 10,000
Revenue $70,000 $50,000 $40,000 $160,000
Less variable costs 32,000 26,000 16,000 74,000
Less direct fixed costs 14,000 19,000 12,000 45,000
Less allocated fixed costs 6,000 10,000 4,000 20,000
Net income $18,000 ($ 5,000) $ 8,000 $ 21,000

All of the allocated costs will continue even if a division is discontinued. Anheiser allocates
indirect fixed costs based on the number of units to be sold. Since the Wise division has a net
loss, Anheiser feels that it should be discontinued. Anheiser feels if the division is closed, that
sales at the Bud division will increase by 20%, and that sales at the Er division will stay the same.

Instructions
(a) Prepare an analysis showing the effect of discontinuing the Wise division.
(b) Should Anheiser close the Wise division? Briefly indicate why or why not.

Solution 144 (10–12 min.)

(a) Bud Er Total
Revenue $84,000 $40,000 $124,000
Less variable costs 38,400 16,000 54,400
Less direct fixed costs 14,000 12,000 26,000
Less allocated fixed costs 12,857 7,143 20,000
Net income $18,743 $ 4,857 $ 23,600

Calculations:
Revenue = $70,000 × 120% = $84,000
Variable costs = $32,000 × 120% = $38,400
Allocation of total allocated fixed costs of $20,000:
To Bud: [3,600 ÷ (3,600 + 2,000)] × $20,000 = $12,857
To Er: [2,000 ÷ (3,600 + 2,000)] × $20,000 = $7,143

(b) Yes. The profit increases by $2,600 ($23,600 – $21,000) when the division is eliminated.
Direct fixed costs and variable costs for Wise division were relatively high compared to those
for the Bud and Er divisions. The increase in sales by 20% of the Bud division was enough to
offset the loss of the Wise division.

Ex. 145
Simon Forest Corporation operates two divisions, the Timber Division and the Consumer
Division. The Timber Division manufactures and sells logs to paper manufacturers. The
Consumer Division operates retail lumber mills which sell a variety of products in the do-it-
yourself homeowner market. The company is considering disposing of the Consumer Division
since it has been consistently unprofitable for a number of years. The income statements for the
two divisions for the year ended December 31, 2005 are presented below:
 Incremental Analysis and Capital Budgeting 27 - 31

Ex. 145 (cont.)

Timber Division Consumer Division Total

Sales $1,500,000 $500,000 $2,000,000
Cost of goods sold 900,000 350,000 1,250,000
Gross profit 600,000 150,000 750,000
Selling & administrative expenses 250,000 180,000 430,000
Net income $ 350,000 $(30,000) $ 320,000

In the Consumer Division, 60% of the cost of goods sold are variable costs and 25% of selling
and administrative expenses are variable costs. The management of the company feels it can
save $60,000 of fixed cost of goods sold and $50,000 of fixed selling expenses if it discontinues
operation of the Consumer Division.

Instructions
(a) Determine whether the company should discontinue operating the Consumer Division.
(b) If the company had discontinued the division for 2005, determine what net income would
have been.

Solution 145 (20–25 min.)

(a) CONSUMER DIVISION
Net Income
Continue Eliminate Increase (Decrease)
Sales $500,000 $ -0- $(500,000)
Variable expenses:
Cost of goods sold 210,000 (A) -0- 210,000
Selling and admin. exp. 45,000 (B) -0- 45,000
Contribution margin 245,000 -0- (245,000)
Fixed expenses:
Cost of goods sold 140,000 (C) 80,000 60,000
Selling and admin. exp. 135,000 (D) 85,000 50,000
Net income $ (30,000) $(165,000) $(135,000)

(A) $350,000 × 60% = $210,000 (C) $350,000 – $210,000 = $140,000

(B) $180,000 × 25% = $45,000 (D) $180,000 – $45,000 = $135,000

The company should continue the Consumer Division because contribution margin, $245,000, is
greater than the avoidable fixed costs, $110,000.

(b) Net income for the total company would have been $215,000:
Timber Division + Decrease in Net Income
$350,000 + $(135,000) = $215,000
27 - 32 Test Bank for Accounting Principles, Seventh Edition

Ex. 146
Parrino has three product lines in its retail stores: books, videos, and music. Results of the fourth
quarter are presented below:
Books Music Videos Total
Units sold 1,000 2,000 2,000 5,000
Revenue $22,000 $40,000 $23,000 $85,000
Variable departmental costs 15,000 22,000 12,000 49,000
Direct fixed costs 1,000 3,000 2,000 6,000
Allocated fixed costs 7,000 7,000 7,000 21,000
Net income (loss) ($1,000) $ 8,000 $ 2,000 $ 9,000

The allocated fixed costs are unavoidable. Demand of individual products are not affected by
changes in other product lines.

Instructions
What will happen to profits if Parrino discontinues the Books product line?

Solution 146 (6 min.)

Incremental revenue ($22,000)
Incremental costs:
Variable costs savings +15,000
Direct fixed costs savings + 1,000
Decrease in profits if discontinued ( $ 6,000)

Ex. 147
A recent accounting graduate from Missouri State University evaluated the operating perform-
ance of Boswell Company's four divisions. The following presentation was made to Boswell's
Board of Directors. During the presentation, the accountant made the recommendation to
eliminate the Southern Division stating that total net income would increase by $40,000. (See
analysis below.)
Other Three Divisions Southern Division Total
Sales $2,000,000 $480,000 $2,480,000
Cost of Goods Sold 950,000 400,000 1,350,000
Gross Profit 1,050,000 80,000 1,130,000
Operating Expenses 800,000 120,000 920,000
Net Income $ 250,000 $ (40,000) $ 210,000

For the other divisions, cost of goods sold is 80% variable and operating expenses are 70%
variable. The cost of goods sold for the Southern Division is 30% fixed, and its operating
expenses are 75% fixed. If the division is eliminated, only $6,000 of the fixed operating costs will
be eliminated.

Instructions
Do you concur with the new accountant's recommendation? Present a schedule to support your
answer.
 Incremental Analysis and Capital Budgeting 27 - 33

Solution 147 (20–25 min.)

Net Income
Continue Eliminate Increase (Decrease)
Sales $480,000 $ -0- $(480,000)
Variable Expenses
Cost of goods sold 280,000 -0- 280,000
Operating expenses 30,000 -0- 30,000
Total Variable 310,000 -0- 310,000
Contribution Margin 170,000 -0- (170,000)
Fixed Expenses
Cost of goods sold 120,000 120,000 -0-
Operating expenses 90,000 84,000 6,000
Net Income (Loss) $(40,000) $(204,000) $(164,000)

The accountant is not correct. If the Southern Division is eliminated, the net income will be
$164,000 less, not $40,000 greater.

The reduction in income is the result of the loss of the contribution margin less the avoidable fixed
costs of $6,000.

Ex. 148
Neagle Company has 8,000 machine hours available to use to produce either Product A or
Product B. The cost accounting department developed the following unit information for each of
the products:
Product A Product B
Sales price $54 $65
Direct materials 19 21
Direct labor 15 14
Variable manufacturing overhead 8 12
Fixed manufacturing overhead 4 8
Machine hours required .6 1.0

Management desires to make a decision regarding which product to produce in order to maximize
the company's income.

Instructions
Taking into consideration the constraint under which the company operates, prepare a report to
show which product should be produced and sold.
27 - 34 Test Bank for Accounting Principles, Seventh Edition

Solution 148 (20–25 min.)

NEAGLE COMPANY
Contribution Margin per Unit Limited Resource

Contribution margin per unit: Product A Product B

Sales price $54 $65
Variable costs
Direct material $19 $21
Direct labor 15 14
Variable overhead 8 42 12 47
Contribution margin $12 $18

Machine hours required: .6 hrs. 1.0 hrs.

Contribution margin per unit of limited resource

($12 ÷ .6) $ 20
($18 ÷ 1.0) $ 18
Machine hours available 8,000 8,000
Contribution margin $160,000 $144,000

The company should produce and sell Product A.

Ex. 149
Dannon Company manufactures and sells two products. Relevant per unit data concerning each
product are given below:
Product
Standard Deluxe
Selling price $42 $48
Variable costs $20 $23
Machine hours 4 5

Instructions
(a) Compute the contribution margin per unit of the limited resource for each product.
(b) If 1,000 additional machine hours are available, which product should be manufactured?
(c) Prepare an analysis showing the total contribution margin if the additional hours are
(1) Divided equally among the products.
(2) Allocated entirely to the product identified in (b) above.

Solution 149 (25–30 min.)

(a) Product
Standard Deluxe
Contribution margin per unit (a) $22 $25
Machine hours required (b) 4 5
Contribution margin per unit of limited resource (a) ÷ (b) $5.50 $5.00
 Incremental Analysis and Capital Budgeting 27 - 35

Solution 149 (cont.)

(b) The Standard product should be manufactured because it results in the highest contribution
margin per machine hour.

(c) Product
Standard Deluxe
Machine hours 1,000 ÷ 2 (a) 500 500
Machine hours per unit (b) 4 5
Units produced (a) ÷ (b) 125 100
Contribution margin per unit $22 $25
Total contribution margin $2,750 $2,500

Product
Standard
Machine hours (a) 1,000
Machine hours per unit (b) 4
Units produced (a) ÷ (b) 250
Contribution margin per unit $22
Total contribution margin $5,500

Ex. 150
Elston Company estimates the following cash flows and depreciation on a project that will cost
$200,000 and will last 10 years with no salvage value:

Revenues
Sales $70,000
Operating expenses
Rent expense $26,000
Depreciation expense 20,000
Miscellaneous expenses 8,000 54,000
Net Income $16,000

Instructions
(a) Calculate the expected annual rate of return on this project showing calculations to support
your answer.
(b) Calculate the cash payback on this project showing calculations to support your answer.

Solution 150 (9–14 min.)

(a) Annual rate of return is 16%.

$200,000
Average investment = ———— = $100,000
2

$16,000
Annual rate of return = ———— = 16%
$100,000
27 - 36 Test Bank for Accounting Principles, Seventh Edition

Solution 150 (cont.)

(b) Cash payback period is 5.56 years.
Investment $200,000
Annual cash inflow ($16,000 + $20,000) $36,000
Cash payback = $200,000 ÷ $36,000 = 5.56 years

Ex. 151
Newman Medical Center is considering purchasing an ultrasound machine for $1,145,000. The
machine has a 10-year life and an estimated salvage value of $30,000. Installation costs and
freight charges will be $24,200 and $800, respectively. The Center uses straight-line depreci-
ation.

The medical center estimates that the machine will be used five times a week with the average
charge to the patient for ultrasound of $800. There are $10 in medical supplies and $40 of
technician costs for each procedure performed using the machine.

Instructions
(a) Compute the payback period for the new ultrasound machine.
(b) Compute the annual rate of return for the new machine.

Solution 151 (16–22 min.)

(a) Cost of the ultrasound machine: $1,145,000 + $24,200 + $800 = $1,170,000

Annual Cash Flow:

Number of procedures: 52 × 5 = 260
Contribution margin per procedure: $800 – $10 – $40 = $750
Total annual cash flow: 260 × $750 = $195,000

$1,170,000
Cash payback: ————— = 6 years
$195,000

(b) $1,170,000 + $30,000

Average Investment: —————————— = $600,000
2

$1,170,000 – $30,000
Annual Depreciation: —————————— = $114,000
10 years

Annual Net Income: $195,000 – $114,000 = $81,000

$81,000
Average Annual Rate of Return: ———— = 13.5%
$600,000
 Incremental Analysis and Capital Budgeting 27 - 37

Ex. 152
Fox Corporation recently purchased a new machine for its factory operations at a cost of
$921,250. The investment is expected to generate $250,000 in annual cash flows for a period of
six years. The required rate of return is 12%. The new machine is expected to have zero salvage
value at the end of the six-year period.

Instructions
Calculate the internal rate of return. (Table 2 from Appendix C is needed.)

Solution 152 (4 min.)

IRR = Capital investment ÷ Annual cash inflows = Factor
$921,250 ÷ $250,000 = 3.685. This factor is found in the PVA table at n = 6 periods.
IRR = 16%

Ex. 153
Douglas Company is considering two new projects, each requiring an equipment investment of
$48,000. Each project will last for three years and produce the following annual net income.
Year TIP TOP
1 $ 4,000 $ 6,000
2 6,000 6,000
3 9,000 6,000
$19,000 $18,000

The equipment will have no salvage value at the end of its three-year life. Douglas Company
uses straight-line depreciation. Douglas requires a minimum rate of return of 12%. Present value
data are as follows:
Present Value of 1 Present Value of an Annuity of 1
Period 12% Period 12%
1 .893 1 .893
2 .797 2 1.690
3 .712 3 2.402
Instructions
(a) Compute the net present value of each project.
(b) Which project should be selected? Why?

Solution 153 (22–27 min.)

(a) Project TIP
Year Annual Cash Inflows* Present Value of 1 Present Value
1 $20,000 .893 $17,860
2 22,000 .797 17,534
3 25,000 .712 17,800
$67,000 $53,194
*Net income plus annual depreciation of $16,000.
27 - 38 Test Bank for Accounting Principles, Seventh Edition

Solution 153 (cont.)

Present value of future cash inflows $53,194
Capital investment 48,000
Positive net present value $ 5,194

Project TOP
Present value of future cash inflows ($22,000 × 2.402) $52,844
Capital investment 48,000
Positive net present value $ 4,844

(b) Both projects are acceptable because both show a positive net present value. Project TIP is
the preferred project because its positive net present value is greater than project TOP's net
present value.

Ex. 154
Unruh Company is considering investing in a project that will cost $152,000 and have no salvage
value at the end of its 5-year life. It is estimated that the project will generate annual cash inflows
of $40,000 each year. The company has a hurdle or cutoff rate of return of 8% and uses the
following compound interest table:

Present Value of an Annuity of 1

Period 6% 8% 10% 12% 15%
5 4.212 3.993 3.791 3.605 3.352

Instructions
Using the internal rate of return method, determine if this project is acceptable by calculating an
approximate interest yield for the project.

Solution 154 (6–11 min.)

Capital Investment
————————— = Internal Rate of Return Factor
Annual Cash Inflows

$152,000
————- = 3.80
$40,000

Since the calculated internal rate of return factor of 3.80 is very near the factor 3.791 for five
periods and 10% interest, this project has an approximate interest yield of 10%, and is therefore
acceptable because it is greater than the company's cutoff rate of 8%.
 Incremental Analysis and Capital Budgeting 27 - 39

Ex. 155
Rodriguez Company has money available for investment and is considering two projects each
costing $17,500. Each project has a useful life of 3 years and no salvage value. The investment
cash flows follow:
Project A Project B
Year 1 $ 2,000 $7,000
Year 2 6,000 7,000
Year 3 13,000 7,000

Instructions
If 8% is an acceptable earnings rate, which project should be selected? Justify your response.
(Table 1 from Appendix C is needed.)

Solution 155 (12 min.)

Project B is acceptable since its net present value is positive. This indicates that project B
provides a return greater than the company's minimum expected return of 8%. Project A earns
less than an 8% return.

Project A
Year 1 $2,000 × .926 = $ 1,852
Year 2 $6,000 × .857 = 5,142
Year 3 $13,000 × .794 = 10,322
Present value of cash inflows 17,316
Cash purchase price (17,500)
Net present value of project A $ (184)

Project B
Year 1 $7,000 × .926 = $ 6,482
Year 2 $7,000 × .857 = 5,999
Year 3 $7,000 × .794 = 5,558
Present value of cash inflows 18,039
Cash purchase price (17,500)
Net present value of project B $ 539
27 - 40 Test Bank for Accounting Principles, Seventh Edition

COMPLETION STATEMENTS
156. An important purpose of management accounting is to provide _____________________
for decision making.
157. The process used to identify the financial data that change under alternative courses of
action is called __________________ analysis.
158. In a decision on whether an order should be accepted at a special price when there is
plant capacity available, a major consideration is whether the special price exceeds
__________________.
159. The potential benefit that may be obtained by following an alternative course of action is
called an _________________ cost.
160. A decision whether to sell a product now or to process it further, depends on whether the
incremental _____________ from processing further are greater than the incremental
processing ______________.
161. The ______________ value of old equipment is irrelevant in a decision to replace that
equipment and is often referred to as a _____________ cost.
162. In an environment where there are limited resources, the products with the highest
contribution per unit of ______________ should identify the products to be produced.
163. The process of making capital expenditure decisions in business is called ___________.
164. Three quantitative techniques which are frequently used in capital budgeting decisions are
(1) _________________, (2) _________________, and (3) ___________________.
165. A major limitation of the annual rate of return approach is that it does not consider the
_______________ of money.
166. The technique which identifies the time period required to recover the cost of the
investment is called the ________________ method.
167. The two discounted cash flow techniques used in capital budgeting are (1) the
_______________________ method and (2) the ______________________ method.
168. Knowledge of the ______________________ is necessary when discounting future cash
flows under the net present value approach.
169. In using the net present value approach, a project is acceptable if the project's net present
value is ____________ or _______________.
170. The internal rate of return method differs from the net present value method in that it
results in finding the ___________________ of the potential investment.

Answers to Completion Statements

156. relevant information 164. annual rate of return, cash payback,
157. incremental (differential) discounted cash flow
158. variable costs (incremental costs) 165. time value
159. opportunity 166. cash payback
160. revenues, costs 167. net present value, internal rate of return
161. book, sunk 168. required rate of return
162. limited resource 169. zero, positive
163. capital budgeting 170. interest yield
 Incremental Analysis and Capital Budgeting 27 - 41

MATCHING
171. Match the items below by entering the appropriate code letter in the space provided.

A. Incremental analysis F. Cash payback technique

B. Opportunity cost G. Hurdle or cutoff rate
C. Discounted cash flow technique H. Net present value method
D. Capital budgeting I. Sunk cost
E. Annual rate of return technique J. Internal rate of return method

____ 1. A cost that cannot be changed by any present or future decision.

____ 2. A capital budgeting technique that considers both the estimated total cash inflows
from the investment and the time value of money.

____ 3. A method used in capital budgeting in which cash inflows are discounted to their
present value and then compared to the capital outlay required by the capital
investment.

____ 4. The process of identifying the financial data that change under alternative courses of
action.

____ 5. A method used in capital budgeting that results in finding the interest yield of the
potential investment.

____ 6. The minimum rate of return management requires on an investment.

____ 7. The determination of the profitability of a capital expenditure by dividing expected

annual net income by the average investment.

____ 8. The potential benefit that may be lost from following an alternative course of action.

____ 9. The process of making capital expenditure decisions in business.

____ 10. A capital budgeting technique that identifies the time period required to recover the
cost of a capital investment from the annual cash inflow produced by the investment.

Answers to Matching

1. I 6. G
2. C 7. E
3. H 8. B
4. A 9. D
5. J 10. F
27 - 42 Test Bank for Accounting Principles, Seventh Edition

SHORT-ANSWER ESSAY QUESTIONS

S-A E 172
Management is often faced with the alternative of continuing to make a product or component
internally, or going to an external source and purchasing the product or component. In gathering
relevant information for these two alternatives, briefly identify the quantitative factors that should
be considered. Are there any qualitative factors that should also be considered?

Solution 172
The quantitative factors to be considered in a make or buy decision include the incremental costs
to make the product, the incremental costs of buying the product, and the opportunity cost
(potential benefit foregone) if the product is made. Generally, all variable production costs are
relevant in a make or buy decision, but only some fixed costs, or no fixed costs, are relevant
because many fixed costs will be incurred regardless of whether the decision is to make or buy.
Qualitative factors include the possible adverse effect on employees and the stability of the
supplier's price and quality.

S-A E 173
Management uses several capital budgeting approaches in evaluating projects for possible
investment. Identify those approaches that are more desirable from a conceptual standpoint, and
briefly explain what features these approaches have that make them more desirable than other
approaches. Also identify the least desirable approach and explain its major weaknesses.

Solution 173
From a conceptual standpoint, the discounted cash flow methods (net present value and internal
rate of return) are considered more desirable because they consider both the estimated cash
flows and the time value of money. The time value of money is critical because of the long-term
impact of capital budgeting decisions. Capital budgeting approaches which do not consider the
time value of money include annual rate of return and cash payback. The cash payback method
is the least desirable because it also ignores the expected profitability of the project.

S-A E 174 (Ethics)

Tom Stanton is on the capital budgeting committee for his company, Canton Tile. Don Rhodes is
an engineer for the firm. Don expresses his disappointment to Tom that a project that was given
to him to review before submission looks extremely good on paper. "I really hoped that the cost
projections wouldn't pan out," he tells his friend. "The technology used in this is pie in the sky
kind of stuff. There are a hundred things that could go wrong. But the figures are very convincing.
I haven't sent it on yet, though I probably should."
 Incremental Analysis and Capital Budgeting 27 - 43

S-A E 174 (cont.)

"You can keep it if it's really that bad," assures Tom. "Anyway, you can probably get it shot out of
the water pretty easily, and not have the guy who submitted it mad at you for not turning it in. Just
fix the numbers. If you figure, for instance, that a cost is only 50% likely to be that low, then
double it. We do it all the time, informally. Best of all, the rank and file don't get to come to those
sessions. Your engineering genius need never know. He'll just think someone else's project was
even better than his."

Required:
1. Who are the stakeholders in this situation?
2. Is it ethical to adjust the figures to compensate for risk? Explain.
3. Is it ethical to change the proposal before submitting it? Explain.

Solution 174
1. The stakeholders include:
Don Rhodes
Canton Tile
the engineer who submitted the proposal.

2. It is ethical, in general, to adjust projections to compensate for risk. However, it should be

clearly stated that the projections have been adjusted for risk, and the method used should be
available for review. Otherwise, the entire selection process is undermined, and it becomes
entirely subjective.

3. It is probably not ethical to modify a proposal at all; certainly not in the way described. The
engineer submitting the proposal should have the right to know about any changes that were
made, and should have the right to review those changes.

S-A E 175 (Communication)

You are the general accountant for Word Systems, Inc., a typing service based in Los Angeles,
California. The company has decided to upgrade its equipment. It currently has a widely used
version of a word processing program. The company wishes to invest in more up-to-date software
and to improve its printing capabilities.

Two options have emerged. Option #1 is for the company to keep its existing computer system,
and upgrade its word processing program. The memory of each individual work station would be
enhanced, and a larger, more efficient printer would be used. Better telecommunications
equipment would allow for the electronic transmission of some documents as well.

Option #2 would be for the company to invest in an entirely different computer system. The
software for this system is extremely impressive, and it comes with individual laser printers.
However, the company is not well known, and the software does not connect well with well-known
software. The net present value information for these options follows:
27 - 44 Test Bank for Accounting Principles, Seventh Edition

S-A E 175 (cont.)

Option #1 Option #2
Initial Investment ($95,000) ($270,000)
Returns Year 1 55,000 90,000
Year 2 30,000 90,000
Year 3 10,000 90,000
Net Present Value 0 0

Required:
Prepare a brief report for management in which you make a recommendation for one system or
the other, using the information given.

Solution 175
I recommend that the company accept Option #1, to purchase upgrades to our present system
and to buy a more efficient printer. In the first place, the changes will be easier to implement
because the equipment is similar to that which we already use. Secondly, the company will have
less money invested in the project, which decreases our risk of loss should the project fail. Option
#2 appears to be too risky.