Solution manual managerial accounting concept and applications by cabrera chapter 19 answer

Fixed costs arerelevant in a decision of whether to offer a product or service, but arenot relevant in deciding what to charge for the product or service.Because price affects unit sales

CHAPTER 19 RELEVANT COSTS FOR DECISION MAKING

I Questions

1 Quantitative factors are those which may more easily be reduced interms of pesos such as projected costs of materials, labor and overhead.Qualitative factors are those whose measurement in pesos is difficultand imprecise; yet a qualitative factor may be easily given more weightthan the measurable cost savings It can be seen that the accountant’srole in making decisions deals with the quantitative factors

2 Relevant costs are expected future costs that will differ betweenalternatives In view of the definition of relevant costs, historical costsare always irrelevant because they are not future costs They may behelpful in predicting relevant costs but they are always irrelevant costsper se

3 The differential costs in any given situation is commonly defined as thechange in total cost under each alternative It is not relevant cost, but it

is the algebraic difference between the relevant costs for thealternatives under consideration

5 No Variable costs are relevant costs only if they differ in total betweenthe alternatives under consideration

6 Only those costs that would be avoided as a result of dropping theproduct line are relevant in the decision Costs that will not differ

regardless of whether the product line is retained or discontinued areirrelevant.

7 Not necessarily An apparent loss may be the result of allocatedcommon costs or of sunk costs that cannot be avoided if the productline is dropped A product line should be discontinued only if thecontribution margin that will be lost as a result of dropping the line isless than the fixed costs that would be avoided Even in that situationthe product line may be retained if its presence promotes the sale ofother products

8 Allocations of common fixed costs can make a product line (or othersegment) appear to be unprofitable, whereas in fact it may beprofitable

9 In cost-plus pricing, prices are set by applying a markup percentage to

a product’s cost

10 The price elasticity of demand measures the degree to which a change

in price affects unit sales The unit sales of a product with inelasticdemand are relatively insensitive to the price charged for the product

In contrast, the unit sales of a product with elastic demand are sensitive

to the price charged for the product

11 The profit-maximizing price should depend only on the variable(marginal) cost per unit and on the price elasticity of demand Fixedcosts do not enter into the pricing decision at all Fixed costs arerelevant in a decision of whether to offer a product or service, but arenot relevant in deciding what to charge for the product or service.Because price affects unit sales, total variable costs are affected by thepricing decision and therefore are relevant

12 The markup over variable cost depends on the price elasticity ofdemand A product whose demand is elastic should have a lowermarkup over cost than a product whose demand is inelastic If demandfor a product is inelastic, the price can be increased without cutting asdrastically into unit sales

II Exercises

Exercise 1 (Identifying Relevant Costs)

j Variable selling expense X X

k Fixed selling expense X X

* Depreciation P2,000Insurance 960Garage rent 480Automobile tax and license 60Total P3,500

Requirement 2

The variable operating costs would be relevant in this situation Thedepreciation would not be relevant since it relates to a sunk cost However,any decrease in the resale value of the car due to its use would be relevant.The automobile tax and license costs would be incurred whether Ingriddecides to drive her own car or rent a car for the trip during summer break

and are therefore irrelevant It is unlikely that her insurance costs wouldincrease as a result of the trip, so they are irrelevant as well The garagerent is relevant only if she could avoid paying part of it if she drives herown car.

Requirement 3

When figuring the incremental cost of the more expensive car, the relevantcosts would be the purchase price of the new car (net of the resale value ofthe old car) and the increases in the fixed costs of insurance and automobiletax and license The original purchase price of the old car is a sunk costand is therefore irrelevant The variable operating costs would be the sameand therefore are irrelevant (Students are inclined to think that variablecosts are always relevant and fixed costs are always irrelevant in decisions.This requirement helps to dispel that notion.)

Exercise 3 (Make or Buy a Component)

Requirement 1

Per Unit Differential Costs 15,000 units

Variable manufacturing overhead 10 150,000

Fixed manufacturing overhead, traceable1

Requirement 2

Make Buy

Cost of purchasing (part 1) P3,000,000Cost of making (part 1) P2,550,000Opportunity cost—segment margin forgone on a

potential new product line 650,000 Total cost P3,200,000 P3,000,000Difference in favor of purchasing from the outside

supplier P200,000Thus, the company should accept the offer and purchase the parts from the outsidesupplier

Exercise 4 (Evaluating Special Order)

Only the incremental costs and benefits are relevant In particular, only thevariable manufacturing overhead and the cost of the special tool arerelevant overhead costs in this situation The other manufacturing overheadcosts are fixed and are not affected by the decision

Even though the price for the special order is below the company’s regularprice for such an item, the special order would add to the company’s netoperating income and should be accepted This conclusion would notnecessarily follow if the special order affected the regular selling price ofbracelets or if it required the use of a constrained resource

Exercise 5 (Utilization of a Constrained Resource)

Requirement 1

X Y Z

(1) Contribution margin per unit P18 P36 P20(2) Direct labor cost per unit P12 P32 P16(3) Direct labor rate per hour 8 8 8(4) Direct labor-hours required per unit (2) ÷ (3) 1.5 4.0 2.0Contribution margin per direct labor-hour (1) ÷ (4) P12 P 9 P10

Direct labor-hours available × 3,000 × 3,000 3,000×

Total contribution margin P36,000 P27,000 P30,000

Although product X has the lowest contribution margin per unit and the

second lowest contribution margin ratio, it has the highest contribution

margin per direct labor-hour Since labor time seems to be the company’s

constraint, this measure should guide management in its production

decisions

Requirement 3

The amount Jaycee Company should be willing to pay in overtime wages

for additional direct labor time depends on how the time would be used If

there are unfilled orders for all of the products, Jaycee would presumably

use the additional time to make more of product X Each hour of direct

labor time generates P12 of contribution margin over and above the usual

direct labor cost Therefore, Jaycee should be willing to pay up to P20 per

hour (the P8 usual wage plus the contribution margin per hour of P12) for

additional labor time, but would of course prefer to pay far less The upper

limit of P20 per direct labor hour signals to managers how valuable

additional labor hours are to the company

If all the demand for product X has been satisfied, Jaycee Company would

then use any additional direct labor-hours to manufacture product Z In that

case, the company should be willing to pay up to P18 per hour (the P8 usual

wage plus the P10 contribution margin per hour for product Z) to

manufacture more product Z

Likewise, if all the demand for both products X and Z has been satisfied,additional labor hours would be used to make product Y In that case, thecompany should be willing to pay up to P17 per hour to manufacture moreproduct Y.

Exercise 6 (Sell or Process Further)

Product A Product B Product C

Sales value after further processing P80,000 P150,000 P75,000Sales value at split-off point 50,000 90,000 60,000

Cost of further processing 35,000 40,000 12,000Incremental profit (loss) P(5,000) 20,000 3,000

Products B and C should be processed further, but not Product A

Exercise 7 (Identification of Relevant Costs)

Requirement 1

The relevant costs of a fishing trip would be:

Fuel and upkeep on boat per trip P25

Junk food consumed during trip* 8

Snagged fishing lures 7

Total P40

* The junk food consumed during the trip may not be completely relevant.Even if Shin were not going on the trip, he would still have to eat Theamount by which the cost of the junk food exceeds the cost of the food hewould otherwise consume would be the relevant amount

The other costs are sunk at the point at which the decision is made to go onanother fishing trip

Requirement 2

If he fishes for the same amount of time as he did on his last trip, all of hiscosts are likely to be about the same as they were on his last trip.Therefore, it really doesn’t cost him anything to catch the last fish Thecosts are really incurred in order to be able to catch fish and would be thesame whether one, two, three, or a dozen fish were actually caught.Fishing, not catching fish, costs money All of the costs are basically fixedwith respect to how many fish are actually caught during any one fishing

trip, except possibly the cost of snagged lures.

Requirement 3

In a decision of whether to give up fishing altogether, nearly all of the costslisted by Shin’s wife are relevant If he did not fish, he would not need topay for boat moorage, new fishing gear, a fishing license, fuel and upkeep,junk food, or snagged lures In addition, he would be able to sell his boat,the proceeds of which would be considered relevant in this decision Theoriginal cost of the boat, which is a sunk cost, would not be relevant.These three requirements illustrate the slippery nature of costs A cost that

is relevant in one situation can be irrelevant in the next None of the costsare relevant when we compute the cost of catching a particular fish; some

of them are relevant when we compute the cost of a fishing trip; and nearlyall of them are relevant when we consider the cost of not giving up fishing.What is even more confusing is that CG is correct; the average cost of asalmon is P167, even though the cost of actually catching any one fish isessentially zero It may not make sense from an economic standpoint tohave salmon fishing as a hobby, but as long as Shin is out in the boatfishing, he might as well catch as many fish as he can

Exercise 8 (Dropping or Retaining a Segment)

Liability insurance P15,000

Program administrator’s salary 37,000 52,000Decrease in net operating income for the

organization as a whole P(28,000)

Depreciation on the van is a sunk cost and the van has no salvage valuesince it would be donated to another organization The generaladministrative overhead is allocated and none of it would be avoided if theprogram were dropped; thus it is not relevant to the decision.

The same result can be obtained with the alternative analysis below:

Current Total

Total If House- keeping Is Dropped

Difference: Net Operating Income Increase or (Decrease)

Revenues P900,000 P660,000 P(240,000)Variable expenses 490,000 330,000 160,000Contribution margin 410,000 330,000 (80,000)Fixed expenses:

Depreciation* 68,000 68,000 0Liability insurance 42,000 27,000 15,000Program administrators’ salaries 115,000 78,000 37,000General administrative overhead 180,000 180,000 0Total fixed expenses 405,000 353,000 52,000Net operating income (loss) 5,000P P(23,000) P  (28,000)

*Includes pro-rated loss on disposal of the van if it is donated to a charity

Requirement 2

To give the administrator of the entire organization a clearer picture of thefinancial viability of each of the organization’s programs, the generaladministrative overhead should not be allocated It is a common cost that

the format for a segmented income statement, a better income statement would be:

Total Nursing Home Meals on Wheels keeping

House-Revenues P900,000 P260,000 P400,000 P240,000Variable expenses 490,000 120,000 210,000 160,000Contribution margin 410,000 140,000 190,000 80,000Traceable fixed expenses:

Depreciation 68,000 8,000 40,000 20,000Liability insurance 42,000 20,000 7,000 15,000Program administrators’

salaries 115,000 40,000 38,000 37,000Total traceable fixed expenses 225,000 68,000 85,000 72,000

Program segment margins 185,000 P  72,000 P105,000 P   8,000General administrative overhead 180,000

Net operating income (loss) P   5,000

Exercise 9 (Special Order)

Requirement 1

Monthly profits would be increased by P9,000:

Per Unit 2,000 Units Total for

Incremental revenue P12.00 P24,000Incremental costs:

Variable costs:

Direct materials 2.50 5,000Direct labor 3.00 6,000Variable manufacturing overhead 0.50 1,000Variable selling and administrative 1.50 3,000Total variable cost P 7.50 15,000Fixed costs:

None affected by the special order 0Total incremental cost 15,000Incremental net operating income P   9,000

Requirement 2

The relevant cost is P1.50 (the variable selling and administrative costs).All other variable costs are sunk, since the units have already beenproduced The fixed costs would not be relevant, since they would not beaffected by the sale of leftover units

Exercise 10 (Make or Buy a Component)

The costs that are relevant in a make-or-buy decision are those costs that can be avoided as

a result of purchasing from the outside The analysis for this exercise is:

Per Unit Differential Costs 20,000 Units

Cost of purchasing P23.50 P470,000Cost of making:

Direct materials P 4.80 P 96,000

Direct labor 7.00 140,000

Variable manufacturing overhead 3.20 64,000

Fixed manufacturing overhead 4.00 * 80,000 Total cost P19.00 P23.50 P380,000 P470,000

* The remaining P6 of fixed manufacturing overhead cost would not be relevant, since it will continue regardless of whether the company makes or buys the parts.The P150,000 rental value of the space being used

to produce part R-3 represents an opportunity cost of continuing to produce the part internally Thus, the completed analysis would be:

Total cost, as above P380,000 P470,000Rental value of the space (opportunity cost) 150,000 Total cost, including opportunity cost P530,000 P470,000Net advantage in favor of buying P60,000

Profits would increase by P60,000 if the outside supplier’s offer is

Requirement (2)

The price elasticity of demand is computed as follows:

Requirement (3)

The profit-maximizing price can be estimated using the following formulas:

This price is much lower than the prices Cecile has been charging in thepast Rather than immediately dropping the price to P9.60, it would beprudent to drop the price a bit and see what happens to unit sales and toprofits The formula assumes that the price elasticity is constant, which

d = In(1 + % change in quantity sold)In(1 + % change in price)

per unit

= (1 + 1.3333) x P4.10 = P9.60

may not be the case.

Exercise 12 (Target Costing)

Sales (50,000 batteries × P65 per battery) P3,250,000Less desired profit (20% × P2,500,000) 500,000Target cost for 50,000 batteries P2,750,000

= P55 per battery

Exercise 13 (Pricing a New Product)

The selling price of the new amaretto cappuccino product should at leastcover its variable cost and its opportunity cost The variable cost of thenew product is P4.60 and its opportunity cost can be computed bymultiplying the opportunity cost of P34 per minute of order filling time bythe amount of time required to fill an order for the new product:

Hence, the selling price of the new product should at least cover both itsvariable cost of P4.60 and its opportunity cost of P25.50, for a total of P30.10

III Problems

Selling price of

the new product

Variable cost of the new product

Opportunity costper unit of theconstrained resource

Amounts of the constrainedresource required by a unit

of the new product x

Problem 1 (Accept or Reject an Order)

Product A Product B

Less Variable costs/unit:

Requirement 2

If management wants a clear picture of the profitability of the segments,the general factory overhead should not be allocated It is a common costand therefore should be deducted from the total product-line segmentmargin A more useful income statement format would be as follows:

Trampoline Total Round Rectangular Octagonal

Sales P1,000,000 P140,000 P500,000 P360,000Less variable expenses 410,000 60,000 200,000 150,000Contribution margin 590,000 80,000 300,000 210,000Less fixed expenses:

Advertising – traceable 216,000 41,000 110,000 65,000Depreciation of special

equipment 95,000 20,000 40,000 35,000Line supervisors’

salaries 19,000 6,000 7,000 6,000Total traceable fixed

expenses 330,000 67,000 157,000 106,000Product-line segment

margin 260,000 P 13,000 P143,000 P104,000Less common fixed

Divided by no of hours required

Product ranking:

Based on the above analysis, first priority should be given to Product D.The company should use 4,000 out of the available 96,000 hrs to produce4,000 units of product D The remaining 92,000 hrs should be used to

produce 9,200 units of Product B Hence, the best product combination is4,000 units of Product D and 9,200 units of Product B.

Requirement 2

If there were no market limitations on any of the products, the companyshould use all the available 96,000 hours in producing 96,000 units ofproduct D only

The difference in profit between the two alternatives is computed asfollows:

Contribution margin of combination (1)

Less contribution margin of D only

Problem 4 (Accept or Reject a Special Order)

Requirement 1

The company should accept the special order of 4,000 @ P10 each becausethis selling price is still higher than the additional variable cost to beincurred Whether or not variable marketing expenses will be incurred, thedecision is still to accept the order

Supporting computations:

(a) Assume no additional variable marketing cost will be incurred

Less variable manufacturing costs:

Multiplied by number of units of order 4,000 units

(b) Assume additional variable marketing cost will be incurred

Less variable costs (P8.75 + P0.25) 9.00

Multiplied by number of units of order 4,000 units