PROBLEM

1. Sherrell Washington owns a successful hole-in-the-wall bagel shop called Big Apple Bagels. Sherrell
wants to expand the shop by leasing the space next door for $500 per month, and adding tables and chairs
so that customers can dine in. She figures that the tables and chairs will cost $4,000 and that the bagel
machine, that cost $3,500 five years ago, would have to be scrapped in favor of a larger machine costing
$6,400. She thinks sales would increase by $4,000 per month. Variable costs are 50% of sales.

A. What are the relevant costs and benefits of expanding into the new space?
B. What are the irrelevant costs and benefits of expanding into the new space?

2. Kara Ring owns a successful flower shower called Always Blooming. Kara wants to expand the shop by
leasing the space next door for $1,200 per month, and adding refrigerators to keep the flowers fresh and
two checkout counters so the customers do not have to wait in long lines. She currently pays $1,000 per
month for her current store space and has two refrigerators that cost her $6,000 each two years ago. She
figures that the new refrigerators and counters will cost $25,000. She also has determined that the
current cash register that initially cost her $1,000 two years ago and has been depreciated $250 each year
would have to be replaced with two new cash registers costing $1,500 each. She thinks sales would
increase by $10,000 per month. Variable costs are 40% of sales.

Required:
A. What are the relevant costs and benefits of expanding into the new space?
B. What are the irrelevant costs and benefits of expanding into the new space?

3. Veblen Company manufactures a variety of athletic shoes: basketball, running, and tennis. Sales of the
tennis shoes have fallen off. Veblen is considering several options: 1) drop the tennis shoe line; 2) replace
the tennis shoe line with golf shoes; 3) retool the tennis shoe line to make "Airtennies." Price and cost
data are as follows:

Basketball Running Tennis Golf Airtennies

Price $90 $65 $40 $60 $70
Variable cost/unit $45 $40 $35 $43 $50
Fixed costs $200,000 $210,000 $50,000 $50,000 $90,000
Number of units 10,000 15,000 2,500 25,000 6,000

If the tennis shoe line is dropped, the $50,000 fixed cost is totally avoidable.

A. Calculate the impact on operating income, using relevant amounts only, for keeping
the tennis shoe line.
B. Calculate the impact on operating income, using relevant amounts only, for option 1.
C. Calculate the impact on operating income, using relevant amounts only, for option 2.
D. Calculate the impact on operating income, using relevant amounts only, for option 3.
E. Which option is best?

4. Tyler Company has been approached by a new customer with an offer to purchase 6,000 units of its
product KR200 at a price of $11 each. The existing sales would not be affected by this special order.
Tyler normally produces 40,000 units but plans to produce and sell 30,000 in the coming year. The
normal sales price is $18 per unit. Unit cost information is as follows:

Direct materials $4.00

 Direct labor $2.75
Variable overhead $1.50
Fixed overhead $3.25
Total $11.50

If Tyler accepts the order, no fixed manufacturing activities will be affected because there is sufficient
excess capacity.

Required:
A. By how much will profit increase or decrease if the order is accepted?
B. Should Tyler accept the special order?

5. Junior Company currently buys 30,000 units of a part used to manufacture its product at $40 per unit.
Recently the supplier informed Junior Company that a 20% increase will take effect next year. Junior has
some additional space and could produce the units for the following per-unit costs (based on 30,000
units):

Direct materials $16

Direct labor 12
Variable overhead 12
Fixed overhead 10
Total $50

If the units are purchased from the supplier, $200,000 of fixed costs will continue to be incurred. In
addition, the plant can be rented out for $20,000 per year if the parts are purchased externally.

Required: Should Junior Company buy the part externally or make it internally?

6. Tapeo Company has always made its electronic components that go into their GPS systems in-house.
Streeter Company has offered to supply these electronic components at a price of $38 each. Tapeo uses
18,000 units of these components each year. The cost per unit of this component is as follows:

Direct material $13.75

Direct labor $16.00
Variable overhead $7.00
Fixed overhead $8.25
Total $45.00

Assume that 45% of Tapeo Company's fixed overhead would be eliminated if the electronic component
was no longer produced in-house.

Required:
A. If Tapeo decided to purchase the electronic component from Streeter Company how much would its
operating income increase or decrease?

B. Should Tapeo continue to make the electronic component or buy it from Streeter Company?
7. Island Princess Pineapples purchases pineapples from area farmers and processes them into rings, juice,
and skins. The cost of the pineapples is a joint cost, as is the initial processing in which the fruits are
skinned, cored, and sliced into rings. At the split-off point, Island Princess sells the skins (for fertilizer).
Juice and rings are processed further (further processing costs occurs for cooking and canning). Data for
the three products follows:

Sales
Rings $2,000
Juice $1,500
Fertilizer $ 400
Further processing costs:
Rings 500
Juice 300
Joint costs $1,600

A. Prepare a segmented income statement for Island Princess, showing results for rings,
juice, fertilizer, and in total. Do not allocate joint costs individually.
B. Now suppose that Island Princess is considering the option of processing the skins
further into pet food which would sell for $1,000. Additional costs would be $450.
Should this be done?

8. Rippey Corporation manufactures a single product with the following unit costs for 5,000 units:

Direct materials $ 60
Direct labor 30
Factory overhead (40% variable) 90
Selling expenses (60% variable) 30
Administrative expenses (20% variable) 15
Total per unit $225

Recently, a company approached Rippey Corporation about buying 1,000 units for $225. Currently, the
models are sold to dealers for $412.50. Rippey's capacity is sufficient to produce the extra 1,000 units. No
additional selling expenses would be incurred on the special order.

Required:
A. What is the profit earned by Rippey Corporation on the original 5,000 units?
B. Should Rippey accept the special order if its goal is to maximize short-run profits?
How much will income be affected?
C. Determine the minimum price Rippey would want to receive in order to increase profits
by $7,500 on the special order.
D. When making a special-order decision, what qualitative aspects of the decision should
Rippey Corporation consider?

9. Salley Company makes pagers. Currently, Salley purchases 10,000 plastic housings per year from an
outside company for $1 each. One of Salley's engineers suggested that the company make its plastic
housings in-house. Estimated unit costs are as follows:

Direct materials $0.30

Direct labor 0.20
Variable overhead 0.15
Fixed overhead* 0.40
 * Fixed overhead is $2,400 per year in equipment costs specifically traceable to the plastic housing line
and $1,600 per year in general overhead costs to be allocated to this line

A. If Salley makes the housing in-house, net income will be $__________________

Higher or Lower?
B. What is the highest price per unit that Salley would pay an outside company for the
housings?
C. Now assume that all of the fixed overhead is allocated fixed overhead and will not be
affected by making the product in-house or purchasing it. If Salley makes the housing
in-house, net income will be $__________________ (Higher / Lower).

Figure 13-10.
Goutam Company prints a variety of publications and colored inserts for newspapers. Currently, Goutam
produces its own ink, including a special metallic color. India Inks has offered to supply Goutam with the
25,000 ounces of metallic ink that it needs each year for $1.24 per ounce. Goutam is interested because
this is a particularly difficult ink to make. The purchasing department must make special efforts to locate
suppliers, the metallic component requires special handling, and, since the metallic ink uses machinery
that is also used to make other colors of ink, the machinery must be cleaned very well before every batch
of metallic. The accounting department supplied the following unit costs:

Direct materials $0.40

Direct labor 0.15
Variable overhead 0.06
Fixed overhead* 0.50

*Fixed overhead is applied on the basis of a plantwide rate based on direct labor hours.

10. Refer to Figure 13-10.

A. Based on the cost figures, if Goutam purchases metallic ink from the outside supplier,
operating income will be $__________________ (Higher / Lower)?
B. What is the highest price per ounce that Goutam would pay an outside supplier for the
ink?

11. Refer to Figure 13-10. Upon hearing of the analysis of the cost of making the metallic ink in-house versus
buying it from an outside supplier, Jim Webb, the production supervisor said "That's nuts! This ink is a
real pain to make and $1.24 per ounce sounds like a bargain to me!" Based on Jim's feelings, Anna Ruiz
(a new CMA in the accounting office) did an ABC analysis of ink production. She came up with the same
direct materials, direct labor and variable overhead, as well as the following information on activities
required by metallic ink production.

Setups $ 60,000 600 setups per year

Purchasing $270,000 9,000 purchase orders per year

The metallic ink requires 300 purchase orders per year and 80 setups.

A. If Goutam purchases the ink from the outside supplier, operating income would be
$__________________ Higher Lower (circle one)
B. What is the highest price per ounce that Goutam would pay an outside company for the
ink?
12. Sherpa Company manufactures tents and sleeping bags. Tents are priced at $80, have variable cost of $55,
and direct fixed costs of $120,000. Sleeping bags are priced at $60, have variable cost of $35, and direct
fixed costs of $66,000. Common fixed costs equal $200,000. Last year, the division sold 5,000 tents and
10,000 sleeping bags.

A. What was the segment margin for tents last year?

B. What was the segment margin for sleeping bags last year?
C. What was Sherpa's operating income last year?
D. If Sherpa stopped making tents, what would operating income be?

13. Mickey Company manufactures three joint products: X, Y, and Z. The cost of the joint process is
$30,000. Information about the three products follows:

X Y Z
Anticipated production 5,600 lbs. 10,000 lbs. 2,500 lbs.
Selling price/lb. at split-off $2.00 $1.00 $3.00
Additional processing costs/lb. after split-off
(all variable) $1.50 $1.25 $.75
Selling price/lb. after further processing $2.50 $3.75 $6.25
Allocated joint costs $12,000 $10,500 $7,500

Required:
A. Determine whether each product should be sold at split-off or processed further.
B. Determine the firm's income if the firm processed all three products beyond split-off.

14. The operations of Grant Corporation are divided into the Fix Division and the Roach Division.
Projections for the next year are as follows:

Fix Roach
Division Division Total
Sales revenue $60,000 $40,000 $100,000
Variable expenses 20,000 15,000 35,000
Contribution margin $40,000 $25,000 $ 65,000
Direct fixed expenses 12,500 30,000 42,500
Segment margin $27,500 $ (5,000) $ 22,500
Allocated common costs 10,000 7,500 17,500
Total relevant benefit (loss) $17,500 $(12,500) $ 5,000

Required:
A. Determine operating income for Grant Corporation as a whole if the Roach Division is
dropped.
B. Should the Roach Division be eliminated?

15. Classy Carry manufactures two types of handbags, the Clutch and the Tote, with unit contribution
margins of $9 and $15, respectively. Regardless of the type, each handbag must go through a stitching
machine. The company owns 4 stitching machines and each provides 3,000 hours of machine time per
year. Each Clutch handbag requires 12 minutes of machine time and each Tote handbag requires 30
minutes of machine time. There are no other constraints.
 Required:
A. What is the contribution margin per hour of machine time for each type of handbag?

B. What is the optimal mix of handbags?

C. What is the total contribution margin earned for the optimal mix?

16. Gordon Company produces two types of gears, Gear Q and Gear S, with unit contribution margins of $2
and $5, respectively. Each gear must spend time on a special machine. The firm owns ten machines that
together provide 25,000 hours of machine time per year. Gear Q requires 0.10 hours of machine time;
Gear S requires 0.4 hours of machine time.

A. What is the contribution margin per hour of machine time for Gear Q? Gear S?
B. If Gordon faces only the production constraint (25,000 hours of machine time), how
many units of Gear Q should be produced? Gear S? What is the total contribution
margin from this product mix?
C. Now suppose that Gordon cannot sell more than 200,000 units of each type of gear.
How many units of Gear Q should be produced? Gear S? What is the total contribution
margin from this product mix?

17. David Company produces two types of gears, Gear A and Gear B, with unit contribution margins of $6
and $8, respectively. Each gear must spend time on a special machine. The firm owns five machines that
together provide 12,000 hours of machine time per year. Gear A requires 12 minutes of machine time;
Gear B requires 24 minutes of machine time.

A. What is the contribution margin per hour of machine time for Gear A? Gear B?
B. If David faces only the production constraint (12,000 hours of machine time), how
many units of Gear A should be produced? Gear B? What is the total contribution
margin from this product mix?
C. Now suppose that David cannot sell more than 45,000 units of each type of gear. How
many units of Gear A should be produced? Gear B? What is the total contribution
margin from this product mix?

18. Auden makes three types of vitamin supplements, all of which require the use of encapsulating machines
that have capacity of 10,000 hours. Information on the three types (per case) follows:

Basic Vita-Stress Antioxidant+

Selling price $100 $125 $160
Variable cost 50 70 90
Machine hours 0.4 0.50 0.8

A. What is the contribution margin per case for each type?

B. What is the contribution margin per hour of machine time for each type?
C. Based on your analysis in requirement B, if the company can sell all that it can make of
all of the products, how many of each type should be sold to maximize total
contribution margin?

19. The Exchange Company is in the process of developing a new product called LS500. The company
requires a 35% profit. The LS500 current design carries with it a total cost of $125.
 Required:

A. What is the sales price of the LS500 using markup costing?

B. Assume that the Exchange Company’s marketing department has determined that consumers are
willing to pay $140 for the LS500. What is the target cost for this product?

ESSAY

1. "The accounting decision making model is not useful in real life because it only looks at the numbers."
Critique this statement and give an example for which it does not hold true.

ANS:
The decision-making model described in Chapter 13 does indeed focus on quantitative factors. However,
before the decision is made, the decision maker must identify the relevant qualitative factors and use them
in making his/her decision. For example, a student may be considering graduate school and look at a
number of schools. The low cost school may be farther from home and have a lesser reputation than the
higher cost school. The student might rationally choose the higher cost, higher reputation school.

2. Why does a special order decision frequently ignore fixed overhead?

ANS:
Special-order decisions are, by definition, one time orders that will yield less than the usual price or
margin. The firm will usually only consider these if it is operating below capacity. As a result, the fixed
overhead will exist whether or not the order is accepted. The fixed overhead is a sunk cost and can be
ignored for purposes of deciding on the special order.

You decide

3. The managers of Computer World are trying to determine the best method of deciding the price of their
new ultra minicomputer. This computer will present the customers with several unique features that their
other computers do not offer. They have asked you to explain the advantages and disadvantages of the
two costing methods they are considering; markup costing and target costing.

ANS:
Markup costing is a percentage applied to the base cost. This includes desired profit and any costs not
included in the base cost. A major advantage of markup pricing is that standard markups are easy to
apply versus adjusting prices as needed if demand is less than anticipated. The effectiveness of costing
plus pricing relies heavily on the accuracy of the cost system and pricing managers’ understanding of the
firm’s cost structure. If they do not have an accurate cost system than they could be setting prices either
too high-which would be undercut by competitors with more appropriate lower prices- or too low- and
would not cover all costs, therefore resulting in a net loss.

Target costing is a method of determining the cost of a product or service based on the price (target price)
that customers are willing to pay. Target costing involves much more up front work than cost-based
pricing. Target costing can be used most effectively in the design and development stage of the product
life cycle because the features of the product as well as its costs are still fairly easy to adjust. Some may
argue that this is the better of the two choices.