Review Handout for Exam 3

CValix

1. Palisades Corporations Midwest Division manufactures subassemblies that are used in the
corporations final product. Lynn Hardt of the Profit Planning Department has been assigned the
task of determining whether a component, J-65, should continue to be manufactured by Midwest
or purchased from Marley Company, an outside supplier. J-65 is part of a subassembly
manufactured by Midwest.
Marley has submitted a bid to manufacture and supply 32,000 units of J-65 that Palisades will
need for 2010 at a unit price of P8.65. While the contract price of P8.65 is only applicable in 2010,
Marley is interested in entering into a long-term agreement beyond 2010.
Hardt has gathered the following information regarding Midwests cost to manufacture J-65 last
year, 2009. These annual costs are incurred to manufacture 30,000 units.
Direct Material
Direct Labor
Factory Space Rental
Equipment Leasing Cost
Other manufacturing overhead
Total Manufacturing Cost

P 97,500
60,000
42,000
18,000
112,500
P 330,000

Hardt has also collected additional information related to manufacturing J-65:

Direct materials used are expected to increase by 8% in 2010.

Direct labor contracts call for a 5% increase in 2010.
The facilities used to manufacture J-65 are rented under a month-to-month rental
agreement. Thus, Midwest can withdraw from the rental agreement without any penalty.
Midwest will have no need for this space if J-65 is not manufactured.
Equipment leasing costs represent special equipment that is used in making J-65. This
lease can be terminated by paying the equivalent of one months lease payment for each
year left on the lease agreement. The lease will terminate in 2012.
40% of the other manufacturing overhead is considered variable. This rate is not expected
to change in 2010. The fixed portion of the manufacturing overhead are not expected to
change regardless of whether J-65 is produced or outsourced.

John Porter, divisional manager of Midwest, stopped by Hardts office to voice his concern
regarding outsourcing J-65. Porter commented, Im really concerned about outsourcing J-65. I
have a son-in-law and a nephew, not to mention a member of our bowling team, who work on J65. They could lose their jobs if we purchase from Marley. I really would appreciate anything you
can do to make sure the cost analysis comes out right to show we should continue making J-65.
Corporate is not aware of the material increases and maybe you could leave out some of those
fixed costs. I just think we should continue making J-65!
Required:
a. Prepare an analysis of relevant costs that shows whether or not Midwest continue making J-65
or buying it from Marley for 2010.
b. Based solely on financial results, what do you recommend?

c. Briefly discuss three qualitative factors that Midwest should consider if it decides to purchase
from Marley.
2. Excalibur, Inc. received an order for a piece of special machinery from Rex Co. Just as Excalibur
completed the machine, Rex Co. declared bankruptcy, defaulted on the order and forfeited the
10% deposit paid on the selling price of P217,500. The manufacturing manager identified the costs
already incurred in the production of the special machinery for Rex Co. as follows:
Direct Material
Direct Labor
Manufacturing Overhead
Variable
Fixed
Fixed selling and admin.
TOTAL

P 49,800
64,200
P 32,100
16,050

48,150
16,215
P 178,365

Another company, Kay Corp., will buy the special machinery if it is reworked to Kays
specifications. Excalibur offered to sell the reworked machinery to Kay as a special order for
P205,200. Kay agreed to pay the price when it takes delivery in 2 months. Additional rework costs
to Kays specifications are as follows: Direct Materials P18,600; Direct Labor P12,600.
A second alternative available to Excalibur is to convert the special machinery to the standard
model, which sells for P187,500. Additional costs for this conversion are as follows: Direct
Materials P8,550; Direct Labor P9,900.
A third alternative for Excalibur is to sell the machine as is for a price of P156,000. The potential
buyer has offered a P21,000 down payment, with the remainder upon delivery.
The following additional information is available regarding Excaliburs operations:
The allocation rates for manufacturing overhead and fixed selling and admin costs are:
Variable MOH 50% of Direct Labor Cost
Fixed MOH 25% of Direct Labor Cost
Fixed Selling and Admin 10% of Total Manufacturing Cost
Sales commission rate on gross sales of standard models is 2%, while for special orders is
3%.
Normal credit terms for standard model sales is 2/10, n/30. Majority of the customers who
purchase the standard model pay within the discount period. For special orders, it is
negotiated with the customer.
It was determined that for the 3 alternatives, there will be no increase in fixed costs.
Required:
a. Compute the contribution margin for each of the alternatives. Based on your computations,
which alternative should Excalibur consider to maximize profit?
b. If Kay makes a counter-offer, what is the lowest price that Excalibur should accept?

3. Microtech Inc. is a high technology company that produces sophisticated testing instruments for
evaluating microcircuits. These instruments sell for P3,500 each and the variable cost to
manufacture the instrument is P2,450. An essential component of the companys manufacturing
process is a sealed vacuum chamber where the interior approaches a pure vacuum. The technology
of the vacuum pumps that the firm uses to prepare its chamber for sealing has been changing
rapidly. On January 2, 2007, Microtech bought the latest in electronic high-speed vacuum pumps,
a machine that allowed the company to evacuate a chamber for sealing in only 6 hours. The
company paid P1,000,000 for the pump. It had a useful life of 3 years and a P50,000 salvage
value. Recently, the manufacturer of the pump approached Microtech with a new pump that would
reduce the evacuation time to 2 hours. The management is considering the acquisition of this new
pump and has asked the controller to evaluate the financial impact of replacing the existing pump
with the new model. The controller has gathered the following information prior to preparing the
analysis:

The new pump would be purchased and installed on December 31, 2009, and placed in
service on January 1, 2010. The cost of the new pump is P1,250,000 and installation and
testing cost prior to use of the new pump costs P12,000. The useful life of the pump is
estimated to be 4 years with a salvage value of P80,000 at the end of its useful life. The
new pump will be depreciated using the sum-of-years digit method.

If the new pump is purchased, the old pump can be sold for P40,000.

At the current rate of production, the new pumps greater efficiency will result in annual
cash savings of P125,000.

Microtech is able to sell all of the testing instruments it can produce. Because of the
increased speed of the new pump, output is expected to be 300 units greater in 2010 than in
2009, 500 units greater in 2011 and 2012 compared to 2009, and 700 units greater in 2013
than in 2009. For all additional units produced, variable manufacturing cost would be
reduced by P150 per instrument.

Microtech is subject to a 40% tax rate and for evaluating capital investment proposals, it
uses a weighted average cost of capital of 28%.

Required: Compute for the following:

a. Net investment
d. Payback period
b. Accounting Rate of Return based on
e. Net Present Value
Original Investment
f. Based on NPV, should Microtech
c. Net Cash inflows after tax for 2010 to 2013. purchase the new pump?