CHAPTER 11
Answer to Questions
1. Quantitative factors are those which may more easily be reduced in terms of pesos such as projected
costs of materials, labor and overhead. Qualitative factors are those whose measurement in pesos
is difficult and imprecise; yet a qualitative factor may be easily given more weight than the
measurable cost savings. It can be seen that the accountant’s role in making decisions deals with
the quantitative factors.
2. Relevant costs are expected future costs that will differ between alternatives. In view of the
definition of relevant costs, historical costs are always irrelevant because they are not future costs.
They may be helpful in predicting relevant costs but they are always irrelevant costs per se.
3. The differential costs in any given situation is commonly defined as the change in total cost under
each alternative. It is not relevant cost, but it is the algebraic difference between the relevant costs
for the alternatives under consideration.
4. Analysis:
Future costs: Replace Rebuild
New Truck P10,200
Less: Proceeds from
disposal, net 1,000
P 9,200 P8,500
Advantage of rebuilding P700
The original cost of the old truck is irrelevant but its disposal value is relevant. It is recommended
that the truck should be rebuilt because it will involve lesser cash outlay.
5. No. Variable costs are relevant costs only if they differ in total between the alternatives under
consideration.
6. Only those costs that would be avoided as a result of dropping the product line are relevant in the
decision. Costs that will not differ regardless of whether the product line is retained or discontinued
are irrelevant.
7. Not necessarily. An apparent loss may be the result of allocated common costs or of sunk costs that
cannot be avoided if the product line is dropped. A product line should be discontinued only if the
contribution margin that will be lost as a result of dropping the line is less than the fixed costs that
would be avoided. Even in that situation the product line may be retained if its presence promotes
the sale of other products.
8. Allocations of common fixed costs can make a product line (or other segment) appear to be
unprofitable, whereas in fact it may be profitable.
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 inelastic demand 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. Fixed costs do not enter into the pricing decision at all. Fixed costs are
11-1
relevant in a decision of whether to offer a product or service, but are not relevant in deciding what
to charge for the product or service. Because price affects unit sales, total variable costs are affected
by the pricing decision and therefore are relevant.
12. The markup over variable cost depends on the price elasticity of demand. A product whose demand
is elastic should have a lower markup over cost than a product whose demand is inelastic. If demand
for a product is inelastic, the price can be increased without cutting as drastically into unit sales.
Answer to Exercises
Case 1 Case 2
Item Relevant Not Relevant Relevant Not Relevant
a. Sales revenue X X
b. Direct materials X X
c. Direct labor X X
d. Variable manufacturing overhead X X
e. Book value – Model E7000 machine X X
f. Disposal value – Model E7000 machine X X
g. Depreciation – Model E7000 machine X X
h. Market value – Model F5000 machine (cost) X X
i. Fixed manufacturing overhead X X
j. Variable selling expense X X
k. Fixed selling expense X X
l. General administrative overhead X X
Requirement 1
Fixed cost per mile (P3,500* ÷ 10,000 miles) .......................................... P0.35
Variable operating cost per mile............................................................... 0.08
Average cost per mile .............................................................................. P0.43
Requirement 2
The variable operating costs would be relevant in this situation. The depreciation 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 Ingrid decides 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 would increase as a result of the trip, so they are irrelevant as well. The garage
rent is relevant only if she could avoid paying part of it if she drives her own car.
11-2
Requirement 3
When figuring the incremental cost of the more expensive car, the relevant costs would be the purchase
price of the new car (net of the resale value of the old car) and the increases in the fixed costs of
insurance and automobile tax and license. The original purchase price of the old car is a sunk cost and
is therefore irrelevant. The variable operating costs would be the same and therefore are irrelevant.
(Students are inclined to think that variable costs are always relevant and fixed costs are always
irrelevant in decisions. This requirement helps to dispel that notion.)
Requirement 1
Per Unit
Differential Costs 15,000 units
Make Buy Make Buy
Cost of purchasing ............................................ P200 P3,000,000
Direct materials ................................................. P 60 P 900,000
Direct labor ........................................................ 80 1,200,000
Variable manufacturing overhead...................... 10 150,000
Fixed manufacturing overhead, traceable1........ 20 300,000
Fixed manufacturing overhead, common .......... 0 0 0 0
Total costs ......................................................... P170 P200 P2,550,000 P3,000,000
1 Only the supervisory salaries can be avoided if the parts are purchased. The remaining book
value of the special equipment is a sunk cost; hence, the P3 per unit depreciation expense is
not relevant to this decision. Based on these data, the company should reject the offer and
should continue to produce the parts internally.
Requirement 2
Make Buy
Cost of purchasing (part 1) ...................................................... P3,000,000
Cost of making (part 1) ............................................................ P2,550,000
Opportunity cost—segment margin forgone on a potential
new product line ................................................................. 650,000
Total cost ................................................................................. P3,200,000 P3,000,000
Difference in favor of purchasing from the outside supplier ..... P200,000
Thus, the company should accept the offer and purchase the parts from the outside supplier.
11-3
Exercise 4 (Evaluating Special Order)
Only the incremental costs and benefits are relevant. In particular, only the variable manufacturing
overhead and the cost of the special tool are relevant overhead costs in this situation. The other
manufacturing overhead costs are fixed and are not affected by the decision.
Per Total
Unit 10 bracelets
Incremental revenue .............................................. P3,499.50 P34,995.00
Incremental costs:
Variable costs:
Direct materials ............................................ 1,430.00 14,300.00
Direct labor ................................................... 860.00 8,600.00
Variable manufacturing overhead ................ 70.00 700.00
Special filigree .............................................. 60.00 600.00
Total variable cost ............................................. P2,420.00 24,200.00
Fixed costs:
Purchase of special tool ............................... 4,650.00
Total incremental cost ............................................ 28.850.00
Incremental net operating income ......................... P 6.145.00
Even though the price for the special order is below the company’s regular price for such an item, the
special order would add to the company’s net operating income and should be accepted. This
conclusion would not necessarily follow if the special order affected the regular selling price of
bracelets or if it required the use 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 2.0
Contribution margin per direct labor-hour (1) ÷ (4) .............. P12 P 9 P10
Requirement 2
The company should concentrate its labor time on producing product X:
X Y Z
Contribution margin per direct labor-hour ........... P12 P9 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.
11-4
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, the company should be willing to pay up to P17 per hour to
manufacture more product Y.
Requirement 1
The relevant costs of a fishing trip would be:
* 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. The amount by which the cost of the junk
food exceeds the cost of the food he would otherwise consume would be the relevant
amount.
The other costs are sunk at the point at which the decision is made to go on another fishing trip.
Requirement 2
If he fishes for the same amount of time as he did on his last trip, all of his costs 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. The costs are really incurred in order to be able to catch fish and would be the same whether one,
11-5
two, three, or a dozen fish were actually caught. Fishing, not catching fish, costs money. All of the costs
are basically fixed with 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 costs listed by Shin’s wife are
relevant. If he did not fish, he would not need to pay 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. The original 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 costs are 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 nearly all 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 a salmon is P167, even though the cost of actually catching any
one fish is essentially zero. It may not make sense from an economic standpoint to have salmon fishing
as a hobby, but as long as Shin is out in the boat fishing, he might as well catch as many fish as he can.
Requirement 1
No, the housekeeping program should not be discontinued. It is actually generating a positive program
segment margin and is, of course, providing a valuable service to seniors. Computations to support this
conclusion follow:
Depreciation on the van is a sunk cost and the van has no salvage value since it would be donated to
another organization. The general administrative overhead is allocated and none of it would be avoided
if the program were dropped; thus it is not relevant to the decision.
The same result can be obtained with the alternative analysis below:
Total If House- Difference: Net
keeping Is Operating Income
Current Total Dropped Increase or (Decrease)
Revenues .................................................................................. P900,000 P660,000 P(240,000)
Variable expenses ..................................................................... 490,000 330,000 160,000
Contribution margin ................................................................... 410,000 330,000 (80,000)
Fixed expenses:
Depreciation*........................................................................ 68,000 68,000 0
Liability insurance ................................................................. 42,000 27,000 15,000
Program administrators’ salaries .......................................... 115,000 78,000 37,000
General administrative overhead ......................................... 180,000 180,000 0
Total fixed expenses.................................................................. 405,000 353,000 52,000
Net operating income (loss) ...................................................... P 5,000 P(23,000) P (28,000)
11-6
Requirement 2
To give the administrator of the entire organization a clearer picture of the financial viability of each of
the organization’s programs, the general administrative overhead should not be allocated. It is a
common cost that should be deducted from the total program segment margin. Following the format
for a segmented income statement, a better income statement would be:
Meals on
Total Home Nursing Wheels House-keeping
Revenues ............................................................. P900,000 P260,000 P400,000 P240,000
Variable expenses ................................................ 490,000 120,000 210,000 160,000
Contribution margin .............................................. 410,000 140,000 190,000 80,000
Traceable fixed expenses:
Depreciation ..................................................... 68,000 8,000 40,000 20,000
Liability insurance ............................................ 42,000 20,000 7,000 15,000
Program administrators’ salaries ..................... 115,000 40,000 38,000 37,000
Total traceable fixed expenses ............................. 225,000 68,000 85,000 72,000
Program segment margins ................................... 185,000 P 72,000 P105,000 P 8,000
General administrative overhead .......................... 180,000
Net operating income (loss) .................................. P 5,000
Requirement 1
Monthly profits would be increased by P9,000:
Total for 2,000
Per Unit Units
Incremental revenue .............................................................................................................. P12.00 P24,000
Incremental costs:
Variable costs:
Direct materials ........................................................................................................... 2.50 5,000
Direct labor .................................................................................................................. 3.00 6,000
Variable manufacturing overhead ............................................................................... 0.50 1,000
Variable selling and administrative ............................................................................. 1.50 3,000
Total variable cost ............................................................................................................ P 7.50 15,000
Fixed costs:
None affected by the special order ............................................................................. 0
Total incremental cost ............................................................................................................ 15,000
Incremental 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 been produced. The fixed costs would not be relevant, since they
would not be affected by the sale of leftover units.
11-7
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
Make Buy Make Buy
Cost of purchasing ................................................................ P23.50 P470,000
Cost of making:
Direct materials ................................................................ P 4.80 P96,000
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:
Make Buy
Total cost, as above ...................................................................................................... P380,000 P470,000
Rental value of the space (opportunity cost) ................................................................ 150,000
Total cost, including opportunity cost ............................................................................ P530,000 P470,000
Net advantage in favor of buying ................................................ P60,000
Requirement (1)
Cecile makes more money selling the ice cream cones at the lower price, as shown below:
11-8
Requirement (2)
d =
In(1 + % change in quantity sold)
In(1 + % change in price)
1,340 – 860
In(1 + 860 )
=
13.90 – 17.90
In(1 + 17.90 )
In(1 + 0.55814)
=
In(1 – 0.22346)
In(1.55814)
=
In(0.77654)
0.44349
= = –1.75
–0.25291
Requirement (3)
Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 1.333
1 + (–1.75)
Profit-maximizing Profit-maximizing Variable cost
= 1 + x
price markup on variable cost per unit
11-9
The selling price of the new amaretto cappuccino product should at least cover its variable cost and its
opportunity cost. The variable cost of the new product is P4.60 and its opportunity cost can be computed
by multiplying the opportunity cost of P34 per minute of order filling time by the amount of time
required to fill an order for the new product:
Selling price of
P4.60 + P34 per minute + 0.75 minute
the new product
Selling price of
P4.60 + P25.50 = P30.10
the new product
Hence, the selling price of the new product should at least cover both its variable cost of P4.60 and its
opportunity cost of P25.50, for a total of P30.10.
Answer to Problems
Product A Product B
Selling price per unit P1.20 P1.40
Less Variable costs/unit:
Materials 0.50 0.70
Labor 0.20 0.24
Factory overhead (25%) 0.10 0.14
0.80 1.08
Contribution margin/unit P0.40 P0.32
Multiplied by number of units to be sold 21,000 units 30,000 units
Total contribution margin P8,400 P9,600
Product B should be accepted because its total contribution margin is higher than that of Product A.
11-10
Requirement 1
No, production and sale of the round trampolines should not be discontinued. Computations to support
this answer follow:
The depreciation of the special equipment represents a sunk cost, and therefore it is not relevant to the
decision. The general factory overhead is allocated and will presumably continue regardless of whether
or not the round trampolines are discontinued; thus, it is not relevant.
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 cost and therefore should be deducted from the total product-
line segment margin. A more useful income statement format would be as follows:
Trampoline
Total Round Rectangular Octagonal
Sales ......................................... P1,000,000 P140,000 P500,000 P360,000
Less variable expenses ............. 410,000 60,000 200,000 150,000
Contribution margin ................... 590,000 80,000 300,000 210,000
Less fixed expenses:
Advertising – traceable .......... 216,000 41,000 110,000 65,000
Depreciation of special equipment 95,000 20,000 40,000 35,000
Line supervisors’ salaries ...... 19,000 6,000 7,000 6,000
Total traceable fixed expenses . 330,000 67,000 157,000 106,000
Product-line segment margin .... 260,000 P 13,000 P143,000 P104,000
Less common fixed expenses ... 200,000
Net operating income (loss) ...... P 60,000
Requirement 1
Product Line
A B C D
Selling price per unit P30 P25 P10 P8
Variable cost per unit 25 10 5 4
Contribution margin / unit P5 P15 P 5 P4
Divided by no. of hours required for each unit 5 hrs. 10 hrs. 4 hrs. 1 hr.
Contribution per hour P1 P1.5 P1.25 P4
Product ranking:
1. D 2. B 3. C 4. A
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 produce 4,000 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 is 4,000 units
of Product D and 9,200 units of Product B.
Requirement 2
11-11
If there were no market limitations on any of the products, the company should use all the available
96,000 hours in producing 96,000 units of product D only.
Requirement 1
The company should accept the special order of 4,000 @ P10 each because this selling price is still
higher than the additional variable cost to be incurred. Whether or not variable marketing expenses
will be incurred, the decision is still to accept the order.
Supporting computations:
(a) Assume no additional variable marketing cost will be incurred.
Selling price per unit P10.00
Less variable manufacturing costs:
Direct materials P5.00
Direct labor 3.00
Variable overhead 0.75 8.75
Contribution margin/unit P 1.25
Multiplied by number of units of order 4,000 units
Total increase in profit P5,000
(b) Assume additional variable marketing cost will be incurred.
Selling price per unit P10.00
Less variable costs (P8.75 + P0.25) 9.00
Contribution margin / unit P 1.00
Multiplied by number of units of order 4,000 units
Total increase in contribution margin P4,000
Requirement 2
P8.75, the total variable manufacturing cost.
Requirement 3
Requirement 4
11-12
Present contribution margin [10,000 units x (P15 - P9)] P60,000
Less proposed contribution margin [(P14 - P9) x 11,000 units] 55,000
Decrease in contribution margin P 5,000
The company should not reduce the selling price from P15 to P14 even if volume will go up because
total contribution margin will decrease.
Requirement (a)
Requirement (b)
Production
4,000 units 5,000 units 6,000 units
Sales (4,000 x P40) P160,000 P160,000 P160,000
Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 - - -
Total P100,000 P125,000 P150,000
Contribution margin P 60,000 P 35,000 P 10,000
Sales (5,000 x P40) P200,000 P200,000 P200,000
Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 45,000 - -
Total P145,000 P125,000 P150,000
Contribution margin P 55,000 P 75,000 P 50,000
Sales (6,000 x P40) P240,000 P240,000 P240,000
Less variable costs
Production cost @ P25 100,000 125,000 150,000
Purchase cost @ P45 90,000 45,000 0
Total P190,000 P170,000 P150,000
Contribution margin P 50,000 P 70,000 P 90,000
Requirement (c)
11-13
Problem 6 (Pricing)
Requirement A:
Operating Result
2013 2014 at Full Capacity
Sales P 100,000 P 400,000 P 480,000
Less Variable cost 130,000 520,000 624,000
Contribution margin (P 30,000) (P120,000) (P144,000)
Less Fixed cost 40,000 40,000 40,000
Net income (loss) (P 70,000) (P160,000) (P184,000)
The company had been operating at a loss because the product had been selling with a negative
contribution margin. Hence, the more units are sold, the higher the loss will be.
Requirement B: P60.14
Requirement C: P74.29
Requirement D: P56.58
11-14
*Salaries avoided by closing the store:
Sales salaries ..................................................................................................................... P45,000
Delivery salaries ................................................................................................................. 7,000
Store management salaries ............................................................................................... 15,000
General office salaries........................................................................................................ 8,000
Total salaries ...................................................................................................................... 75,000
Employment tax rate .......................................................................................................... × 12%
Employment taxes avoided ................................................................................................ P 9,000
Requirement 2
The Ortigas Store should not be closed. If the store is closed, overall company net operating income
will decrease by P9,800 per quarter.
Requirement 3
The Ortigas Store should be closed if P200,000 of its sales are picked up by the Makati Store. The net
effect of the closure will be an increase in overall company net operating income by P76,200 per
quarter:
Gross margin lost if the Ortigas Store is closed....................................................................................... P(228,000)
Gross margin gained at the Makati Store:
P200,000 × 43% ................................................................................................................................. 86,000
Net loss in gross margin .......................................................................................................................... (142,000)
Costs that can be avoided if the Ortigas Store is closed (part 1)............................................................. 218,200
Net advantage of closing the Ortigas Store ............................................................................................. P 76,200
Requirement 1
Product KK-8 yields a contribution margin of P14 per gallon (P35 – P21 = P14). If the plant closes,
this contribution margin will be lost on the 22,000 gallons (11,000 gallons per month × 2 = 22,000
gallons) that could have been sold during the two-month period. However, the company will be able to
avoid certain fixed costs as a result of closing down. The analysis is:
Contribution margin lost by closing the plant for two months (P14 per gallon × 22,000 gallons) P(308,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost (P60,000 × 2 months = P120,000) ................. P120,000
Fixed selling costs (P310,000 × 10% × 2 months) .................................................. 62,000 182,000
Net disadvantage of closing, before start-up costs ...................................................... (126,000)
Add start-up costs ........................................................................................................ (14,000)
Disadvantage of closing the plant ................................................................................ P(140,000)
No, the company should not close the plant; it should continue to operate at the reduced level of 11,000
gallons produced and sold each month. Closing will result in a P140,000 greater loss over the two-
month period than if the company continues to operate. Additional factors are the potential loss of
goodwill among the customers who need the 11,000 gallons of KK-8 each month and the adverse effect
on employee morale. By closing down, the needs of customers will not be met (no inventories are on
hand), and their business may be permanently lost to another supplier.
11-15
Alternative Solution:
Difference—Net
Operating Income
Plant Kept Open Plant Closed Increase (Decrease)
Sales (11,000 gallons × P35 per gallon × 2) ........................................ P 770,000 P 0 P(770,000)
Less variable expenses (11,000 gallons × P21 per gallon × 2) ........... 462,000 0 462,000
Contribution margin ............................................................................. 308,000 0 (308,000)
Less fixed costs:
Fixed manufacturing overhead cost (P230,000 × P170,000 × 2).. 460,000 340,000 120,000
Fixed selling cost (P310,000 × 2; P310,000 × 90% × 2) ................ 620,000 558,000 62,000
Total fixed cost ..................................................................................... 1,080,000 898,000 182,000
Net operating loss before start-up costs .............................................. (772,000) (898,000) (126,000)
Start-up costs ....................................................................................... (14,000) (14,000)
Net operating loss ................................................................................ P (772,000) P(912,000) P(140,000)
Requirement 2
Ignoring the additional factors cited in part (1) above, Kristin Company should be indifferent between
closing down or continuing to operate if the level of sales drops to 12,000 gallons (6,000 gallons per
month) over the two-month period. The computations are:
Cost avoided by closing the plant for two months (see above) ............................................ P182,000
Less start-up costs ............................................................................................................... 14,000
Net avoidable costs .............................................................................................................. P168,000
11-16
Problem 10 (The Economists’ Approach to Pricing)
Requirement (1)
The postal service makes more money selling the souvenir sheets at the lower price, as shown below:
P500 Price P600 Price
Unit sales ................................................................. 50,000 40,000
Requirement (2)
d =
In(1 + % change in quantity sold)
In(1 + % change in price)
40,000 – 50,000
In(1 + )
50,000
= 600.00 – 500.00
In(1 + )
500.00
In(1 – 0.2000)
=
In(1 + 0.2000)
In(0.8000)
=
In(1.2000)
= –0.2231
0.1823
= –1.2239
Requirement (3)
Profit-maximizing –1
=
markup on variable cost 1 + d
–1
= = 4.4663
1 + (–1.2239)
Profit-maximizing Profit-maximizing Variable cost
= 1 + x
price markup on variable cost per unit
11-17
The critical assumption in the calculation of the profit-maximizing price is that the percentage increase
(decrease) in quantity sold is always the same for a given percentage decrease (increase) in price. If this
is true, we can estimate the demand schedule for souvenir sheets as follows:
Price* Quantity Sold§
P600 40,000
P500 50,000
P417 62,500
P348 78,125
P290 97,656
P242 122,070
P202 152,588
P168 190,735
P140 238,419
P117 298,024
*
The price in each cell in the table is computed by taking 5/6 of the price just above it in the table. For
example, P500 is 5/6 of P600 and P417 is 5/6 of P500.
§
The quantity sold in each cell of the table is computed by multiplying the quantity sold just above it in
the table by 50,000/40,000. For example, 62,500 is computed by multiplying 50,000 by the fraction
50,000/40,000.
The profit at each price in the above demand schedule can be computed as follows:
11-18
The contribution margin is plotted below as a function of the selling price:
23,000,000
22,000,000
Contribution Margin
21,000,000
20,000,000
19,000,000
18,000,000
17,000,000
100.00 200.00 300.00 400.00 500.00 600.00
Selling Price
The plot confirms
that the profit-maximizing price is about P328.
Requirement (4)
If the postal service wants to maximize the contribution margin and profit from sales of souvenir sheets,
the new price should be:
Profit-maximizing price = 5.4663 × P70 = P383
Note that a P100 increase in cost has led to a P55 (P383 – P328) increase in the profit-maximizing
price. This is because the profit-maximizing price is computed by multiplying the variable cost by
5.4663. Since the variable cost has increased by P100, the profit-maximizing price has increased by
P100 × 5.4663, or P55.
Some people may object to such a large increase in price as “unfair” and some may even suggest that
only the P10 increase in cost should be passed on to the consumer. The enduring popularity of full-cost
pricing may be explained to some degree by the notion that prices should be “fair” rather than calculated
to maximize profits.
11-19
Problem 11 (Ranking Alternatives and Managing with a Constraint)
Requirement (1)
This problem can be solved by first computing the profitability index of each customer and then ranking
the customers based on that profitability index:
Ji Eun’s Time
Incremental Profit Required Profitability Index
Customer (A) (B) (A) ÷ (B)
Lalaine P1,400 4 P350
Emily 1,240 4 P310
Anna 1,600 5 P320
Catherine 960 3 P320
Gee Ann 1,900 5 P380
Lily 2,880 8 P360
Lourdes 930 3 P310
Ma. Cecilia 1,360 4 P340
Sheila Raya 2,340 6 P390
Jane 2,040 6 P340
Cumulative Amount
Ji Eun’s Time of Ji Eun’s Time
Customer Profitability Index Required Required
Sheila Raya ....... P390 6 6
Gee Ann ............ P380 5 11
Lily ..................... P360 8 19
Lalaine ............... P350 4 23
Jane ................... P340 6 29
Ma. Cecilia ......... P340 4 27
Anna .................. P320 5 38
Catherine ........... P320 3 41
Emily .................. P310 4 45
Lourdes.............. P310 3 48
Given that Ji Eun should not be asked to work more than 33 hours, the four customers below the line
in the above table should be told that their reservations have to be cancelled.
Requirement (2)
The total profit on wedding cakes for the weekend after canceling the four reservations would be:
11-20
Notes:
● Both Ji Eun’s time and the cakes would have to be very carefully scheduled to make sure that all
cakes are completed on time. We have assumed that the 33 hours of Ji Eun’s time that are available
for cake decorating do not include hours that have been set aside as a buffer to provide protection
from inevitable disruptions in the schedule.
● If the cumulative amount of Ji Eun’s time required did not exactly consume the total amount of
time available, some adjustment might be required in which reservations are cancelled to ensure
that the most profitable plan is selected.
Requirement (3)
To avoid disappointing customers, reservations should probably not be accepted for any particular
weekend after 33 hours of Ji Eun’s time have been committed for that weekend’s cakes. To ensure that
only the most profitable cake reservations are accepted, a reservation for any cake with a profitability
index of less than P340 should probably not be accepted. This was the cutoff point for the cakes in the
first weekend in June. This cutoff may need to be adjusted upward or downward over time—the cakes
that were reserved for the first weekend in June may not be representative of the cakes that would be
reserved for other weekends. If too many reservations are turned down and Ji Eun’s time is not fully
utilized, then the cutoff should be adjusted downward. If too few reservations are turned down and Ji
Eun’s time is once again overbooked or profitable cake orders are turned away, then the cutoff should
be adjusted upward.
Requirement (4)
Ms. Hye Young should consider changing the way prices are set so that they include a charge for Ji
Eun’s time. On average, the prices may be the same, but they should be based not only on the size of
the cakes, but also on the amount of cake decorating that the customer desires. The charge for Ji Eun’s
time should be her hourly rate of pay (including any fringe benefits) plus the opportunity cost of at least
P340 per hour. Because Ji Eun will not be working more than 33 hours per week, if another cake
reservation is accepted, some other cake reservation will have to be cancelled. Ms. Hye Young would
have to give up at least P34 profit per hour to accept another cake reservation.
Requirement (5)
Making Ji Eun happy involves not asking her to work more than 33 hours per week decorating cakes.
Making customers happy involves not canceling their reservations, not raising prices, and providing
top quality wedding cakes. Ms. Hye Young can accomplish both of these objectives and increase her
profits by clever management of the constraint—Ji Eun’s time. The possibilities include:
Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on unnecessary tasks. For
example, Ji Eun should not be asked to cream butter by hand for frostings if a machine could do
the job as well with less labor time.
Ms. Hye Young should make sure that none of Ji Eun’s time is wasted on tasks that can be done by
other persons. For example, an assistant can be assigned to prepare frosting and to clean up,
relieving Ji Eun of those tasks. As long as the cost of the assistant’s time is less than P34 per hour,
the result will be higher profits and more pleased customers.
Ms. Hye Young should consider assigning an apprentice to Ji Eun. The apprentice could relieve Ji
Eun of some of her workload while learning the skills to eventually expand the company’s cake
decorating capacity.
Ms. Hye Young might consider subcontracting some of the less demanding cake decorating to
another baker. This would be profitable as long as the charge is less than P340 per hour.
11-21
Answer to Multiple Choice Questions
1. C 11. D 21. D 31. A
2. C 12. A 22. A 32. D
3. B 13. D 23. D 33. C
4. B 14. A 24. E 34. A
5. A 15. D 25. B 35. C
6. B 16. C 26. D
7. C 17. A 27. D
8. B 18. C 28. C
9. A 19. B 29. A
10. B 20. C 30. A
20. R S T
Sales (10,000 x P20) P200,000 P200,000 P200,000
Less: Variable costs
R (P12 x 10,000) 120,000
S (P 8 x 10,000) 80,000
T (P 4 x 10,000) 40,000
Contribution margin P 80,000 P120,000 P160,000
11-22
21. R S T
Sales (P16 x 15,000) P240,000 P240,000 P240,000
Less: Variable costs
R (P12 x 15,000) 180,000
S (P 8 x 15,000) 120,000
T (P 4 x 15,000) 60,000
Contribution margin P 60,000 P120,000 P180,000
Less: Fixed costs 40,000 80,000 120,000
Operating income P 20,000 P 40,000 P 60,000
11-23
25. Direct materials (P2 x 5,000) P10,000
Direct labor (P8 x 5,000) 40,000
Variable overhead (P4 x 5,000) 20,000
Total variable costs P70,000
Add: Avoidable fixed overhead 10,000
Total P80,000
26. Avoidable fixed overhead P 4
Direct materials 4
Direct labor 16
Variable overhead 18
Total P42
Multiplied by: Number of units to be produced 20,000
Total relevant costs to make the part P840,000
11-24