CHAPTER

Cost Analysis for Decision Making

16

E16.1.
a. Differential cost: What costs will differ if a friend comes along?
b. Allocated cost: How to allocate? Based on number of people, weight, number of
suitcases, or what?
c. Sunk cost: What costs have already been incurred and cannot be recovered, even if you
don't make the trip? For example, the cost of the car is a sunk cost.
d. Opportunity cost: What are other opportunities for you to earn revenue? What is the
cost of alternative travel for your classmate?

E16.3.
Differential cost analysis:
Incremental selling price ($36 - $29)……… $7
Incremental costs of further processing…… (8)
($40,000 / 5,000 gallons)
Incremental Profit………………………….. $ (1)

No, the basic compound should be sold as is for $29. Further processing will result in a
decrease in profits of $5,000.

E16.5.
a. Raw materials per unit …………………………………………………… $3.00
Direct labor per unit ……………………………………………………… 3.00
Variable overhead per unit………………………………………………… 4.00
Fixed overhead per unit …………………………………………………… 4.00 a
Total cost per unit ………………………………………………………… $14.00
(a)
The fixed overhead per unit is based on the total fixed overhead for the year of
$240,000 divided by the current output of 60,000 units per year.

b. The above calculation includes an inappropriate unitization of fixed expenses. Unless

the additional production of 20,000 units results in a movement to a new relevant
range, total fixed expenses will not change.

c. The offer should be accepted because it would generate a contribution margin of $2 per
unit (revenue of $12 per unit less variable cost of $10 per unit).

© The McGraw-Hill Companies, Inc., 2009 16-1

Chapter 16 Cost Analysis for Decision Making

E16.7.
a. Eagle, Ltd., would consider the following costs as relevant to the decision to enter the
digital binocular market: design and engineering costs, new equipment, raw materials,
direct labor, variable overhead, any possible new fixed overhead costs such as a
production supervisor that may be dedicated to this product line. Note that no new
facility costs are required for this product line since current plant has enough square
footage to accommodate the new product line.

b. Target cost = Selling price – Desired profit

Target cost = ($98 * 15,000) – ($3,750,000 * .12)
Target cost = $1,470,000 – $450,000
Target cost = $1,020,000
Target cost per unit = 1,020,000 / 15,000 units
Target cost per unit = $68

E16.9.
Current Avoidable
Production Cost if
Costs Purchased Cost to Buy
Manufacturing costs:
Direct material…………………… $ 240 $ 240
Direct labor………………………. 120 120
Variable overhead ($120 x 25%). 30 30
Fixed overhead ($120 x 75%)….. 90 0
Total cost per unit ………………… $ 480 $ 390
Purchase costs:
Engine assembly part sets...……… $ 400
Advantage to make……………… $ 10

Kirkwood Engine, Inc. should continue to produce the engine part sets because the
costs it can avoid by buying the part sets are less than the outside purchase cost.

E16.11.
Product A Product B
Contribution margin per unit………………………….. $ 300 $ 400
Machine hours required per unit………………………. 6 8

Contribution margin per machine hour………………... $ 50 $ 50

Since both products generate the same amount of contribution margin per machine
hour, any production mix combination of Product A or Product B will yield $60,000,
the maximum amount of contribution margin available on 1,200 machine hours
($50 contribution margin per machine hour x 1,200 machine hours).

© The McGraw-Hill Companies, Inc., 2009 16-2

 Solutions to Odd-Numbered Problems

E16.13.
a. 0 1 2 3 4 5
$75,000
0.6209 (Table 6-4, 5 period row,
10% column)
$46,567.50

b. This is a future value problem, the opposite of present value. As shown in the diagram,
$46,567.50 invested today at 10% interest compounded annually would grow to
$75,000 in four years.

c. Less could be invested today because at a higher interest rate, more interest would be
earned. This can be seen by calculating the present value of $75,000 in five years at an
interest rate greater than 10%. As can be seen in Table 6-4, the present value factors
are smaller as interest rates get higher.

E16.15.
a. If the investment is too high, the net present value will be too low.
b. If the cost of capital is too low, the net present value will be too high.
c. If the cash flows from the project are too high, the net present value will be too high.
d. If the number of years over which the project will generate cash flows is too low, the
net present value will be too low.

E16.17.
a. 0 1 2 3 4 5 6
Investment………… $(95,000)
Annual cash flow……………………$21,000 per year
Salvage value……………………………………………… $14,000
4.1114 (Table 6-5 0.5066 (Table 6-4
$(95,000) 6 period row, 6 period row,
86,339 12% column) 12% column)
7,092
$ (1,569) net present value

b. Because the net present value is negative, the internal rate of return on this project will
be lower than the cost of capital of 12%.

E16.19.
a. The net present value is positive $3,330 (present value of inflows of $39,330 less the
investment of $36,000). Therefore, the return on investment is greater than 16%.

b. The payback period should not carry much weight at all, because it does not recognize
the time value of money.

© The McGraw-Hill Companies, Inc., 2009 16-3

Chapter 16 Cost Analysis for Decision Making

P16.21.
a. Relevant costs for the special sales order include the following:
Per Gallon
Raw materials ……………………………………… $3.60
Direct labor ………………………………………… 1.80
Variable overhead…………………………………… 1.20
Distribution ………………………………………… 1.00
Total relevant costs per gallon ……………………… $7.60

b. Per Gallon
Sales price …………………………………………… $9.00
Less: relevant costs ………………………………… 7.60
Contribution margin per gallon……………………… $ 1.40
Daily sales in gallons………………………………… 300
Daily increase in operating income ………………… $420.00

c. Since Loop Beverage is now operating at full capacity, relevant costs for the special
sales order would include any forgone contribution margin (opportunity cost) on
regular sales given up by Loop Beverage to fulfill the special sales order:
Per Gallon
Current sales ………………………………………… $12.00
Less variable costs: …………………………………
Raw materials ……………………………………… 3.60
Direct labor………………………………………… 1.80
Variable overhead ………………………………… 1.20
Distribution (on current sales)……………………… 0.80 7.40
Current contribution margin ………………………… $ 4.60

Per Gallon
Current contribution margin ………………………… $ 4.60
Contribution margin from special order …………… 1.40
Decrease in contribution margin …………………… $ 3.20
Daily sales in gallons………………………………… 300
Daily decrease in operating income ………………… $ 960.00

d. When Loop Beverage is operating under conditions of idle capacity, the only relevant
costs incurred in producing the gallons of root beer needed to fulfill the special order
are the incremental variable costs - Loop Beverage would not be giving up any of their
current sales. Conversely, when Loop Beverage is producing and selling root beer at
full capacity, there is no reason to accept an offer for any amount less than the current
selling price unless, perhaps, more cost can be avoided than the drop in selling price.

© The McGraw-Hill Companies, Inc., 2009 16-4

 Solutions to Odd-Numbered Problems

P16.23.
a. Sales……………………………………………………... $ 120,000
Variable operating expenses:
Cost of sales (food, beverages, and snack items @ 40%) 48,000
Food service items (spoons, napkins, etc.).…………….. 1,800
Wages for part time employees..……………………….. 24,000 73,800
Contribution Margin.…………………………………….. $ 46,200
Fixed operating expenses:
Utilities….……………………………………………… $ 3,600
Convenience operation manager’s salary………………. 33,000
General manager’s salary………………………………. 9,000
Advertising...…………………………………………… 10,800
Insurance……………………………………………….. 6,000
Property taxes…………………………………………... 1,500
Food equipment depreciation...………………………… 3,000
Building depreciation...………………………………… 7,500 74,400
Operating loss…..………………………………………... $ (28,200)

b. Note – relevant revenues and costs are those items that would be eliminated if the
segment is discontinued:
Relevant
Amount
Sales……………………………………………………... 120,000
Cost of sales (food, beverages, and snack items @ 40%).. 48,000
Food service items (spoons, napkins, etc.)………………. 1,800
Wages for part time employees………………………….. 24,000
Utilities (50% of total)…………………………………... 1,800
Convenience operation manager’s salary………………... 33,000
General manager’s salary………………………………... Not relevant
Advertising………………………………………………. 2,700
Insurance………………………………………………… 1,500
Property taxes……………………………………………. Not relevant
Food equipment depreciation……………………………. Not relevant
Building depreciation……………………………………. Not relevant

c. Loss of contribution margin……………………………... $ (46,200)

Less direct fixed costs:
Utilities (50% of total)………………………………… 1,800
Convenience operation manager’s salary……………... 33,000
Advertising……………………………………………. 2,700
Insurance……………………………………………… 1,500 39,000
Decrease in operating income…………………………… $ (7,200)

© The McGraw-Hill Companies, Inc., 2009 16-5

Chapter 16 Cost Analysis for Decision Making

P16.23. (continued)
d. Mario should continue the convenience operation. The quantitative results of the
relevant cost analysis indicate that if Mario discontinued the convenience operation he
would see overall profits for this location decrease by $7,200 because he would lose
more contribution margin than the amount of fixed costs he would be able to eliminate.
However, Mario should investigate whether there is a more profitable use of this space
if the convenience operation were discontinued. For example, would it be more
profitable to replace the convenience operation with an additional service bay?

P16.25.
a. 0 1 2 3 4 5 6 7 8 9 10
Investment……… $(280,000)
Annual cash flow……………………………. $42,000 per year
Salvage value…………………………………………………………… $30,000
6.1446 (Table 6-5 0.3855 (Table 6-4
$(280,000) 10 periods, 10 periods,
258,073 10%) 10%)
11,565
$ (10,362) net present value

b. Present Value Ratio = ($269,638 present value of inflows / $280,000 investment) = 0.96

c. Internal rate of return (actual rate of return) is considerably less than the cost of capital of
10% because the net present value is negative and the present value ratio is relatively low.

d. Payback period = 6.67 years.

Investment..……………………………………………………………… $(280,000)
Total return in years 1-6 ($42,000 annual cash flow * 6 years) ………… 252,000
Return required in year 7 ($28,000 / $42,000 = 0.67 years)…………… 28,000
Total return in 6.67 years ……………………………………………… $ 280,000

P16.27.
a. PV of Inflows
(Investment + Profitability Index
Proposal Investment Net PV Net PV) (PV of Inflows / Outflows)
1 $40,000 $24,000 $64,000 $64,000 / $40,000 = 1.6
2 48,000 19,200 67,200 67,200 / 48,000 = 1.4
3 24,000 12,000 36,000 36,000 / 24,000 = 1.5
4 36,000 7,200 43,200 43,200 / 36,000 = 1.2

Proposal 1 is most desirable because its profitability index is the highest.

© The McGraw-Hill Companies, Inc., 2009 16-6

 Solutions to Odd-Numbered Problems

P16.29.
a. Accounting rate of return =
Net Income $43,500 - $15,000 #
= = 20%
Average Investment ($150,000 + $135,000 # # ) / 2

# Depreciation expense = (Cost - Salvage) / Life

= ($120,000 - $75,000) / 3 = $15,000

## Investment at end of the year = Investment at beginning of the year, less

Accumulated depreciation = $150,000 - $15,000 = $135,000

Since the accounting rate of return of 20% exceeds the company’s desired rate of return of
18%, the investment would be made.

b. Investment: Year 1 Year 2 Year 3 Year 4

Machine $(120,000)
Working Capital (30,000)
Cash returns:
Operations $21,000 $36,000 $43,500 $30,000
Salvage 75,000
Working Capital 30,000
Totals $(150,000) $21,000 $36,000 $43,500 $135,000
PV Factor for 18% 0.8475 0.7182 0.6086 0.5158
Present value $17,798 $25,855 $26,474 $69,633
Sum of present values 139,760
Net present value $ (10,240)

Based on this analysis, the investment would not be made because the net present value is
negative, indicating that the ROI on the project is less than the discount rate of 18%.

c. The net present value analytical approach is the best technique to use because it recognizes
the time value of money.

© The McGraw-Hill Companies, Inc., 2009 16-7