Accounting: Information for Decision Making

CHAPTER 1
ACCOUNTING: INFORMATION FOR DECISION MAKING

Exercises

1. Toys Ahoy! has 1,000 action figures in inventory that cost $6.25 per unit to produce. Due to
changing consumer preferences, the sales department is having great difficulty selling the action
figures, and Toys Ahoy! must choose between two options. Option 1—scrap (dispose of) the action
figures at a total cost of $1,000 (for landfill fees); Option 2—rework all of the action figures, at a
total cost of $1,200 in labor and materials, and sell them to a local toy store for a total of $750.

Required:
a. What is the value of scrapping the action figures?

b. What is the value of reworking the action figures and selling them to the toy store?

c. Is the fact that Toys Ahoy! spent $6.25 to produce each action figure relevant to your value
computations?

2. Jon Tyler is a handyman who does odd jobs such as painting, fixing leaky faucets, installing ceiling
fans, and minor electrical work. Jill Safford recently contracted with Jon to paint the outside of her
home, and chose a unique color that few persons would consider. The day before he planned to
paint, Jon purchased an initial batch of 20 gallons of the paint. The local hardware store, which
mixed the paint to order, charged Jon $325; the store also noted its policy of “no refunds or
exchanges on custom colors.” Unfortunately, Jon threw his back out that evening. By the time he
recovered a month later, Jill had sold her home.

Required:
a. What is Jon’s opportunity cost of using the paint for a new job?

b. Suppose Jon decides to throw the paint out because no one else wants the color that Jill had
picked out. As a hazardous substance, paint has to be properly disposed. The landfill will charge Jon
$40 to dispose of the paint ($2 per can). In light of this new information, what is Jon’s opportunity
cost of using the paint for a new job?

c. Suppose Jill had paid a nonrefundable advance of $350 to Jon. How, if at all, does this information
affect Jon’s opportunity cost of using the paint for another job?
Balakrishnan/Managerial Accounting, 2e

3. Consider a professional sports team such as the Miami Heat, the Chicago Cubs, or the Colorado
Avalanche. The team comprises many individuals, each of whom is a gifted athlete and is well paid.
As a multimillion dollar business, the team also has several layers of management staff in addition to
the usual complement of coaches and trainers. Professional sports teams are often owned by
partnerships and corporations, with a wealthy individual having controlling interest.

Required:
a. What are the goals of a team’s owners? Do these goals mesh with the goals of the coaching staff
and the individual players?

b. What methods do owners use to align the goals of individual players with the goals of the team?

4. Many firms in the retail industry use “mystery shoppers” to evaluate the quality of their stores and
employees. In addition, audit staff for fast-food restaurants such as McDonald’s and Burger King use
extensive checklists to evaluate the degree to which their franchisees are complying with company
policies. On these unannounced audits, representatives of the company may check the freshness of
the food, the average wait time for the drive through, and the cleanliness of the facilities.

Required:
Why do companies invest resources in such monitoring programs? Why is it not enough
to instruct employees to follow prescribed company policies?

5. Dr. Sam “Smiley” Shapiro, DDS, has just graduated from a prestigious dental school in the Western
United States. He has asked for your assistance in classifying the following actions/decisions within
the context of the planning and control cycle: Plan, Implement, Evaluate, and Revise.
Item # Description
1 Whether to hire two or three dental hygienists? Dr. Shapiro has narrowed his choices to two or
three hygienists based on expected patient volume.
2 Prepare a staffing schedule so that at least one hygienist is available during all times the office is
open.
3 Track the number of patients seen by each hygienist per week.
4 Reevaluate the adequacy of current staffing levels.

Required:
Classify each decision according to its stage in the planning and control cycle. Provide a brief
rationale for each classification.
 Accounting: Information for Decision Making

6. After years of working for others, Gina Matheson has decided to open her own florist shop. Over
time, Gina has gained considerable experience in the nuances of selling flowers and flower
arrangements in the retail market. She also has developed good contacts with flower wholesalers.
She currently is contemplating the pricing of bouquets for Mother’s Day. This is an important
decision because, as per the Society of American Florists, sales on this day account for 15 to 20% of
the annual sales of flowers in the United States. (The other critical sales day is Valentine’s Day,
which falls on February 14).

Required:
Identify at least one decision/action for each of the four stages of the planning and control cycle:
Plan, Implement, Evaluate, and Revise.

7. “I was trained as an engineer, I work as an engineer, and I intend to retire as an engineer. Why on
earth would I want to learn accounting? Linda Payton, a senior production engineer at a Fortune 500
firm, clearly is unhappy that her boss asked her to attend a one-week seminar on managerial
accounting before taking on her new position. Linda’s new duties deal with managing tools. She has
overall authority for when to replace tools, whether to buy them or make them, and what quantities
to purchase or produce.

Required:
The following list presents five decisions that Linda might face in her job. How can managerial
accounting information help with these decisions? For each decision, list at least one information
item that Linda might use and whether the item is financial or nonfinancial in nature.
1. Whether actual costs are in line with expectations?
2. Whether to make a tool in-house or buy it from a supplier?
3. How many tools to purchase for making 100,000 units of a product?
4. What is the right inventory level for a given tool?
5. Whether to make a new tool or to refurbish an existing tool?

8. You have spent the last two days in San Diego, California, on company business. You flew in on
Wednesday morning and took the red-eye flight out on Thursday evening. During this trip, you
stayed with your friend, Darren. As Darren lives in the suburbs, you rented a car and paid $80 for the
rental and gas. Finally, as a courtesy, you treated Darren and his wife to dinner on Wednesday night
(cost: $90). You also spent $45 toward other meals, even though you had breakfast with Darren on
Thursday. Usually, your firm puts up its employees in a downtown hotel. The average cost for San
Diego is $140 per night (this is the discounted corporate rate). The firm also pays a per-diem meal
allowance of $50 (no receipt required). However, if you were with clients, the firm would reimburse
the actual cost for the meal (receipt required).

Required:
Prepare an expense report for your trip (excluding airfare). Assume that if you stayed at the hotel,
no car would have been needed as you can walk from the hotel to your firm’s office.
Balakrishnan/Managerial Accounting, 2e

Solutions to Exercises

1. (LO-1)
a. The value associated with scrapping the action figures is the cost associated with disposing of
them. Because scrapping the action figures will cost $1,000, the value of this option is ($1,000).

b. Reworking the action figures will cost Toys Ahoy! $1,200, but selling them to the toy store will
bring in $750 in revenues. Thus, the value of reworking the action figures and selling them to the
toy store is $750 – $1,200 = ($450).
Unfortunately, the value of both options is negative. However, relative to scrapping the toys,
reworking them increase’s Toys Ahoy!’s profit by ($450) – ($1,000) = $550. Thus, reworking the
action figures is the preferred option.

c. Intuitively, the fact that Toys Ahoy! spent $6.25 to produce each action figure is not relevant to
the decision at hand because Toys Ahoy! has already incurred the expenditure – it is a sunk cost.
That is, this cost does not change relative to the status quo. As discussed in more detail in
Chapter 2, value is forward looking and involves measuring future sacrifices and future benefits.

2. (LO-1)
a. The opportunity cost of any option is the value of the next-best option. Assume Jon could use
the same color paint for another job. What’s Jon’s next-best option? The problem makes it clear
that the paint is “unique” and has few, if any, alternative uses. Given this, Jon’s opportunity cost
of using the paint for another job is $0. This estimate assumes that there is no cost to storing the
paint.

b. Jon’s next-best option is to dispose of the paint at a cost of $40. Jon can avoid this cost by using
the paint for another job. Thus, the opportunity cost of using the paint for another job is ($40).
Jon should therefore be willing to pay someone up to $40 to let him use the paint in their job!

c. The fact that Jon received a non-refundable advance of $350 does not change the opportunity
cost in any way. The revenue and the cash costs are past events and are sunk. Both value and
opportunity cost are forward looking – because this amount does not change relative to the
status quo, the $350 is not relevant to the decision at hand.
 Accounting: Information for Decision Making

3. (LO-2)
a. The owners likely have multiple goals. Making a profit is important, as is winning games and
championships. Some owners probably enjoy the prestige and glamour associated with owning
a professional team. Other owners wish to give back to the community by funding appropriate
recreational outlets. Each person in the coaching staff ultimately worries about his or her own
career. Surely, the coaching staff enjoys what they do and being associating with “winners.”
However, some part of their concern about the team’s success stems from its effect on their
personal career prospects. Coaches are not as worried as owners about the team’s overall
profitability or other monetary issues. Players have potentially conflicting goals. On the one
hand, they wish to do what is best for the team. However, they also recognize that they have
only a few years in their careers and that their earnings during this period must sustain them
through their lives. Thus, players bargain aggressively with owners, sometimes putting team
profitability in jeopardy. Such actions may also create animosity among players and affect the
team’s effectiveness. For instance, a player may “hold out” (i.e., not report to training camps)
for more compensation. Players are also known to engage in acts that increase their visibility
and stature at the team’s expense. Who among us does not know a “hot-dogging” athlete?

b. Teams can and do use a number of systems to align players’ incentives with team incentives.
Clauses giving incentive pay for reaching different levels of the playoffs and reaching milestones
in performance (e.g., batting averages, rushing yards) are common. Contracts also usually
specify parameters for physical fitness, as well as norms for expected behavior. Contracts often
allow teams to ‘fire’ players if they engage in behavior that damages a team’s reputation.
Designing and implementing contract-based and formal control measures is difficult in this
setting as team performance depends on many factors. It is often difficult to specify what
players should do or to measure their contribution to the team’s success. Teams therefore rely a
great deal on intangibles such as “leadership” and “culture” when motivating players to do the
right thing. Coaches sometimes discipline players by benching them for games or denying
players time on the field/court. They also rely on the players’ ego and the value players attach to
their reputation to keep players in check.

4. (LO-2) Organizations invest in monitoring programs because the organization’s goals may not
always coincide with the goals of individual employees. When owners and other stakeholders
delegate decision making, they run the risk that employees will make decisions that may not be in
the organization’s best interests. For example, employees may pad expense accounts, take excessive
breaks or time off, or even steal from the company.
Monitoring can help by either penalizing undesired behavior or rewarding desired behavior. For
example, mystery shopper programs help assess the quality of store operations and make sure that
employees are following company policies. For example, a Burger King franchisee may substitute
lower quality ketchup or other condiments, or not keep the facilities up to the standards consistent
with the franchisor’s corporate image. Audit visits and other mechanisms serve to deter such
behavior – in extreme instances, the franchisee could lose its license.
Just telling someone to follow the rules is not enough. Enforcement or follow-up is necessary.
Without enforcement, employees might simply agree to the rules but then ignore them and do
whatever they want. Incentive schemes such as bonus pay and stock options also help align
individual goals with organizational goals.
Balakrishnan/Managerial Accounting, 2e

5. The following table provides the required classifications, including comments pertaining to the
rationale underlying each classification.

Action/Decision Stage Rationale

Whether to hire two or Plan This decision relates to the choice of a resource
three dental hygienists? level. Hiring more staff provides greater capacity,
Dr. Shapiro has narrowed allowing Dr. Shapiro to serve more patients, but
his choices to two or also commits Dr. Shapiro to greater costs.
three hygienists based on
expected patient volume.

Prepare a staffing Implement This action relates to implementing the choice.

schedule so that at least The associated decision (we could view each
one hygienist is available possible schedule as a decision option) relates to
during all times the office how resources, in this case hygienists, will be used
is open. to deliver services.

Track the number of Evaluate This on-going control process helps Dr. Shapiro
patients seen by each figure out the efficiency and effectiveness with
hygienist per week. which he is using costly resources. Moreover,
because Dr. Shapiro sees each patient during each
visit, he also can personally track the quality of
work done by each of his hygienists.
Re-evaluate the Revise Over several weeks or months, Dr. Shapiro will get
adequacy of current a sense of whether his hygienists are fully utilized.
staffing levels. He will also determine whether additional
hygienists need to be hired or which, if any, of his
hygienists need to be let go.
This problem illustrates the classical loop between planning and control. We typically begin with a
plan that is based on a set of assumptions (in this case, expected patient volume). These
assumptions are our beliefs about the unknown future. We then implement our choices. As time
passes, we obtain new information about the actual outcomes (in this case, actual patient volume
and the quality of work done by each hygienist). On an on-going basis, this new information will
cause us to adjust how we implement our plans (e.g., change the schedule for the next week). Over
a period, we will accumulate enough information to revise our original set of assumptions, which
might cause us to revisit the decision. The overall point is that there is a natural cycle of doing
something based on a set of assumptions, comparing actual outcomes with expectations, and then
revising our assumptions. In many instances, the broad loop relating to a decision contains smaller
loops within it. For instance, we can think of creating each week’s schedule as forming a separate
planning and control cycle.
 Accounting: Information for Decision Making

6. (LO-3)
The following table lists the four stages of the planning and control cycle and the associated
decisions/actions. There are many possible decisions for each category.

Stage Action/Decision

Plan One possible decision is whether to price at the same levels as last year or
to raise prices by, for example, 10% to account for the higher cost of flowers
this year. Other decisions include whether to hire additional help or how
much money to spend on advertising.
Implement Based on the chosen price level, order and stock enough bouquets to meet
the expected demand. (Notice that we could view this as a decision in itself,
viewing each volume of order as an option.)
Evaluate Compare actual sales to budgeted sales. Identify reasons for any deviations.
(Again, we could view this as a decision by framing each possible reason for
a deviation as a possible option. We then choose among possible
explanations.)
Revise Gina would use data on actual sales, her prices versus the prices of other
florists, and national trends to revise her expectations about future sales.
This revised belief will be a key input into her pricing decision for next
Mother’s day.
As we see, Gina begins with a plan that is based on a set of assumptions (in this case, how much
demand she might expect for any given price). These assumptions are her beliefs about the
unknown future. She then implements her choices (e.g., post prices, order flowers). As Mother’s day
nears, pre-orders and information about other florists’ prices might give Gina an impetus to revise
her prices. That is, she obtains new information on an ongoing basis, which in turn causes her to
adjust her implementation (e.g., revise prices, run more ads). Over a period, she will accumulate
enough information to revise her original set of assumptions, which might cause her to improve the
next pricing decision.
The overall point is that there is a natural cycle of doing something based on a set of assumptions,
comparing actual outcomes with expectations, and then revising our assumptions. In many
instances, the broad loop relating to a decision contains smaller loops within it. For instance, we can
think of offering a discount at day’s end as forming a separate planning and control cycle within the
overall cycle that we discussed above.
Balakrishnan/Managerial Accounting, 2e

7. (LO-4) As shown below, Linda may be surprised to find managerial accounting information
invaluable in her new position. As a manager, Linda decides how best to use the organizational
resources entrusted to her, and she will find both financial and non-financial information from her
company’s managerial accounting system to be helpful for making these decisions.

Information Items Are information items financial/non-financial in

Decision nature?
Whether Budgeted costs Budgeted and actual cost data are financial in
actual costs nature.
are in line with Actual costs
expectations? Linda may use non-financial data such as the
Actual volume of volume of production to adjust her estimates of
production expected costs. The more units produced, the
greater the expected cost as the company will be
using more materials and labor. Linda also may rely
on non-financial data such as absenteeism rates and
whether her company was starting a new product
to figure out the source of the cost differences.

Whether to Price charged by the The supplier’s price and internal cost data are
make a tool in- supplier financial.
house or buy it
from a Cost to make the tool Non-financial data include supplier quality and
supplier? internally reliability, as well as the reliability and quality of the
tools if they were manufactured by Linda’s firm.
Supplier quality and
reliability

How many Rate of wear Use data, such as rate of wear, are non-financial.
tools to Cost data, which would be used to determine the
purchase for Expected cost of tool amount of safety stock, are in financial terms.
making
100,000 units Expected loss if tool not
of a product? available
 Accounting: Information for Decision Making

What is the Expected rate of use, Data concerning use patterns, including rate of
right inventory variance in use rates wear and variance in use rates, are non-financial.
level for a across time periods Data about cost estimates, including storage costs
given tool? (e.g., Linda’s firm may and capital costs, are expressed in financial terms.
have seasonal
production cycles)

Cost of tool, cost of

capital, other storage
costs

Whether to Cost to make the new Again, the cost data are in financial terms whereas
make a new tool data pertaining to quality and expected lives are
tool or to non-financial in nature.
refurbish an Cost to refurbish
existing tool? existing tool

Expected lives of the

two tools

Quality of the tools

Balakrishnan/Managerial Accounting, 2e

8. Let us begin by computing the expected cost if you had stayed at a hotel:

Cost of hotel for one night $140.00

Per-diem meal allowance $100.00
Total $240.00

Next, let us compute your actual expenses:

Cost of car rental $80.00

Cost of dinner Wednesday $90.00
Cost of other meals $45.00
Total cost $215.00

At least five views exist regarding the appropriate expense report:

 You could turn in a report for $240, arguing that the firm would have spent this amount for the
trip. Any cost savings stemming from your actions should belong to you.
 You have saved the firm some money by staying with Darren rather than in a hotel. Thus, you
should turn in a report for $215, justifying the dinner with Darren and the car rental as
offsetting hotel costs.
 At another extreme, some would argue for a report of $45 only, being the actual meal cost.
Under this view, the car rental and the dinner are personal expenses and non-reimbursable.
Further, you should only claim the lower of actual expenses or the per-diem allowance.
 You could claim the $100 as the per-diem allowance for two days. After all, company policy
allows you to claim $50 per day for meals, no matter what you actually spend.
 A final view, which is perhaps what many of us would do, is to claim the car rental and the per-
diem for two days ($180 = $80 + 2 days × $50 per day), reasoning that the car rental is a
reasonable off-set to the cost of the hotel.

There is no clear answer, and different people would reasonably claim different amounts. Deciding
the reasonableness of travel expenses can be difficult. For instance, some might argue that the cost
savings are fictitious. You might have been more productive if you had stayed in a hotel and had a
restful night. Partying with friends might adversely affect your work quality the next day. In addition,
perhaps you would have dined with clients or engaged in other beneficial activities (e.g., having
dinner with colleagues to continue the meeting). These opportunities might have been missed
because of your desire to have dinner with Darren. On the other hand, some might argue that the
company is imposing costs by having you travel and spend time away from your family. Allowing you
to spend time with friends and sightsee is one way to compensate for these non-pecuniary costs.

Many firms avoid these problems by formulating explicit policies. For instance, they might reimburse
you $100 per day as a flat fee if you do not stay at a hotel.

This exercise nicely illustrates that, just like beauty “lies in the eyes of the beholder,” there often is
no bright line test for what is ethical or unethical. We can see this confusion in advice columns such
as “Ask the Ethicist” that appear in the New York Times Magazine.
 Accounting: Information for Decision Making

CHAPTER 2
IDENTIFICATION AND ESTIMATING COSTS AND BENEFITS

Exercises

1. Sarah is not currently using the fitness loft, a special area of the gym that houses state-of-the-art
cardio and strength training equipment. Based on a visit as a friend’s guest, Sarah has decided to
enroll in the loft. She is deciding between buying a pass to the fitness loft (cost: $120 per semester)
and buying a pass for each use (cost: $4 per visit). She wants to work out at least three times a
week, which translates to 45 times for the semester. Towel rental at the loft is $0.50 per use. Sarah
pays a facilities fee of $175 per semester with her tuition; this fee entitles her to “free” use of one
locker.

Required:
a. Is the facilities fee of $175 relevant or controllable for Sarah’s decision?

b. Is the towel rental of $0.50 per visit controllable or relevant for this decision?

c. Is the per-use fee controllable or relevant for this decision?

2. Sam Walters is leaving tomorrow for a three-day business trip and is trying to decide the most
economical way to get to and from the airport and his home. Sam could either drive (using his own
car) or take the shuttle. If Sam drives, then he estimates that it will cost $0.30 per mile driven in
operating costs (e.g., for gas and oil) and $7.50 per day for parking. The one-way cost of the shuttle
is $25. Sam’s home is exactly 30 miles from the airport.

Required:
a. What are the controllable costs for Sam’s decision?

b. What are the relevant costs and benefits for Sam’s decision?

c. Are the controllable costs the same as the relevant costs for Sam’s decision? If so, why? Can
controllability and relevance give the same costs and benefits even when the status quo is not a
feasible option?
Balakrishnan/Managerial Accounting, 2e

3. Saburo and Akiko Watanabe have been married for a bit less than three years and just had their first
baby. They want to have another child within two or three years and look forward to “settling
down” into the classic American dream of a home with a large yard, a dog, and BBQs on lazy
summer afternoons. Both Saburo and Akiko have professional degrees and well-paying jobs. Each of
them earns roughly $80,000 per year, which has allowed them to save up for a down payment on a
nice house. Currently, they are wondering if one of them should take some time off (for say, five to
ten years) from work and devote the freed-up time to building a family. They both care deeply about
instilling the right mixture of Japanese and American values in their children and are worried that
without adequate parental involvement, their children may lose track of their Japanese heritage.
The following lists nine decisions that Saburo and Akiko will be facing in the near future:

1 Reconsidering the decision to give up one income (neither person has quit yet).
2 Deciding whether to buy a second car (Saburo and Akiko currently only have one car because they
live in the city).
3 Deciding whether to pay this month’s mortgage payment by check or electronic transfer.
4 Deciding whether to hire a housekeeper.
5 Deciding the type of dog to get.
6 Deciding whether to spend $10,000 on a 4-week tour to Japan and Southeast Asia.
7 Deciding whether to have the stay-at-home spouse look for part-time, home-based employment.
8 Deciding whether to grill steak or fish for their dinner party this coming Saturday.
9 Deciding which house to buy.

Required:
a. Classify each decision according to its time horizon, short term or long term. Provide a brief
rationale for each.

b. As discussed in the text, many short-term decisions have longer-term implications. Given this
linkage, what is the benefit from classifying decisions according to their time horizon? (Hint:
Think about the benefits of breaking down a large assignment into manageable pieces.)

4. The Greek Corporation makes two products: Kappa and Gamma. Although each product uses a
different type of raw material, the firm produces both products in its Eastern plant. The products
make use of the same equipment as well.
Greek Corporation produces Kappa during the day shift and Gamma during the night shift. The
following list presents six costs incurred by the Greek Corporation to produce Kappa:
1 Eastern plant rent
2 Raw materials purchased to produce Kappa
3 Eastern plant utilities and water
4 Salary of the Eastern plant manager
5 Equipment maintenance
6 Salary of a production employee who works the day shift at the Eastern plant

Required:
For each cost, classify whether it is direct (D) or indirect (I) with respect to Greek’s decision
to produce the Kappa product. Provide a brief rationale for each classification.
 Accounting: Information for Decision Making

5. Sun and Sand Hotels (S&S), an exclusive beach resort, offers all-inclusive vacations—the package
price includes the room, food, and access to all facilities. However, alcoholic beverages and special
services (e.g., boat tours) are extra. S&S offers many attractions such as an enclosed lagoon within
which guests may pet dolphins. The resort also offers snorkeling and diving tours at a nearby coral
reef. Sun and Sand is interested in calculating its cost to host a typical member. Customers usually
are couples, and the average couple stays for three nights and four days.

Required:
Treating the number of couples as a unit of activity, identify a unit-, batch-, product- and facility
level cost for Sun and Sand.
Balakrishnan/Managerial Accounting, 2e

Solutions of Exercises

1. Controllability and Relevance (LO1).

A. The amount is not controllable or relevant. This is a past expenditure and nothing Sarah could
do now will change this sunk cost.
B. The amount is controllable. This is an additional expenditure relative to the status quo of not
using the fitness loft. However, the amount is not relevant. The amount spent on this item will
be the same whether Sarah decides to buy a semester or per-use pass.
C. The amount is controllable. This is an additional expenditure relative to the status quo of not
using the fitness loft. The amount also is relevant. The amount spent on this item will differ
based on whether Sarah decides to buy a semester or per-use pass.

2. Controllability and Relevance (LO1).

a. A cost is controllable if it changes relative to the status quo. Relative to not taking the business
trip, Sam expects to incur the following costs under each option:
Drive – the controllable costs for the round trip are:
Parking $7.50 per day × 3 days $22.50
Operating costs $0.30 per mile × 60 miles (round trip) $18.00
Total controllable cost $40.50
Shuttle – since a one-way trip on the shuttle costs $25, the controllable costs for the round trip
are $25 × 2 = $50.
Thus, we find that Sam prefers driving to taking the shuttle. Sam’s preference for driving versus
taking the shuttle changes as the length of his trip changes (e.g., for a five-day trip, the shuttle is
cheaper as the cost of driving increases by $15 while the cost of taking the shuttle stays the
same). For short trips, driving and parking is cheaper than taking the shuttle. For trips that are
longer, taking the shuttle is cheaper than driving. We can link this to students’ behavior – for
winter break, it is likely that students take the shuttle to avoid 2-3+ weeks of parking costs. For
shorter trips, it is likely that many students drive and use the airport parking lot

b. A cost is relevant if it differs across decision options. We also know that relevant costs are a
subset of controllable costs. By examining the controllable costs in part [b], we find that all of
the controllable costs are relevant – i.e., the options do not share any common costs.
Thus, the relevant costs of driving = $40.50, and the relevant costs of taking the shuttle = $50.
c. Yes, for Sam’s decision, the set of controllable costs is the same as the set of relevant costs.
Moreover, we find that controllability and relevance give us the same amounts even when the
status quo is not part of the opportunity set. How can this happen? The answer is that
controllability and relevance will give us the same amounts when decision options do not share
any common costs or benefits. When each cost or benefit is unique to a specific decision option.
 Accounting: Information for Decision Making

3. Classifying Decisions According to their Time Horizon (LO2).

a. The following table provides the decision classifications, including comments pertaining to the
rationale underlying each classification (please note that there clearly is room for
discussion/debate regarding some of the classifications – as discussed in the chapter, the
boundaries between the horizons are often fuzzy).
Classification & Comments
1 Long-term. One spouse plans to give up work for 5 to 10 years. This decision clearly
has life-long consequences and affects the couple for many years to come.
2 Long-term. This decision has multi-year implications. Even so, this decision is
relatively easy to reverse as the car can be sold. Moreover, it is likely that Saburo
and Akiko will revisit this decision on an ongoing (annual) basis.
3 Short-term. This decision affects the timing of the couple’s cash flows by a matter of
days – the impact of this decision is felt almost immediately.
4 Short-term/Long-term. This decision commits the couple for a few months or so,
and it is a decision that is relatively easy to reverse. One also might argue for a long-
term classification, as most such hires are made with the intent of keeping the
arrangement going for several years.
5 Long-term. The average life of a dog is about 12 years. Over their life most dogs cost
anywhere from $9,000 to $20,000 in food and vet fees.
6 Short-term. The decision turns on the couple’s available cash and expected cash
flow. Saburo and Akiko are likely to experience the benefits and costs of this
decision immediately. The decision could have longer-term effects such as the type
of house they buy or if they are able to afford a second car.
7 Long-term/short-term. This decision commits the couple for at least several months
because most hires are made with the intent of keeping the arrangement going for
several months, if not longer. The decision can be reversed (the stay-at-home
spouse can always give “two-weeks” notice), and one can make a good argument for
a short-term classification.
8 The decision is purely short term. The decision’s horizon only spans several hours on
Saturday evening; further, it is unlikely (although not out of the question) that any
long-term effects will result from this decision.
9 Long-term. This decision has multi-year ramifications as they are likely to live in the
home for many years. This decision is like a business deciding where to site the
plant. Reversing this decision can be difficult and costly.
Balakrishnan/Managerial Accounting, 2e

b. Many short-term decisions have longer-term implications, and it frequently is not possible to
cleanly separate decisions. For example, an expensive vacation to Japan and Southeast Asia may
put on hold Saburo and Akiko’s plans to have one person stay at home. In the current context,
the couple’s budget links their decisions. Buying a second car may limit the couple’s ability to
hire a housekeeper (or vice-versa). Classifying decisions via their time horizon greatly assists
individuals in simplifying decision making – when confronted with a decision, thinking about
the time horizon assists in delineating the costs and benefits of the decision options and when
they are likely to materialize. Unfortunately, the potential for making bad decisions arises every
time we eliminate an entire class of choices (by, e.g., de-coupling decisions) and /or reduce the
number of costs and benefits we consider. Good managers excel at making this tradeoff. They
can quickly narrow the choices to the most viable and exciting options; they also excel at
figuring out which costs and benefits are easily quantifiable, and at getting a “gut feel” estimate
of the hard to quantify costs and benefits.

4. Traceability (LO3).
The following table provides the cost classifications, including comments pertaining to the
rationale underlying each classification.

Cost Classification& Comments

1 I – This cost is only partly attributable to Kappa as both Kappa and Gamma
are produced in the same plant.

2 D – This cost is entirely attributable to Kappa. Kappa and Gamma use

different raw materials, allowing us to directly trace the materials costs to
each product.

3 I – This cost is only partly attributable to Kappa as the utilities relate to the
entire plant and the production of both Kappa and Gamma.

4 I – This cost is only partly attributable to Kappa as the plant manager

oversees all activities in the plant (i.e., the production of both Kappa and
Gamma).

5 I – This cost is only partly attributable to Kappa as the equipment is used to

produce both Kappa and Gamma.

6 D – This cost is entirely attributable to Kappa as the production employee

only works the day shift (when the firm produces Kappa but not Gamma).
 Accounting: Information for Decision Making

5. Hierarchical Cost Structure: Cost Classifications (LO4).

Unit-Level. The cost of food and drinks consumed is likely a unit-level activity – the more people,
the more food and drink. While it is not possible to predict food costs perfectly, Sun and Sand will
consider the number of members in residence when deciding the amount of food to make. From a
control perspective, S&S’s managers likely track the cost of food per member quite closely.

Batch-Level. S&S incurs many batch level costs. Consider the cost of posting lifeguards on the
beach. The number of lifeguards posted is not strictly proportional to the number of members on
the beach. Rather, the head lifeguard probably follows some kind of a gut feel (and local
regulations) in posting more lifeguards as more people enter the beach. From experience, the
head lifeguard may be able to predict usage patterns and will adjust staffing schedules
accordingly.

Product-Level. The cost of maintaining the dolphins in good health is a product level cost. S&S
needs to incur this cost even when there are only a few members in residence. That said, there is
some correlation with the number of members; beyond a certain number, S&S might have to train
more dolphins to swim with humans. This point underscores that it is only the step-size that
differs between unit-, batch- and product-level costs. Ultimately, a firm’s volume of business
influences virtually all of its costs.

Facility-level. In addition to rent and executive salaries, the fee charged by the city for erosion
control would be an example of S&S’s facility level cost. S&S incurs this cost as a part of staying in
business. The amount does not depend on the number of members, lifeguards on duty, or
program offered.

CHAPTER 3
COST FLOWS AND COST TERMINOLOGY
Problems

1. The following are some of the costs incurred by a CPA firm relating to its tax practice.

Required:
Indicate by placing an “X” in the appropriate column whether each of the following items describes
a product cost (above the line for gross margin) or a period cost (below the line for gross margin.)

Product Period Type of Cost

a. _____ _____ Receptionist’s salary.

b._____ _____ Depreciation on tax preparation software.

c._____ _____ Cost of adding annual tax update to tax preparation

software.

d._____ _____ Tax preparers’ salaries.

Balakrishnan/Managerial Accounting, 2e

e_____ _____ Rent for office space.

2. Walker Consulting specializes in helping small companies protect their assets from employee theft.
Walker has provided the following data relating to its current year:

Revenues $850,000
Gross margin $560,000
Profit before taxes $300,000

Walker’s period costs are made up 30 percent marketing costs and 70 percent administrative costs.

Required:
a. Complete a GAAP income statement.

b. What is the firm’s cost to provide service?

c. What are its general and administrative costs?

 Accounting: Information for Decision Making

3. The following is a condensed income statement for Watson’s Bicycle Sales, a retail entity specializing
in racing bicycles.

Watson’s Bicycle Sales

GAAP Income Statement
Revenue $425,000
Beginning inventory January 1 $15,000
Purchases ?
Ending inventory, December 31 $11,500
Cost of goods sold ?
Gross Margin $235,000
Selling and administrative costs ?
Profit before taxes $82,000

Required:
a. Determine the cost of purchases.

b. Determine the selling and administrative costs.

4. Mitchell’s Small Engine Repair Company’s accounting records show the following information
relating to its inventories:

Beginning Raw Materials Inventory $ 45,000

Raw Materials Purchased during year 550,000
Ending Raw Materials Inventory 42,000
Beginning Work In Process Inventory 95,000
Manufacturing costs charged to operations during year 900,000
Ending Work In Process Inventory 125,000
Beginning Finished Goods Inventory 90,000
Ending Finished Goods Inventory 65,000

Required:
a. What was the cost of raw materials issued into work in process during the year?

b. What is the cost of goods completed and transferred to finished goods during the year?

c. Calculate the cost of goods sold during the year.

Balakrishnan/Managerial Accounting, 2e

5. Virgo is a manufacturer of office furniture. Virgo uses large molding machines to produce its
fiberglass molded chair seats. The chairs are then covered with a protective glaze, connected to the
chair legs, packaged and shipped. The following data pertain to setting up a molding machine.
Annual setup costs total $150,000. The machine has to be set up for the following models: child’s
desk chair, regular desk chair, super-model desk chair.

Number of Hours per Total number of setup

Model
setups per year setup hours for the year
Child’s desk chair 15 8 120
Regular desk chair 30 12 360
Super-model desk chair 5 20 100
Total 50 n/a 580

Required:
a. Suppose Virgo allocates setup costs to products using the number of setups as the allocation
basis. What is the setup cost allocated to the super-model desk chair?

b. Suppose Virgo allocates setup costs to products using the total number of setup hours as the
allocation basis. What is the setup cost allocated to the regular desk chair?
 Accounting: Information for Decision Making

Problem Solutions

1. Product versus period cost (LO1)

a. Period
b. Product
c. Product
d. Product
e. Period

2. GAAP Income Statement (LO2)

Walker Consulting
GAAP Income Statement for Current Year
Revenue $850,000
Cost of Providing Services 290,000
Gross Margin $560,000
Marketing costs 78,000
Administrative costs 182,000
Profit before Taxes $300,000

3. Cash flow in merchandising entity(LO3)

a. Cost of purchases.

$425,000 (revenue) - $235,000 (gross profit) = $190,000 cost of goods sold.

$190,000 (cost of goods sold) + $11,500 (ending inventory) - $15,000 (beginning inventory) =
$186,500 cost of purchases.

b. Selling and administrative costs.

$235,000 (gross margin) - $82,000 (profit before taxes) = $153,000 selling and administrative
costs.

4. Cost flows in manufacturing (LO4)

a. Cost of raw materials charged to work in process:
$553,000 = $45,000 (beginning inventory) + $550,000 (purchases) - $42,000 (ending inventory)

b. Cost of goods completed and transferred to finished goods during the year:
$870,000 = $95,000 (beginning inventory) + $900,000 (manufacturing costs charged to
operations) = $125,000 (ending inventory)

c. Cost of goods sold during the year:

$895,000 = $90,000 (beginning inventory) + $870,000 (goods transferred in) - $65,000 (ending
inventory)
Balakrishnan/Managerial Accounting, 2e

5. Allocation mechanics (LO5)

a. Setup cost allocated to the Super-model desk chair.
($150,000 costs/50 total number of setups) x 5 Super-model setups = $15,000

b. Setup cost allocated to the regular desk chair?

($150,000 costs/580 total setup hours) x 360 regular setup hours = $93,103.
 Accounting: Information for Decision Making

Chapter4:Techniques for Estimating Fixed and Variable Costs

Problems

1. Jerry’s Manufacturing Company provides you with the following income statement.

Jerry’s Manufacturing Company

Income Statement for Current Year

Revenue $250,000

Cost of Goods Sold 125,000

Gross Margin $125,000

Administrative Costs 45,000

Selling Costs 55,000

Profit $ 25,000

Jerry’s provides the following information for the current year:

Fixed manufacturing overhead costs $22,000

Variable manufacturing overhead costs $-0-

Variable selling costs 3% of revenue

Fixed administrative costs $45,000

Required:

Prepare an income statement in the contribution margin format.

Balakrishnan/Managerial Accounting, 2e

2. User Friendly Computer Company, in addition to its retail sales, conducts night classes in computer
technology. User Friendly has provided you the following information:

Anticipated new class offerings 3

Anticipated new students 60

Anticipated revenue $650 per student

Student-related variable costs $125 per student

Salary for new instructors $2,000 per class

Administrative costs $300 per instructor

Maintenance on building $15,000 per year

Required:
Using account classification, construct a Contribution Margin Statement.
 Accounting: Information for Decision Making

3. Michael’s Specialty Woodworking Shop specializes in custom rod racks for fishing rods. Michael’s
business has flourished since he opened two years ago. His hand made rod racks with drawers for
accessories have been a favorite of his customers. Michael believes the average cost of supplies to
make the racks and his cost structure has remained the same during his first two years of operations
and believes they will remain steady in the future. Michael’s condensed income statements for his
first two years of operation is shown below:

Year 1 Year 2

Number of racks sold 750 1,100

Total revenue $187,500 $275,000

Total costs 75,000 98,800

Profit before Taxes $112,500 $176,200

Required:

a. Use the high-low method to estimate Michael’s Specialty Woodworking Shop’s annual cost
equation (i.e., use the data from years 1 and 2 to estimate Michael’s annual fixed costs and
variable cost per rack).

b. Michael has been asked to participate in a national “Outdoor Sports Extravaganza”. If he

participates, he will have to pay $1,000 booth fee as his only additional expense. Michael
believes that she will be able to sell at least 30 additional racks during the event. By how much
is Michael’s Specialty Woodworking Shop’s profit expected to change if Michael participates in
the Outdoor Sports Extravaganza.

4. Cindy’s Boutique is trying to derive a cost equation that predicts its monthly inventory-handling
costs. Cindy estimates the following two equations using regression analysis:

Equation #1

Inventory-handling costs per month = $15,000 + ($0.02 x value of inventory handled)

R-square = 27.3%
Both coefficients have p-values of 0.05 or lower

Equation #2:

Inventory handling costs per month = $8,000 + ($5.20 x number of inventory items handled)
Balakrishnan/Managerial Accounting, 2e

R-square = 38.2%
Both coefficients have p-values of 0.01 or lower

Required:
Which of the two equations do you believe better predicts Cindy’s monthly inventory handling
costs?
 Accounting: Information for Decision Making

5. Outdoor Toys manufactures and sells two lines of trampolines: rabbit (for younger children) and
kangaroo (for older children and adults). The following data pertain to Outdoor Toy’s most recent
year of operation:

Outdoor Toys

Income Statement for the Current Year

Revenues $1,350,000

Cost of Goods Sold 565,000

Gross Margin $785,000

Selling,& Administrative Costs 700,000

Profit Before Taxes $ 85,000

Outdoor Toys also provides the following information:

Rabbit Kangaroo

Number of Trampolines Sold 2,800 4,000

Price per Trampoline $125 $250

Variable Manufacturing Cost per

$40 $80
Trampoline

Traceable Fixed Manufacturing Cost $150,000 $150,000

Traceable Selling & Administrative Costs $100,000 $150,000

The remainder of fixed costs is common to both products.

Required:

Create a monthly contribution margin statement by product for Outdoor Toys.

Balakrishnan/Managerial Accounting, 2e

Problem Solutions

1. Income Statement in Contribution Margin Format (LO1)

Jerry’s Manufacturing Company

Income Statement for Current Year

Revenue $250,000

Variable costs 110,500*

Contribution Margin $139,500

Fixed Costs 114,500**

$ 25,000

*$103,000 (manufacturing) + $7,500 (selling)

** $22,000 (manufacturing) + $45,000 (administrative) + $47,500 (selling)

2. Contribution Margin Statement using Account Classification (LO2)

User Friendly Computer Company

Income Statement for Current Year

Revenue $39,000*

Variable costs 14,400**

Contribution Margin $24,600

Fixed Costs 15,000***

$ 9,600

*$650 x 60 students = $39,000

** ($125 x 60 = 7,500 student costs) + ($2,000 x 3 = $6,000 instructor salary) + ($300 x 3 administrative
costs) = $14,400

***$15,000 maintenance

3. (LO3)
a. Annual Cost Equation:
 Accounting: Information for Decision Making

$98,800 - $75,000
Cost Equation: = $68
1,100 – 750

Total Cost HIGH ACTIVITY LEVEL $98,800 = $24,000 Fixed Costs + $74,800 Variable Cost

Total Cost LOW ACTIVITY LEVEL $75,000 = $24,000 Fixed Costs + $51,000 Variable Cost

b. If Michael participates in Outdoor Sports Extravaganza:

Revenue for additional 30 racks $7,500

Additional variable costs 2,040
Additional fixed costs 1,000
Total change in profit $4,460
4. Interpreting Regression Analysis (LO4)
Equation #2 provides a better prediction of Cindy’s monthly inventory handling costs. The closer the value of
R-square to one, the better the fit. R-square for Equation #2 is closer to 1 (38.2% #2 vs. 27.3 #1). In addition,
the p-value indicates the confidence that the coefficient estimates reliably differ from zero. P-values with
lower values represent tougher thresholds to meet. Equation #2 has a p-value of less than .01 while Equation
#1 has a p-value of less than .05, indicating that Equation #2 has a sufficiently high level of confidence n the
estimates.
5. Segmented Contribution Margin Statements (LO5)
Outdoor Toys

Product-Level Contribution Margin Statement

Rabbit Kangaroo Total

Volume 2,800 4,000

Revenue $350,000 $1,000,000 $1,350,000

Variable Manufacturing Costs 112,000 320,000 432,000

Variable Selling & Administrative Costs 100,000 150,000 250,000

Contribution Margin $138,000 $530,000 $668,000

Traceable Fixed Costs 150,000 150,000 300,000

Segment Margin ($12,000) $380,000 $368,000

Common Fixed Costs 283,000

Balakrishnan/Managerial Accounting, 2e

Profit Before Taxes $ 85,000

CHAPTER 5
COST-VOLUME-PROFIT ANALYSIS
Problems

6. River Toys manufactures Angler’s Choice kayaks. River Toys believes that the demand during the
current year’s fishing season will be 4,000 units. Additional cost data follows:

Value
Item per unit
Selling Price $800
Variable manufacturing costs 300
Fixed manufacturing overhead 25
Gross margin $475
Variable selling costs 20
Fixed selling and administrative costs 125
Profit margin $330

Required:
a. What is River Toys’ breakeven point in units?

b. What is River Toys’ breakeven point in revenue?

7. Bubba’s Bait Shop sells spinner, top water, diving and tube baits. Bubba estimates that his variable
costs are $0.20 per sales dollar and fixed costs total $4,500 per month.

Required:
a. How much revenue does Bubba need to break even each month?

b. How much revenue does Bubba need to generate in order to realize a profit of $3,000 each
month?

c. If Bubba expects his vendors to increase the price of baits by 40%, what will be his break-even
revenue per month?
 Accounting: Information for Decision Making

8. Casting Company manufactures ultra-lite fishing rods called Catch’ums. The rods are sold exclusively
via Internet. Each Catch’um sells for $18 ($15 plus $3 shipping and handling.) Casting’s contribution
margin ratio is 60%. Casting calculates breakeven units to be 5,000 per month.

Required:
d. What is the unit variable cost of a Catch’um rod?

e. What is Casting’s monthly fixed cost?

f. Suppose Casting introduces an offer for “free” shipping and handling. How many additional rods
will Casting have to sell each month to break even?.

9. Buck’s Camo Shop sells a variety of camo-patterned outdoor garments. Buck has built up a loyal
customer base because of the quality of his garments and the customer service he provides. In a
typical month Buck’s revenue is $150,000 and he earns a net profit of $9,300. Buck’s contribution
ratio is 60%.

Required:
c. Determine Buck’s margin of safety at his current sales level.

d. What is Buck’s operating leverage?

e. What is the revenue required for Buck to break even on a cash basis? Assume that 25% of
Buck’s fixed costs represent non-cash items such as depreciation. All other expenses are paid in
cash and all revenues are received in cash.
Balakrishnan/Managerial Accounting, 2e

10. The Doggy Palace is an upscale grooming salon for dogs. Doggy Palace sells two types of doggy
shampoo. Shiny Coat sells for $20 per bottle and Flea-B-Gone sells for $10 per bottle. Fixed costs
total $20,000. Additional cost data is as follows:

Shiny Coat Flea-B-Gone

Price per bottle $20 $10
Unit variable cost $10 $ 5
Unit contribution margin $10 5
Sales volume 1,600 3,200

Required:
d. How many bottles of Shiny Coat and Flea-B-Gone must The Doggy Palace sell in a year to break
even?

e. At the current product mix, how many bottles of Shiny Coat and Flea-B-Gone must The Doggy
Palace sell in a year in order to earn a profit of $25,000?
 Accounting: Information for Decision Making

11. The CVP relation captures how revenues, costs, and profit vary as the volume of business varies. It is
important to understand the assumptions underlying CVP analysis and the extent to which they are
likely to be valid.

Required:
Identify the following statements regarding the assumptions underlying CVP analysis that are valid.
Place an “X” in the appropriate response column.

Valid Invalid Statement

CVP analysis assumes a known and constant product mix.
CVP is a tool that helps managers improve profit by answering “what if”
questions.
CVP analysis assumes that unit variable cost changes proportionally as
volume changes.
Companies generally base assumptions about product mix on a history of
past sales data and from the marketing department.
CVP analysis assumes that all revenues and costs occur in a single period.
Managers evaluate alternative product-mix assumptions to assess their
confidence in estimated profit as change in product mix can significantly
affect profit.
CVP analysis assumes that total sales remain constant from period to
period.
CVP analysis is not well suited for a setting in which available capacity is not
sufficient to meet all demand, meaning that companies have to decide
which products to cut back on.
CVP analysis takes into account the time value of money.
Managers can predict with relative certainty when machines will break
down.
Balakrishnan/Managerial Accounting, 2e

Problem Solutions

6. Contribution Margin, Unit level costs (LO1)

a. Breakeven units:
Total fixed costs = (4,000 x $25) + (4,000 x $125) = $600,000
Unit contribution margin = $800 - $300 - $20 = $480

Breakeven = $600,000 ÷ $480 = 1,250 units

b. Breakeven revenue
Breakeven units x selling price
1,250 x $800 = $1,000,000

7. CVP Relation and solving for unknown (LO1, LO2)

a. Breakeven revenue:
(Revenue - .2 Revenue) - $4,500 Fixed Cost = 0
.8 Revenue = $4,500
Revenue = $4,500 ÷.8
Revenue = $5,625

b. Profit
(Revenue - .2 Revenue) - $4,500 Fixed Cost = $3,000 Profit
.8 Revenue = $4,500 + $3,000
Revenue = $7,500 ÷.8
Revenue = $9,375

c. Breakeven revenue:
(Revenue - .28 Revenue) - $4,500 Fixed Cost = 0
.72 Revenue = $4,500
Revenue = $4,500 ÷.72
Revenue = $6,250
 Accounting: Information for Decision Making

8. CVP Relation, Inferring Cost Structure, Extension to Decision Making (LO2, LO3)

a. Unit Variable Cost = $7.20

Unit variable cost = $18 (selling price) – (.60 x $18)
Unit variable cost = $18 - $10.80
Unit variable cost = $7.20

b. Fixed cost = $54,000

$18(5,000) =($7.20 x 5,000) – FC
FC = $90,000 – 36,000
FC = $54,000

c. Breakeven units = 6,923

$15x - $7.20x - $54,000 = 0
$7.80x = $54,000
x = 6,923

9. CVP Relation and Decision Making, margin of Safety, Operating Leverage, Cash-Basis Breakeven
Analysis (LO 3, LO4)

a. Margin of Safety = 10.33%:

At Current Breakeven
Level Level
Revenue $150,000 $134,500
Variable Costs (40%) 60,000 53,800
Contribution Margin (60%) 90,000 80,700
Fixed Cost 80,700 80,700
Profit $ 9,300 $ 0

Margin of Safety: ($150,000 - $134,000) ÷$150,000 = 10.33%

b. Operating Leverage = 57.36%

Fixed Costs ÷ Total Costs
$80,700 ÷ ($80,700 + $60,000) = 57.36%

c. Cash-Basis Breakeven = $100,875

Fixed Costs Contribution margin%
$60,525 ÷ 60% = $100,875
Balakrishnan/Managerial Accounting, 2e

10. Multiple Products (LO5)

a.
Shiny Coat Flea-B-Gone Total
Price per bottle $20 $10 $30
Unit variable cost $10 $ 5 $15
Unit contribution margin $10 5 $15
Sales volume 1,600 3,200

Weighted average contribution = (1/3 x $10) + (2/3 x $5) = $6.667

Break even = $6.667x + $20,000
$20,000/$6.667 = 3,000 units

1,600 units 1/3

3,200 units 2/3
4,800 units

3,000 units x 1/3 = 1,000 units of Shiny Coat

3,000 units x 2/3 = 2,000 units of Flea-B-Gone

b. ($20,000 + $25,000) ÷ $6.667 = 6,750 units

6,750 units x 1/3 = 2,500 units of Shiny Coat

6,750 units x 2/3 = 4,500 units of Flea-B-Gone
 Accounting: Information for Decision Making

11. CVP Assumptions (LO6)

Valid Invalid Statement

x CVP analysis assumes a known and constant product mix.
x CVP is a tool that helps managers improve profit by answering “what if”
questions.
X CVP analysis assumes that unit variable cost changes proportionally as
volume changes.
CVP analysis assumes that unit variable cost is constant and does not
vary with sales volume.
x Companies generally base assumptions about product mix on a history of
past sales data and from the marketing department.
x CVP analysis assumes that all revenues and costs occur in a single period.
x Managers evaluate alternative product-mix assumptions to assess their
confidence in estimated profit as change in product mix can significantly
affect profit.
X CVP analysis assumes that total sales remain constant from period to
period.
CVP analysis assumes that the selling price per unit is constant does not
vary with sales volume.
x CVP analysis is not well suited for a setting in which available capacity is not
sufficient to meet all demand, meaning that companies have to decide
which products to cut back on.
X CVP analysis takes into account the time value of money.
CVP analysis does not take into account the time value of money.
X Managers can predict with relative certainty when machines will break
down.
Managers cannot be sure when a machine a machine will break down.
Balakrishnan/Managerial Accounting, 2e

CHAPTER 6
DECISION MAKING IN THE SHORT TERM
Problems

1.Robin offers Christmas tree decorating services six days per week during late November and
December. She charges $50 per live tree regardless of the size of the tree. Robin’s clients provide
all the decorations. Her variable cost, solution to keep the tree fresh, is $10 per tree and the fixed
costs per month total $100. Robin has had more calls by the end of October than she had expected
and is considering hiring a helper. She will pay the helper $8 per hour. Robin estimates that she can
decorate 8 trees in a 10-hour day (before hiring a helper) during the holiday season (25 days.)

Required:
c. Does Robin’s decision deal with excess supply or excess demand?

d. If Robin decides not to hire a helper, list three alternatives she should consider.

e. List three long-term effects of Robin’s decision alternative courses of action..

 Accounting: Information for Decision Making

2. Trisha Hardin owns Ice Flavors, a small business selling fruit-flavored slush drinks. Each drink sells
for $2.50. Trisha derived her price as follows:

Drink mixture and crushed ice $0.60

Labor per drink ($8 per hour ÷ 20 drinks per $0.40
hour)
Variable overhead per drink (cups, etc) $0.35
Fixed overhead per drink $0.40
Total cost per drink $1.75

Trisha is considering a special order for a sale of 100 drinks for a local birthday party. The
hostess is willing to pay $1.50 per drink. The party will be in the evening, which is not during
Trisha’s regular business hours. Trisha will provide the drink mixture, ice and labor. Her only
additional expense will be one employee for two hours ($8 per hour), travel to and from the
party location (estimated to be $15). Since the party is not at Trisha’s business, Her fixed
overhead will not change. The party hostess will furnish all cups, napkins and other variable cost
items.

Required:
d. What is the incremental cost associated with accepting the special order?

e. List the costs that are not relevant to the decision.

f. Should Trisha accept the special order? Why?

Balakrishnan/Managerial Accounting, 2e

3.Outdoor Flames manufactures 5,000 outdoor gas fireplaces each period. The company has been
manufacturing the ignition system for the fireplaces. The unit cost of each ignition is as follows:

Direct Material $12

Direct Labor 5
Variable manufacturing overhead 2
Fixed manufacturing overhead 14
Unit product cost $33

A local supplier has offered to sell the company the ignition system for $30 each. If the ignition
systems are purchased from the outside supplier, the facilities now being used to make them
can be used to make other units of a product that is in high demand. The additional
contribution margin on the other unit would be $42,000 per year. If the ignition systems are
purchased from an outside supplier, all the direct labor would be avoided, but $8 of the fixed
cost would continue and be applied to the remaining products even if the part is purchased.

Required:
a. How much of the unit product cost of $33 is relevant to the decision to make or buy the
ignition systems?

b. What is the net total dollar advantage or disadvantage of purchasing the ignition systems
rather than making them?

c. List three qualitative characteristics that the owner of Outdoor Flames should consider in
looking at the long-term effect of purchasing the ignition systems.
 Accounting: Information for Decision Making

4. The Gant Company produces three items in its manufacturing plant. The plant has a total
capacity of 9,600 minutes per month for production. The following information is provided for
the products:
Products
X Y Z
Direct material $16 $10 $14
Direct labor (all variable) 15 14 15
Variable overhead 2 3 4
Fixed overhead 20 23 30
Unit cost $53 $50 $63

Minutes required per unit 5 4 6

Selling price per unit $70 $65 $80
Variable selling expense per unit $5 $4 $2
Monthly demand in units 2,200 1,000 800

Required:
a. How many minutes would be required to meet the demand for all three products?

b. How many units of each product should Gant product to maximize profit? Show your
calculations.
Balakrishnan/Managerial Accounting, 2e

5. Hermitage Farms produces two products, X and Y, in a joint process. The products may each be
sold at the split-off point or processed further. The selling price $1.10 for X and $0.80 for Y if the
products are sold without further processing. Data for the two products, if processed further, is
presented below:

Product X Product Y Total

Sales volume 28,000 units 16,000 units
Revenues $42,000 $18,400 $60,400
Traceable processing cost 12,000 5,000 17,000
Segment Margin $30,000 $13,400 $43,400
Joint costs $35,000
Profit before Taxes $6,000

Required: What is the monetary advantage (disadvantage) of further processing the products?
Show calculations.

6. Creative Lawn Ornaments sells three categories of lawn structures: Fountains, Bird and Butterfly
Houses, and Obelisks. For the current year, Creative reported the following results:

Fountains Houses Obelisks Total

Revenue $175,000 $145,000 $95,000 $415,000
Variable costs 85,000 43,000 45,000 173,000
Contribution margin $ 90,000 $102,000 $50,000 $242,000
Traceable fixed costs 30,000 33,000 30,000 93,000
Common fixed costs 35,000 35,000 35,000 105,000
Profit $ 25,000 $ 34,000 ($15,000) $ 44,000

Creative’s owner is pleased with the overall profit, but is concerned about the loss on the
Obelisks line and is considering eliminating it. The owner believes that if the Obelisk sales are
discontinued he will be able to display more Fountains and increase the revenues by 5% without
increasing any fixed costs. If the Obelisk line is discontinued, all of its traceable fixed costs will
be avoided, but its common fixed costs will be allocated to the Fountains.

Required:
Evaluate whether Creative Lawn Ornaments should discontinue its line of Obelisk structures.
Show all calculations.
 Accounting: Information for Decision Making

Solutions to Problems

1.Short-term decision (LO1)

a. Robin’s decision deals with excess demand.

b. Answers may vary. Some alternative courses of action include:

 Instead of hiring a helper, work longer hours.
 Instead of hiring a helper, extend business from six days to seven days per week.
 Increase the price per tree, and thereby, reduce the number of clients.
 Limit the size of tree, thereby being able to complete more trees in the same amount of
time.
 Instead of hiring a helper paid per hour, outsource some work for a fixed fee per tree.
 Begin decorating a few days earlier in November.

c. Answers may vary. Some long-term effects include:

 If Robin increases the price per tree, in the long-run she may lose clients.
 By hiring a helper and accepting additional clients, in the long run Robin may have to
consider hiring additional employees.
 If Robin increases business and hires helpers, in the long-run she may wish to offer
additional services such as decorating mantels, doorways, dining rooms, etc.
 With increased business, Robin should consider the long-term effect on her health.
 With increased business, Robin should consider the long-term effect on her personal
and family obligations.
Balakrishnan/Managerial Accounting, 2e

2. Special Order (LO2)

A. Incremental cost associated with accepting the order:
Accept Order Reject Order
Revenue $150 $0
Drink mix and ice $ 60 $0
Labor ($8 per hr x 2 hrs) $ 16 $0
Transportation $ 15 $0

Total Incremental costs: $60 + $16 + $15 = $91

B. Non-relevant costs:
Fixed overhead $0.40 per drink
Variable overhead $0.35 per drink

C. Trisha should accept the order:

Incremental Revenue $150
Incremental Costs $ 91
Incremental profit $ 59

Because Trisha’s incremental revenue exceeds her incremental costs and she has the
capacity to accept the order (it does not interfere with regular business), it would be
profitable to accept the special order.

3. Make or buy decision (LO2, LO3, LO5))

A. Relevant unit product cost:

$12 + $5 + $2 + $6 = $25

B. Net total dollar advantage (disadvantage) of purchasing:

Relevant cost $125,000

Additional contribution margin 42,000
Cost of purchasing (150,000)
Net advantage $17,000

C. Qualitative considerations:
 Will the supplier continue to sell the ignition systems at the $30 price?
 Over the long run, will the company be able to absorb all the employees from the
ignition system into other areas of the company?
 What are the alternatives if the purchased ignition systems turn out to be a lower
quality than expected?
 Does the high-demand item expected to use the space formerly used for making the
ignition systems have a long-range high demand?
 Accounting: Information for Decision Making

4. Best use of resources in short supply( LO4)

A. Total minutes required to meet demand:

(2,200 units x 5 minutes) + (1,000 x 4 minutes) + (800 x 6 minutes) = 16,600 minutes

B. Production to maximize profit:

Products
X Y Z
Selling price per unit $70 $65 $80

Direct material $16 $10 $14

Direct labor (all variable) 15 14 15
Variable overhead 2 3 4
Variable selling expense per unit 5 4 2
Total variable cost $38 $31 $35

Contribution margin per unit $32 $34 $45

Minutes required per unit 5 4 6
Contribution margin per minute $160 $136 $270

Gant should produce the following units to maximize profit:

Optimal Units Minutes Used Available Minutes
9,600
Product Z 800 units @ 6 minutes 4,800 4,800
Product X 1,000 units @4 minutes 4,000 800
Product Y 160units @ 5 minutes 800 -0-

5. Joint costs (Appendix A)

Product X Product Y Total

Process Further:
Sales volume 28,000 units 16,000 units
Revenues $42,000 $18,400 $60,400
Traceable processing cost 12,000 5,000 17,000
Segment Margin $30,000 $13,400 $43,400

Sell at Split-Off
Revenue $30,800 $12,800 $43,600
Traceable processing costs 0 0 0
Segment Margin $30,800 $12,800 $43,600

a. The disadvantage of processing Product X further is $800.

($30,000 - $30,800)

b. The advantage of processing Product Y further is $600.

($13,400 - $12,800)
Balakrishnan/Managerial Accounting, 2e

6. Dropping product line (Appendix B

Fountains Houses Obelisks Total

Revenue $175,000 $145,000 $95,000 $415,000
Variable costs 85,000 43,000 45,000 173,000
Contribution margin $90,000 $102,000 $50,000 $242,000
Traceable fixed costs 30,000 33,000 30,000 93,000
Segment Profit $ 60,000 $ 69,000 $20,000 $149,000
Increased revenue if
Obelisk

Continue Discontinue
Fountain Obelisk Total Fountain Obelisk Total
Revenue $175,000 $95,000 $270,000 $183,750 0 $183,750
Variable costs 85,000 45,000 130,000 89,250 0 89,250
Traceable fixed costs 30,000 30,000 60,000 30,000 0 30,000
Common fixed costs 35,000 35,000 70,000 70,000 0 70,000
Net Income $ 25,000 ($15,000) $ 10,000 ($5,500) 0 ($5,500)

Creative’s owner should not discontinue its Obelisk line of products. The increase in revenue
from the additional fountain sales does not offset the portion of common fixed costs that the
Obelisk absorbs.