Short Term Decisions

Medium Practice Test

Introduction to Accounting

Things You Must Know

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Practice As You Learn

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Self Test

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Easy Practice Test

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Medium Practice Test

Medium Practice Test

Click the “Check Your Answer” box below each question to reveal the correct answer and explanation.

1. A valid reason for eliminating a product line is

a. the product line has a negative contribution margin
b. traceable/direct fixed costs are less than the contribution margin
c. allocated fixed costs are more than contribution margin
d. none of the above
Answer
A. A negative contribution margin means that the product line has nothing to contribute to the overall profitability of the company. When the company has a positive contribution margin, this can be used to cover shared costs and increase the overall profitability of the company, even in the situation of c. Situation b. means the product line is profitable when analyzed separately, allowing the product line to increase the overall profitability of the company.

2. A cost that is relevant to a particular decision must

a. be different for each alternative
b. be a cost that will occur in the future
c. be a sunk cost
d. both a. and b.
Answer
D. Relevant costs differ among decision and occur in the future. Sunk costs are the same among decisions and are never relevant. Past costs are never relevant as they won’t change based on a decision that is made.

3. A cost which will be the same under different alternatives is

a. relevant only for the best alternative
b. relevant for all alternatives
c. irrelevant for all alternatives
d. an opportunity costs
Answer
C. Irrelevant costs will be the same regardless of the decision that is made. Relevant costs differ with alternative decisions. Opportunity costs are always relevant because they are different for alternatives.

4. When determining whether to make or buy, which of the following qualitative factors should you consider most?

a. the quality of the suppliers product
b. the quantity of sales
c. the price of your product to your customers
d. the amount of additional profit made on your product
Answer
A. The sales quantity and price of the product will not change just because you buy a part of the product from outside the company. Since they will not change, they are not relevant and should not be considered. The quality is important because the quality of the part purchased should be at least equal to the quality of the part when you make it yourself or sales may be impacted. Profitability should increase if you decide to buy because the costs will be less. How much it increases should not be a major factor in the decision, the key is that it increases.

5. A company operating at full capacity should price a special order to cover

a. all variable costs plus added fixed costs
b. all variable costs plus added fixed costs plus lost contribution margin from other customers that won’t be sold units because of the order
c. all variable costs plus unavoidable costs plus lost contribution margin from other customers that won’t be sold units
d. all incremental production costs
Answer
B. Full capacity means that all orders will not be able to be filled if the special order is accepted. The contribution margin on the lost orders must be considered along with the incremental profit directly related to the special order. Unavoidable costs are irrelevant and are not considered. a. and d. mean the same thing and do not include the lost contribution margin that must be considered when operating at capacity.

6. When deciding whether or not to replace a machine, the current book value of the old machine is considered a

a. sunk cost
b. relevant cost
c. avoidable costs
d. opportunity cost
Answer
A. This cost will not change regardless of the decision because it occurred in the past and is not a future cost. It is irrelevant and unavoidable. Opportunity costs are not actually incurred and the cost of the old machine was incurred, so it is not an opportunity cost.

7. When deciding whether to add a product line, you should base your decision on

a. total contribution margin of the product line only
b. total operating income of the product line
c. total contribution margin from the product line less allocated fixed costs
d. total contribution margin from the product line less direct fixed costs
Answer
D. The goal of adding a product line is to add incremental profits to the total company. When d. is positive, profits will be added to the total company that will be available to cover shared costs. Allocated costs are irrelevant and should not be part of the decision. Total operating income can be negative due to allocated shared costs and still provide profits to cover the shared allocated costs of the company. You must also consider any added direct fixed costs (a.)

8. Sales revenue given up by processing further rather than selling at the split off point is

a. a sunk revenue
b. an irrelevant incremental revenue
c. an avoidable revenue
d. an opportunity cost
Answer
D. An opportunity cost is something that is given up because you chose another alternative. In this case, the alternative chosen is to process further. This is a good decision for the company if profits are greater from processing further.

9. Which of the following cost characteristics is most relevant to decision making?

a. fixed or variable
b. product or period
c. avoidable or unavoidable
d. direct or indirect
Answer
C. Relevant means it will differ among decisions. Avoidable will differ and is always relevant while unavoidable will not differ and is always irrelevant. All other choices can be either relevant or irrelevant to a decision depending on the decision and the classification is not important to deciding if a cost is relevant or not.

10. A company with constrained resources

a. should reduce production on all units equally so they do not run out of the constrained resource
b. should produce more of the units with the highest total contribution margin per unit using all of the constrained resource
c. should produce more of the units which give the highest operating income before considering unavoidable direct fixed costs
d. should produce more of the units which give the highest contribution margin per unit of constrained resource
Answer
D. The company should make the products that give them the most profit from the constrained resource that is used. Using the resource will limit the quantity of other products that can be produced. Producing the higher contribution margin per unit product may use too much of the constrained resource and reduce the total profits of the company.
11. A company manufactures several product lines. Financial results for the period related to one product line is as follows: Products are sold for $20 each and total sales for the period were $200,000. Variable production costs were $7.50 per unit, product line management costs were $42,000, product line machine related items cost $27,000, other allocated fixed M O/H costs were $65,000, product line advertising costs were $21,000, product line sales commission expense was 10% of sales, and allocated administrative expenses were $60,000.

 

The company expects sales will not increase and is attempting to determine if the product line should be discontinued. Do the analysis to help the company make the decision and determine the impact to total company operating income if the product line is discontinued.

Answer

Determine how many units were sold:
$200,000 / $20 each = 10,000 units 

Determine total variable costs:
Production costs $7.50 x 10,000 = $75,000

   Commission $2.00 x 10,000 = $20,000

 
Sales $200,000
– Variable Costs:
Production costs 75,000
Sales commission 20,000
– Fixed costs avoided if discontinued
Management 42,000
Machine related 27,000
Advertising 21,000
Product line contribution $15,000

Do not drop because the Company will lose contribution margin.

Allocated costs will not change for the total company and are ignored.

12. A manufacturing company makes one of the major components used in its products. Annual production of the component is 25,000 units. Annual production cost are as follows

Direct materials
$500,000
Direct labor
$320,000
Variable manufacturing overhead
$40,000
Fixed ovehead
$180,000

The company has received a proposal from an outside supplier to supply 20,000 units of the component made for a cost of $38 per unit. The company can rent part of the facility the component is currently being manufactured in for $84,000 annually and 25% of the fixed overhead costs would no longer be incurred if the component was purchased.

A. Determine if the company should make or buy the component?

B. What is the maximum price the company should be willing to pay the supplier?

Answer

You must first determine the production variable cost per unit:

Total variable costs (500 + 320 + 40) = $860,000 / 25,000 = $34.40

 

Then use the common format for your analysis:

$34.40			$38.00
x 20,000		    x 20,000
$688,000		    $760,000
+ 84,000		 
  45,000 
$817,000		    $760,000

The company will increase total operating profit by $57,000 if they buy the component from the supplier.

The rent that could be earned is an opportunity cost and is relevant.
All variable production costs are relevant
Only avoidable fixed costs are relevant

Make sure you use the 20,000 the supplier can provide and not the 25,000 currently produced in your analysis. The company will still have to make 5,000 units to meet their need.

B. $817,000 current cost / 20,000 purchased = $40.85, the maximum cost the company should be willing to pay the supplier for the component.

13. A manufacturing company makes 2 products, product J and product M in a joint process. At the split off point, 50,000 units of J and 20,000 units of M are produced. Joint production costs are $300,000.

 

Product J and M can be sold at the split off point for $5 and $8 respectively and if processed further, J and M can be sold for $7 and $12 respectively. Additional processing costs for J are $2.50 and for M are $3.75. Additional advertising costs for M if processed further are $0.30 per unit. Total fixed costs for J and M are $1.20 per unit and $3.50 respectively. Allocated joint costs are $100,000 to J and $200,000 to M.

Determine if product J and product M should be sold at split off or processed further.

Answer

Use only relevant information.

 
Product
Use the common format:
J
M
Final Sales $ after further processing
$7
$12
Less Sales $ at the split-off point
$5
$8
Incremental Revenue from further processing
$2
$4
Less Cost of further processing
$2.50
$4.05
Profit or Loss from further processing
($0.50)
($0.05)

Both products should be sold at split off. Processing further will reduce profits.

Only incremental revenues and incremental costs are relevant.
Further processing costs and additional advertising costs are incremental costs.

Joint costs are not relevant as this will not change by a decision to process further.
Total fixed costs should be ignored. You do not know what part occurred in joint production and what part is related to further processing it is not usable information.

14. A company manufactures one product line. Financial results related to this product follows:

Sales ($20 each) $1,600,000
Less costs:
Variable production costs
$320,000
Product management
$102,000
Product machine related
$77,000
Other allocated fixed M O/H
$228,000
Product advertising – fixed
$81,000
Product line sales commission
paid at 10% of sales
$160,000
Administrative expenses
$460,000

The company has received a special order from a customer for 8,000 units at a price of $13 each. Special equipment costing $21,000 will have to be purchased and the normal sales commission will have to be paid. Additional packaging costs of $0.50 per unit and shipping of $4,000 will be incurred. Do the analysis and determine the impact to total company operating income if the order is accepted.

Given the company is currently producing at capacity, should the company accept the special order?

Answer

Determine the quantity of units sold $1,600,000 / $20 each = 80,000

Calculate the total variable cost per unit:

$320,000 + $160,000 = $480,000 / 80,000 units = $6 per unit variable cost production + selling

Sales $ per unit $13.00
– Variable cost per unit $ 6.50
= CM per unit $ 6.50
x Total units 8,000
= Total contribution margin $52,000
– Additional total fixed costs $25,000 (21,000+4,000)
= Added from special order $27,000

The company is currently at capacity, so the lost contribution margin from sales that won’t occur from regular customers must be considered.

Sales $ per unit $20
– variable cost per unit $ 6
= CM per unit $14
x total units 8,000
= total lost contribution margin $112,000

 

Total gained from special order $ 27,000
Lost CM on lost regular sales ($112,000)
Lost if special order is accepted ($ 85,000)

Do not accept this order because company total profitability will be $85,000 lower.

Ignore all current fixed costs as they will not change and are not relevant.

15. The most recent operating and cost information for a company that operates 3 convenient stores follows:

 
Store 1
Store 2
Store 3
Sales
$320,000
$220,000
$290,000
Variable expenses
$120,000
$82,000
$108,000
Direct/avoidable fixed costs
$66,000
$29,000
$39,000
Allocated fixed admin. costs
$82,000
$55,000
$52,000
Direct fixed sales costs
$32,000
$15,000
$25,000
Allocated sales costs
$50,000
$25,000
$42,000

The company has noted that store 1 is not profitable given all costs associated with the store. Determine the impact to total company profits if Store 1 is closed.

Answer
Contribution Margin lost if discontinued ($200,000)    (S – VC)
– Fixed costs avoided if discontinued $98,000    direct/avoidable
Lost operating income if discontinued ($102,000)

Only variable, direct and avoidable fixed costs are relevant and should be included. Allocated costs are not relevant since they will not change in total for the company.

Store 1 is not currently profitable considering all costs assigned to it, however, the $200,000 contribution margin is necessary to help cover other costs of the company that are shared by all stores.

If Store 1 is closed, total company profits would drop by $102,000. Do not close the store.