Short Term Decisions
Practice As You Learn
Do the following when making a short-term decision:
1) Identify irrelevant costs and ignore them
2) Identify relevant costs and use them in the analysis
3) Memorize and use the format that is common for the type of analysis required
Answer – Practice as You Learn – Problem 1. Special Order
A manufacturing company produces a single product. They have the capacity to produce 100,000 units and are currently producing 70,000 units. A special order has been received for 5,000 units at a price of $8. Units are normally sold to customers for $10 per unit. When producing at 70,000 units, per unit costs are as follows:
| Per unit |
|
| Direct materials | $2 |
| Direct labor | $1 |
| Variable manufacturing overhead | $0.50 |
| Fixed manufacturing overhead | $2.50 |
| Variable selling expenses | $0.40 |
| Fixed administrative and selling | $1.50 |
For the special order, variable selling costs will not be incurred and an additional part for the machine that costs $15,000 must be purchased. The order will be shipped separately at a cost of $800.
A. Should the company accept the special order
B. Should the company accept the special order if the company had a capacity of 70,000 and are currently selling 70,000 units without the order?
Answer
A. Use the common format for special orders:
| Sales $ per unit | $8.00 |
| – Variable cost per unit | $3.50 (2+1+.50) |
| = CM per unit | $4.50 |
| x Total units | 5,000 |
| = Total contribution margin | $22,500 |
| – Additional total fixed costs | $15,800 |
| = Impact on profits | $ 6,700 Accept the order |
Current fixed costs are ignored because they are not relevant and won’t change if the special order is accepted.
Variable selling costs are not included in variable costs because they will not be incurred for the special order
B. If the company is currently at capacity, the contribution margin lost from normal orders that will not occur must be considered.
| Sales $ per unit | $10 |
| – Variable cost per unit | $3.90 (2+1+.40+.50)) |
| = CM per unit | $6.10 |
| x Total units | 5,000 |
| = Total contribution margin | $30,500 lost if accept the special order |
| Additional profits from special order | $ 6,700 |
| – Contribution margin lost if accept special order | ($30,500) |
| =Net impact of accepting the special order if at capacity | ($23,800) |
Do not accept the order if currently producing at capacity
Answer – Practice as You Learn – Problem 2. Make or Buy?
A manufacturing company currently makes a part that is part of one of its products. The costs of making the part at their factory is as follows:
| Per unit | |
| Direct materials | $2.25 |
| Direct labor | $1.10 |
| Variable manufacturing overhead | $0.50 |
| Fixed manufacturing overhead -allocated | $2.00 |
| Fixed manufacturing overhead – related to machines that make the part |
$4.25 |
| Fixed manufacturing overhead – related to the supervisor making the part |
$1.75 |
A supplier has proposed to supply the part for $10 per unit. The supervisor salary and the machine related overhead can be avoided if the part is purchased rather than made. The space that is currently used to manufacture the part can be used for warehousing and would save $10,000 paid currently for additional outside warehouse space. Currently, 15,000 parts are manufactured annually.
A. Should the company continue to make the part or purchase it from the supplier?
B. What is the maximum amount the company should be willing to pay the supplier?
Answer
A. Use the common format for analysis:
Make
$2.25
$1.10
$0.50
$3.85 per unit
x 15,000 units
$57,750
+ $10,000 opportunity costs
= $67,750
Buy:
$10.00
($4.25)
($1.75)
= $4.00
x 15,000
= $60,000
The company is $7,750 more profitable if they buy the part from the supplier
Allocated fixed costs are ignored; they are irrelevant since they will not change
B. To answer this question, determine what it costs the company to make each unit.
$67,750 / 15,000 units = $4.52 per unit
This is the maximum amount the company can pay someone else to make it and keep profits the same
Answer – Practice as You Learn – Problem 3. Process Further?
A manufacturing company produces two products from a joint process. Information relative to each product follows:
| Product X | Product Y | |
| Sales value at split-off | $50,000 | $75,000 |
| Joint process costs – allocated | $30,000 | $60,000 |
| Sales value after further processing | $60,000 | $80,000 |
| Further processing costs |
$ 6,000 |
$ 7,000 |
Should each product be sold at the split off point or processed further?
Answer
| Use the common format: | Product X | Product Y |
| Final Sales $ after further processing | $60,000 | $80,000 |
| – Sales $ at the split-off point | ($50,000) | ($75,000) |
| = Incremental Revenue from further processing | $10,000 | $ 5,000 |
| – Cost of further processing | ($6,000) | ($7,000) |
| = Profit or Loss from further processing | $4,000 | ($2,000) |
The company should process further Product X because it will bring the company more profit. Product Y should not be processed further
Joint process costs are ignored because they are irrelevant, sunk costs
Answer – Practice as You Learn – Problem 4. Constrained Resources
A manufacturing company manufactures 2 products. The company has available 10,000 labor hours per month of trained labor. Information related to the two products follows:
| Product A | Product B | |
| Sales price per unit | $10 | $14 |
| Variable manufacturing cost per unit | $ 5 | $ 8 |
| Variable sales cost per unit | $ 1 | $ 1 |
| Fixed cost per unit | $ 2 | $ 2 |
| Direct labor hours required per unit | 0.5 | 0.6 |
| Units that can be sold each month | 15,000 | 15,000 |
A. Is direct labor hours a constrained resource?
B. What is the mix of products the company should make to maximize profits?
C. What is the maximum contribution margin the company can earn given the amount of direct labor hours available?
Answer
A. To determine this, you must first determine how many direct labor hours it will take to produce the products that can be sold each month and compare this to how many direct labor hours are available.
| Product A | Product B | |
| Units | 15,000 | 15,000 |
| x Direct labor hours/unit | 0.5 | 0.6 |
| =Total hours required | 7,500 | 9,000 |
Total of 16,500 needed and only 10,000 available — constrained
B. To determine the most profitable mix, first determine the contribution margin per unit and then determine the contribution margin per constrained resource – direct labor hours.
| Product A | Product B | |
| Sales | $10 | $14 |
| – Variable costs | $ 6 | $ 9 |
| CM per unit | $ 4 | $ 5 |
| / hours required | 0.5 | 0.6 |
| = CM per hour | $8 | $8.33 |
Product B will give more contribution margin per each unit of restrained resource. The company should use 9,000 of the hours to produce 15,000 units of Product B. The other 1,000 hours should be used for Product A which will produce 2,000 units (1,000 hours / .5 hours per unit = 2,000 units)
C. The maximum contribution margin the company can achieve is calculated as follows
| Product A | Product B | |
| Units to be sold | 2,000 | 15,000 |
| x CM per unit | $ 4 | $ 5 |
| = Total CM | $8,000 + | $75,000 |
| Total CM = | $83,000 |
Answer – Practice as You Learn – Problem 5. Dropping a Product Line
A manufacturing company currently produces the following 2 product lines. The company is considering dropping Product Line B. The following information has been gathered:
| Product Line A | Product Line B | |
| Sales | $1,000,000 | $1,500,000 |
| Variable expenses | 600,000 | 900,000 |
| Fixed expenses – direct | 100,000 | 400,000 |
| Fixed expenses – allocated | 200,000 | 200,000 |
| Operating Income | 100,000 | 0 |
The company is considering dropping product line B. If product line B is dropped, the direct costs would not be incurred and the allocated costs would still be incurred by the company. Sales of product line A are expected to increase by 20% if product line B is dropped.
Should the company drop product line B?
Answer
Fixed expenses allocated are ignored because they will not change and are irrelevant
| Use the common format: | Product Line B |
| Contribution Margin lost if discontinued | ($600,000) (S – VC) |
| – Fixed costs avoided if discontinued | $400,000 Direct only |
| Lost operating income if dropped | ($200,000) |
Also consider:
Sales will increase 20% for product line A.
If sales increase 20%, contribution margin will increase 20% also
| Product Line A | |
| Sales | $1,000,000 |
| – Variable Costs | 600,000 |
| = Contribution Margin | 400,000 |
| x 20% | .20 |
| Increase in CM | $80,000 |
The company will increase CM $80,000 from product line A The company will lose operating income of $200,000 from product line B The net to the company is a loss of $120,000 operating profit
The company should not drop product line B
Answer – Practice as You Learn – Problem 6. Adding a Product Line
A manufacturing company currently manufactures only product line X. The company is considering adding product line Y. Information related to the two product lines follows:
| Line X | Line Y | |
| Sales price per unit | $10 | $14 |
| Variable manufacturing cost per unit | $ 5 | $ 6 |
| Variable sales cost per unit | $ 1 | $ 1 |
| Annual direct fixed costs | $40,000 | $50,000 |
| Annual shared administrative costs | $60,000 | $25,000 |
| Units sold each year | 30,000 | 10,000 |
Should the company add product line Y?
Answer
Use the common format for analysis:
| Contribution Margin gained if added – fixed costs added if add the product line Change in overall company operating income |
| Line Y | |
| Sales | $14 |
| – All variable costs | $ 7 |
| = CM per unit | $ 7 |
| x units | 10,000 |
| =Total CM | $70,000 |
| – Added fixed costs | ($50,000) |
| =Change in income | $20,000 |
Add product line Y
Annual shared administrative costs are ignored because the company is already incurring this shared cost and it will not change in total if the product line is added.
Shared costs will be allocated differently with some going to product line Y.