Stamford University Bangladesh
MBA Program, Dhanmondi Campus
Cost and Management Accounting
Course Teacher: Shahadat Hosan, E-mail:
Relevant Cost for Decision Making
Exercise-13-8:Bed and Bath, a retailing company has two departments, Hardware and Linens. A recent monthly contribution format income statement for the month follows:
Department
Total Hardware Linens
Sales $ 40,00,000 $ 30,00,000 $ 10,00,000
Variable expenses 13,00,000 9,00,000 4,00,000
Contribution margin 27,00,000 21,00,000 6,00,000
Fixed expense 22,00,000 14,00,000 8,00,000
Net operating income ( loss) 5,00,000 7,00,000 (2,00,000)
A study indicates that $ 3,40,000 of fixed expenses being charged to Linens are sunk cost or allocated costs that will continue even if the Linens Department is dropped. In addition, the elimination of the Linens Department will result in a 10% decrease in the sales of the Hardware department.
Required:Should the production and sale of the Linens Department be discontinued? Show computation to support your answer. If the Linens Department is dropped, what will be the effect of the net operating income of the company as a whole?
Solution:
Contribution margin lost if the Linen Department is dropped:
Lost from the Linen Department ...... $600,000
Lost from the Hardware Department (10% × $2,100,000) ...... 210,000
Total lost contribution margin ...... 810,000
Less fixed costs that can be avoided ($800,000 – $340,000)...... 460,000
Decrease in profits for the company as a whole ...... $350,000
The production and sale of the liens Department not be discontinued. If the liens Department is discontinued then overall profit of the company will decrease.
Exercise 13-15: Han products manufactures 30,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is as follows:
Direct materials ………………………….. $ 3.60
Direct labor………………………………... 10.00
Variable Manufacturing overhead……… 2.40
Fixed Manufacturing overhead…………. 9.00
Total cost per part $ 25.00
An outside supplier has offered to sell 30,000 units of part S-6 each year to Han Products for $ 21 per part.If Han Products accept this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $ 80,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier.
Required: Prepare computation showing how much profit will increase or decrease if the outside supplier’s offer is accepted.
Solution:
The costs that are relevant in a make-or-buy decision are those costs thatcan be avoided as a result of purchasing from the outside. The analysis forthis exercise is:
Per unit differential
cost 30,000 Units
Make Buy Make Buy
Cost of purchasing ……. $ 21.00 $ 630,000
Cost of making:
Direct materials $ 3.60 $ 108,000
Direct labor 10.00 300,000
Variable overhead 2.40 72,000
Fixed overhead 3.00 90,0000 00
Total cost $19.00 $ 21.00 $ 570,000 $ 630,000
The $80,000 rental value of the space being used to produce part S-6represents an opportunity cost of continuing to produce the part internally.Thus, the completed analysis would be:
Make Buy
Total cost, as above...... $570,000 $630,000
Rental value of the space (opportunity cost) ...... 80,000 ………...
Total cost, including opportunity cost ...... $650,000 $630,000
Net advantage in favor of buying ...... $20,000
Problem 13-21:
Birth Company normally produces and sells 30,000 units of RG-6 each month. RG-6 is a small electrical relay used as a component part in the automotive industry. The selling price is $ 22 per unit, variable costs are $ 14 per unit. Fixed manufacturing overhead costs total $ 1, 50,000 per month, and fixed selling costs total $ 30,000 per month.
Employment –contract strikes in the companies that purchase the bulk of the RG-6 units have caused Birch Company’s sales to temporarily drop to only 8,000 units per month. Birch Company estimates that the strikes will last for the two months, after which time sales of RG-6 should return to normal. Due to the current low level of sales, Birch Company is thinking about closing down its own plant during the strikes, which would reduce its fixed manufacturing overhead costs by $45,000 per month and its fixed selling costs by 10%. Start-up costs at the end of shutdown period would total $8,000. Since Birch Company uses just-in-time (JIT) production methods, no inventories are on hand.
Required:
- Assuming that the strikes continue for the two months, would you recommend that Birch Company close its own plant? Explain, show computations to support your answer.
- At what level of sales (in units) for the two-month period should Birch Company be indifferent between closing the plant or keeping it open? Show computations.
Solution:
1. Product RG-6 yields a contribution margin of $8 per unit ($22 – $14 =$8). If the plant closes, this contribution margin will be lost on the16,000 units (8,000 units per month × 2 months) that could have beensold during the two-month period. However, the company will be able toavoid certain fixed costs as a result of closing down. The analysis is:
Contribution margin lost by closing the plant for
two months ($8 per unit × 16,000 units)...... $(128,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost $45,000 per
month × 2 months = $90,000) ...... $90,000
Fixed selling costs ($30,000 per month × 10% ×
2 months) ...... 6,000 96,000
Net disadvantage of closing, before start-up costs . (32,000)
Add start-up costs ...... 8,000
Disadvantage of closing the plant ...... $ (40,000)
No, the company should not close the plant; it should continue to operateat the reduced level of 8,000 units produced and sold each month. Closing will result in a $40,000 greater loss over the two-month period than if the company continues to operate. An additional factor is the potential loss of goodwill among the customers who need the 8,000 units of RG-6 each month. By closing down, the needs of these customers will not be met (no inventories are on hand), and their business may be permanently lost to another supplier.
2. Birch Company will be indifferent at a level of 11,000 total units soldover the two-month period. The computations are:
Cost avoided by closing the plant for two months
(see above) ...... $96,000
Less start-up costs ...... 8,000
Net avoidable costs ...... $88,000
Net avoidable cost = $88,000 = 11,000 units
Per unit contribution margin $8 per unit
The End