Professional Documents
Culture Documents
7.2
Fixed costs are only fixed in the short-run so any long-run decision may have differential fixed
costs. For instance, decisions affecting capacity would include differential fixed costs.
7.3
Short-term pricing decisions are based on differential costs, any price higher than differential costs
will increase profits even if it is lower than full cost. However, in the long-term, prices must cover
the full cost of producing the product.
7.4
No. Facility-sustaining costs are fixed in the short-term; they will be incurred regardless of
production level. Therefore, they are not differential and should not be considered in a short-term
pricing decision.
7.5
7.6
d.
7.7
b.
depreciation of buildings.
7-1
Solutions
7.8
"Setup" or "order" costs are costs incurred each time an order is placed or a production run is
made. "Carrying" costs are the costs of keeping inventory, for example, maintaining warehouse
facilities.
Costs
Total
Costs
Carrying
Costs
Order
Costs
Optimal
Order
Order Size
7.9
The costs that are relevant for make-or-buy decisions are the differential costs.
7.10
7.11
Any differential costs should be considered in the decision, including overtime, and costs of
additional shifts or other means of expanding capacity.
7.12
7.13
In the long-term full costs must be met so full-cost information is useful for decisions affecting the
long-term.
7.14
The statement is true in general short-term decisions in which there is excess capacity. However,
in any situation where the decision affects capacity, the statement would not be true.
7.15
In the short-run, sales revenues need only cover the differential costs of production and sale. So,
from a short-run perspective so long as the sale does not affect other output prices or normal sales
volume, a below cost sale may result in a net increase in income so long as the revenues cover
the differential costs. However, in the long-run all costs must be covered or management would
not reinvest in the same type of assets. If the company must continually sell below the full cost of
production then it will most likely get out of that particular business when it comes time to replace
those facilities.
7.16
Differential Costs
Solutions
7-2
Fuel
Wear and tear related to miles driven such as tires, mileage-related maintenance, lube and
oil
Parking and tolls, if any
Car wash if needed due to the trip
Risk of casualties that vary with mileage
Other costs that vary with mileage
7.17
Differential Costs
Cost of the car
Foregone interest income on funds paid for the car
Interest on debt on the car
Insurance
Maintenance that is time-related
License and taxes
These costs are different from the costs in Question 7.16. The costs in Question 7.16 are those
required to operate the car for an additional few miles. The costs that vary with the number of
cars do not vary with mileage. The costs in this question vary with the number of cars and not
with the mileage driven.
7.18
Activity-based costing may actually provide better cost information than costing systems that
allocate indirect costs based on one volume-based cost driver. Activity-based costing provides
more detailed cost data that might lead to more informed decision making regarding prices. Since
market prices are typically not available for custom orders, many companies use cost-plus pricing.
Since this company uses activity-based costing, it has the cost information necessary to use a costplus pricing approach.
7.19
In differential analysis, only alternative future cash flows are relevant for decision making. Past
costs may provide useful information, but they are essentially sunk costs and not directly relevant
to a decision.
7.20
The contribution margin per unit would be the most appropriate figure since it represents the price
minus the products variable costs. The gross margin is based on full absorption unit costs that
include allocated fixed costs, which can be misleading to the decision maker.
7-3
Solutions
7.21
Answers will vary but should include identification of differential costs. This question is directed
to having students think about the many situations in which there are make or buy decisions.
7.22
(Special order.)
Revenue.................................
Variable Costs.......................
Contribution Margin..............
Fixed Costs............................
Operating Profit.....................
Alternative
$ 41,280a
31,200c
$ 10,080
7,000
$ 3,080
Higher
Higher
Higher
Higher
Ciscos should accept the order because it will increase profits by $80 for the period.
a$41,280 = (2,000 jerseys X $20) + (80 jerseys X $16).
b$40,000 = 2,000 jerseys X $20.
c$31,200 = (2,000 jerseys + 80 jerseys)($12 + $3).
d$30,000 = 2,000 jerseys X ($12 + $3).
7.23
(Differential costs.)
Yes. Road-Runner should accept the special order. Operating profit will increase $5,400 as
shown below.
Special-Order Sales (400 X $30)......................................................
Less Variable Costs:
Manufacturing (400 X $15).........................................................
Sales Commissions (400 X $1.50)...............................................
Addition to Company Operating Profit..............................................
7.24
Solutions
a.
c.
f.
Sales commissions.
7-4
$ 12,000
$ 6,000
600
$
6,600
5,400
7.25
$40.
The highest acceptable manufacturing costs for which Donelan Products would be willing to
produce the lines is $40 per foot.
7.26
$4.80.
The highest acceptable manufacturing costs for which Irish Products would be willing to produce
the wheels is $4.80.
7.27
Status Quo
Difference
Total
$ 580
$ 230
Lower
517
212
Lower
55
572
8
212
$ 18
Lower
Lower
Squeaky should not drop the Super 6 Motel account in the short run as profits would drop by
$18,000.
7.28
7-5
Solutions
Status Quo
Difference
Total
$ 2,320
$ 920
Lower
2,068
848
Lower
200
2,268
52
848
$ 72
Lower
Lower
H & B should not drop the Hospital account in the short run as profits would drop by $72,000.
7.29
7.30
(Product choice.)
Alternative 1: Warehouse.
Solutions
7-6
Y
$ 30
(5)
$ 25
1
$ 25
Z
$ 55
(9)
$ 46
2
$ 23
Revenue...................................................
Variable Costs.........................................
Total Contribution Margin.......................
Fixed Costs.............................................
Operating Profit......................................
$
$
$
1
960,000
40,000
920,000
600,000
320,000
Alternative
2
$ 982,800
70,000
$ 912,800
600,000
$ 312,800
$
$
$
3
1,101,100
95,000
1,006,100
600,000
406,100
7.31
(Throughput contribution.)
With Option (a) the throughput contribution increases by $360 [= 24 units X ($25 selling price
$10 variable costs)] which is more than the additional cost of $100 per Saturday.
Option (b) would increase throughput contribution by $180 [= 12 units X ($25 selling price $10
variable costs)] which is less than the additional costs of $200.
Victorias should go with Option (a) which has a positive impact on contribution while Option (b)
has a negative effect on contribution.
7.32
(Throughput contribution.)
Increasing capacity to 15,000 is an increase of 1,560 units (=15,000 13,440 units with current
capacity). The throughput contribution increases by $85,800 [= 1,560 units ($120 selling price
$65 variable costs)]. This exceeds the additional cost of $60,000 per month by $25,800. Stay
Warm should pursue this option to alleviate the bottleneck because it provides a positive
contribution.
7.33
(Make or buy.)
a.
Variable Costs...................................
Buy
$ 300,000
7-7
Make
$ 250,000
=
=
Difference
$ 50,000
Solutions
Ol Salt should make the sails. The fixed costs are not relevant to this decision because they
will be incurred regardless of the decision.
b.
Variable Cost..............
Less Revenue.............
Net Effect on
Costs.....................
Buy
300,000
80,000
Make
=
Difference
250,000 = $ 50,000 Higher
-0=
80,000 Higher
220,000
250,000 = $
30,000
Lower
Yes, it would affect the recommendation in Part a. Ol Salt should buy in view of the rental
opportunity.
7.34
(Make or buy.)
Direct Material...................................................................................................
Direct Labor.......................................................................................................
Other Variable Costs...........................................................................................
Total................................................................................................................
a.
No, since the $200 price is greater than the incremental (variable) cost of $175. The fixed
costs are not differential.
b.
Yes. The $160 price is less than the incremental cost of $175.
Solutions
Variable
Cost per
100 Units
$100
50
25
$ 175
Sell
= Difference
7-8
(0.3 x 75,000 x $32 for large grade) + (0.7 x 75,000 x $16 for medium grade)
= $720,000 + $840,000 = $1,560,000
Milk
= Difference
Revenue
Less Additional
Processing Costs
70,000
70,000 higher
The company should process further. The additional $20,000 mentioned in the
exercise should either be ignored, as in the solution here, or included in both the
cheese and milk alternatives.
7.37
Manual
0.4 hr.
$10.00
$25.00a
Electric
2.5 hr.
$ 16.00
$ 6.40b
Quartz
5.0 hr.
$ 22.00
$ 4.40c
7.38
7-9
Status Quo
= Difference
Solutions
Revenue....................................
Variable Costs...........................
Contribution Margin.................
Fixed Costs...............................
Operating Profit........................
50,000a
37,000a
13,000
10,000b
3,000
$
$
$
$ 88,000
71,000
$ 17,000
15,000
$ 2,000
$ 38,000
34,000
$ 4,000
5,000
$ 1,000
Lower
Lower
Lower
Lower
Higher
Yes. Tiger Products should drop Product C because the loss of its contribution margin is lower
than the reduction in fixed costs.
aSales and variable costs of Product C are eliminated.
bTotal fixed costs reduced by $5,000.
7.39
( Inventory
management.)
Order Average Number Inventory
Size
of Units
Carrying
a
in Units
in Inventory
Costsb
Annual
Orders
40
50
60
1,250
1,000
833.33
625
500
416.67
$3,125
2,500
2,083
Order
Costsc
Total
Costs
$4,000 $7,125
5,000
7,500
6,000 8,083
( Inventory
management.)
Order Average Number Inventory
Size
of Units
Carrying
in Unitsa
in Inventory
Costsb
Annual
Orders
40
50
60
2,000
1,600
1,333
1,000
800
666.67
$4,000
3,200
2,667
Order
Costsc
$2,000 $6,000
2,500
5,700
3,000 5,667
Solutions
10A + 13B
7-10
Total
Costs
Subject to:
Units of A
4,000
3,600
3,000
a
6,000
Labor
Hours: 4A + 2B = 14,400; 4A = 14,400 2B
14,400 2B
A=
= 3,600 .5B
4
b
1,000
c
0
1,000
7,200
2,000
At (a):
At (c):
3,0004,000
At (b): Substitute the labor hours equation into the machine hours equation: A = 3,600 .5B =
6,000 1.5B.
B = 2,400
A = 3,600 .5(2,400) = 2,400.
Contribution Margin
Points (A, B)
A
B
(6,000, 0) $60,000
$0 $60,000
(2,400, 2,400)$24,000 $31,200 $55,200
(0, 7,200)
$0 $93,600 $93,600
Total
Optimal Point
The company should produce 0 units of Product A and 7,200 units of Product B.
7.42
7-11
Solutions
Beta
-0-0275 a
400 b
400
Total Contribution
Marginc
-0$ 4,250.00*
$ 3,356.25
$ 2,418.75
$ 2,100.00
*Optimal Solution.
aZ + 2B = 1,000 [Process 1 Constraint].
Z + 3B = 1,275 [Process 2 Constraint].
Solving simultaneously:
(1,000 2B) + 3B
= 1,275
B =
275.
Z + 2(275) = 1,000
Z = 450.
bZ + 3B =
B=
1,275
400.
Solving simultaneously:
Z + 3(400) = 1,275
Z =
75.
cTotal Contribution Margin = ($4.25 X Zetas) + ($5.25 X Betas).
7.43
7.44
Solutions
7-12
N= =
10, 000
= 100
100
7.45
a.
2DK o
Kc
Ko = $15
Kc = $4
D = 30,000
Q
b.
7.46
2 X $15X 30,000
= 474
$4
D
30,000
=
= 63
Q
474
Revenue.........................................
7-13
Solutions
Variable Costs................................
Contribution Margin......................
Fixed Costs....................................
Operating Profit.............................
$
$
60,000c
149,000
61,000e
88,000
$
$
69,000d
231,000
61,000e
170,000
$
$
9,000 Lower
82,000 Lower
-82,000 Lower
Radios Inc. should turn down the contract unless there are non-pecuniary benefits that will offset
the $82,000 reduction in profits.
a$209,000 = (10,000 units X $15) + (10,000 units X $3.40) + $25,000.
b$300,000 = 20,000 units X $15.
c$60,000 = (10,000 units X $3.45) + (10,000 units X $2.55).
d$69,000 = 20,000 units X $3.45.
e$61,000 = 20,000 units X ($0.85 + $2.20).
7.47
(Special order.)
The company should have accepted the special order. Profits would increase by $400,000.
Alternative
Status Quo
Difference
Order
Order Not
Incremental
Accepted
Accepted
Cash Flows
a
b
Revenues............................ $
66,500,000 $
64,000,000 $ 2,500,000 Higher
c
Variable Costs....................
40,500,000
38,400,000d
2,100,000 Higher
e
e
Fixed Costs........................
9,600,000
9,600,000
-0Operating Profit................. $
16,400,000 $
16,000,000 $
400,000 Higher
a$66,500,000 = ($400 160,000 regular sales units) + ($250 10,000 special order units).
b$64,000,000 = $400 160,000 units.
c$40,500,000 = [($160 + $80) 160,000 regular sales units] + [($160 + $50) 10,000 special order units].
d$38,400,000 = ($160 + $80) 160,000 regular sales units.
e$9,600,000 = $60 160,000 units = total fixed costs under both the alternative and the status quo.
Solutions
7-14
7.48
(Pricing decisions.)
a.
Sales Revenue....................
Less Variable Costs:
Materials.......................
Labor.............................
Variable Overhead............................
Total Variable
Cost.....................
Contribution Margin...........
Less Fixed Costs................
Operating Profit.................
Alternative
20,400
Quarts
$ 61,000a
Status Quo
20,000
Quarts
$ 60,000b
Difference
$ 1,000 Higher
20,400
10,200
20,000
10,000
400 Higher
200 Higher
5,100
5,000
100 Higher
35,700
25,300
20,000
$ 5,300
35,000
25,000
20,000
$ 5,000
700 Higher
300 Higher
0
300 Higher
a$61,000 = (20,000 quarts $3.00 per quart) + (400 quarts $2.50 per
quart).
b$60,000 = 20,000 quarts $3.00 per quart.
b. The lowest price for which the ice cream could be sold without reducing profits is
$1.75 per quart, which would just cover the variable costs of the ice cream.
7-15
Solutions
7.49
(Special order.)
On the basis of the data in the question, it would not pay Nancy to accept the order.
New Sales (10,000 Units $6).................................................... $
Less Standard Sales.....................................................................
Differential Revenue.....................................................................
Differential Costsa.......................................................................
Net Advantage to Special Units....................................................
60,000
12,500
$
$
47,500
49,050
(1,550)
Other factors must be considered such as the reliability of the cost estimates and the importance of
this valued customer.
aDifferential cost of the order is:
Costs Incurred to Fill Order*
Material (10,000 Units $2)......................................................................
Labor (10,000 Units $3.60).....................................................................
Special Overhead........................................................................................
$
$
$
$
$
20,000
36,000
2,000
58,000
4,000
4,500
450
8,950
49,050
*Depreciation, rent, heat, and light are not affected by the order. Power might be dependent upon
the particular requirements of the special units. It is assumed here that the same amount of
power will be used in each case.
Solutions
7-16
a.
b.
c.
(1) $0. Total fixed costs do not change as a result of the special order.
d.
e.
7.51
2.25
2.00
0.25
7-17
Solutions
Customer Z: ($.80 1,300 miles) + ($1 80 minutes) + ($10% $1,500 sales) + $500
= $1,040 + $80 + $150 + $500
= $1,770.
b. Using the sales dollars given in the problem, compute the profitability as follows:
X: $600 $410 = $190.
Y: $2,000 - $1,995 = $5.
Z: $1,500 -$1,770 = $(270).
If these customers are representative of all customers (and that is questionable), then the company has
a big problem with its shipments to foreign locations and a small problem with domestic national
shipments. Management should consider ways to manage costs (e.g., outsource shipments to Mexico or
Canada), or raise prices on unprofitable shipments or drop unprofitable product lines or some
combination of these suggestions.
Solutions
7-18
310 units
300 units
10 units
$62,000
$60,000
$2,000 higher
$36,000
$1,820 higher
Contribution margin
$24,180
$24,000
$180 higher
If both options are taken, then the company would still get the contribution margin for Option b +
the contribution from Option a for the five additional units, less the $200 cost for additional
capacity. Here are the calculations, starting with Option b:
Option b
Option a
[310 units ($200 - $122)] + {[5 units ($200 - $120)] - $200} = $24,380.
Compare this contribution to the $24,000 status quo or the $24,180 for Option b alone or the
$24,200 for Option a alone. Consequently, we recommend that the company take both Options a
and b.
7-19
Solutions
7.55
Direct Material...................................................................................................
Direct Labor.......................................................................................................
Other Variable Costs...........................................................................................
Total................................................................................................................
7.56
Solutions
Variable
Cost per
500 Units
$ 80
90
25
$ 195
a.
No, since the $200 price is greater than the incremental (variable) cost of $195.
b.
Yes. The $180 price is less than the incremental cost of $195.
c.
$195 plus the incremental cash inflow which can be generated from the alternative use of the
facilities.
7-20
a. Like many sell or process further problems in the real world, this problem is easier than it
appears if one just cuts to the chase. The costs of producing product X up to the split-off
point are sunk. The costs of producing y and z are not differential to this decision and are
therefore not relevant to the decision to sell X or process it further. If processed further,
product X would generate a contribution after split-off of $322,000 [= ($4.30 - $2.00)
140,000 pounds]. At present, product X has sales at split-off of $280,000. Processing
further increases contribution by $42,000 =($322,000 - $280,000).
b. The memo would make the points in part a above. Management should not attempt to
incorporate sunk costs into this decision or be concerned about the costs of products Y
and Z. Our recommendation to process further does assume that product X will not
cannibalize (i.e., reduce) sales of products Y and Z.
7.57
Lower
Lower
Lower
Higher
7.58
7-21
Solutions
Disagree. Assuming all expenses except depreciation are variable, the number 2 machine should
be dropped. Depreciation expense will be incurred whether or not a machine is operating, it is a
sunk cost, and so should not be considered when deciding which machines to operate. (We ignore
tax consequences in this solution.) Only variable costs requiring future cash outlays are relevant
in this decision.
CASH OUTFLOWS20X5
No. 1
Labor.............................................. $ 15,000
Materials.........................................
4,000
Maintenance....................................
500
Total............................................. $ 19,500
7.59
No. 3
$ 18,000
5,000
500
$ 23,500
No. 4
$ 21,000
2,500
400
$ 23,900
Solutions
No. 2
$ 19,000
4,500
500
$ 24,000
One
7-22
Four
Eight
Seminars
80
Participants
$
600
8,000
5,000
Seminars
144
Participants
$
600
14,400
8,800
900
$ 5,200
3,750
$ 17,350
6,600
$ 30,400
1,040
$ 6,240
3,470
$ 20,820
6,080
$ 36,480
One
Seminar
25
Participants
Revenues......................................... $ 6,240
Less:
Startup costs..............................
600
Materials....................................
2,500
Direct labor................................
1,200
Contribution Margin....................... $ 1,940
Four
Seminars
80
Participants
$ 20,820
Eight
Seminars
144
Participants
$ 36,480
One
Seminar
25
Participants
Revenues......................................... $ 6,240
Less:
Startup costs..............................
600
Materials....................................
2,500
Direct labor................................
1,200
Contribution Margin....................... $ 1,940
Four
Seminars
80
Participants
$ 20,820
Startup costs..................................
Materials.......................................
Direct labor...................................
Fixed costs (75% of direct
labor)........................................
Total costs............................
Profit margin (20% above
cost)..........................................
Bid price........................................
b.
c.
Seminar
25
Participants
$
600
2,500
1,200
600
8,000
5,000
7,220
600
8,000
5,000
7,220
600
14,400
8,800
$ 12,680
Eight
Seminars
144
Participants
$ 32,102a
600
14,400
8,800
$ 8,302
Disagree. Eight seminars provide a greater contribution to fixed costs and profits even with
the lower price.
a $32,102 = .88 x $36,480
7-23
Solutions
Alternative
Status Quo =
a
Revenue.................. $ 3,000,000
$ 3,000,000b
Variable
Costs..................
960,000c
1,200,000d
Contribution
Margin................ $ 2,040,000
$ 1,800,000
Fixed
Costs..................
1,000,000
1,300,000
Operating
Profit.................. $ 1,040,000
$
500,000
Differential
$
--
240,000
Lower
240,000
Higher
300,000
Lower
540,000
Higher
Solutions
Since the additional 1,000 hours are within the firms capacity of 6,000 hours, Columbo
Connections would want to cover its variable costs of $240 at a minimum. Therefore, the
minimum price would be slightly higher than $240.
7-24
7.61
Recommendation: Lowering prices reduces operating profit. Other factors, such as the
reduction of available capacity and the impact on market share, could also affect the decision.
3,150,000 $
1,050,000
900,000
150,000 Increase
350,000
300,000
50,000 Increase
1,750,000 $
600,000
600,000
300,000
850,000 $
300,000
-900,000 $50,000 Decrease
7-25
--
Note
Equality
Solutions
7.61 continued.
b.
Total
3,775,000
1,200,000
350,000
2,225,000
600,000
300,000
1,325,000
aGovernment revenue (500 X $300) + (1/8 X $600,000) + $50,000 = $275,000, assuming the
governments share of March fixed manufacturing costs is 12.5% (= 500 units /4,000 units).
Alternatives are to get 1/6 X $600,000 fixed manufacturing costs, which would increase revenue
from $275,000 to $300,000; or get no reimbursement for fixed manufacturing costs, which would
reduce revenue to $200,000.
The deal would be a good one if the company had no opportunity costs. The $50,000 fee and
reimbursement for (nondifferential) fixed costs would normally flow to the bottom line. But in this
case, the company gives up the contribution from 500 units to regular customers making the deal a
bad one.
Solutions
7-26
7.61 continued.
c.
d.
The manufacturing costs are sunk; therefore, any price in excess of the differential costs of
selling the hoists will add to income. In this case, those differential costs are apparently the
$100 per unit variable marketing costs, since the hoists are to be sold through regular
channels; thus, the minimum price is $100. (If the instructor wishes to reinforce the concept
of opportunity cost, the general answer to this question is that the price should exceed the
sum of 1) the differential marketing costs and 2) the potential scrap proceeds, which are an
opportunity cost of selling the hoists rather than scrapping them.)
7-27
Solutions
7.61 continued.
e.
Alternative
1,000 Units
Contracted
Total Revenue............................................. $ 3,000,000
Total Variable Manufacturing
Costs.....................................................
600,000
Total Variable Nonmanufacturing Costs................................................
280,000
Total Contribution Margin.......................... $ 2,120,000
Total Fixed Manufacturing
Costs.....................................................
420,000
Total Fixed Nonmanufacturing
Costs.....................................................
300,000
Payment to Contractor......................
X
Profit............................................ $ 1,400,000 X
$1,400,000
Status Quo
All Production
In-house
$ 3,000,000
900,000
300,000
1,800,000
600,000
300,000
-900,000
X = $900,000
X = $500,000 or $500 per unit maximum purchase price.
Therefore, a $600 purchase price is not acceptable; it would decrease income by $100,000 [=
($600 $500) X 1,000].
A shorter (but more difficult) approach uses the concept of opportunity costs:
Variable Manufacturing Cost......................................................................
Variable Nonmanufacturing Opportunity Cost
($100 $80)..........................................................................................
Fixed Manufacturing Opportunity Cost......................................................
Equivalent In-house Cost............................................................................
300
20
180*
500
Revenue............................
Var. Mfg. Costs.................
Var. Nonmfg. Costs...........
Contrib. Margin.............
Fixed Mfg. Costs..............
Fixed Nonmfg. Costs........
Payment to Contractor......
Profit.............................
Alternative
Contract 1,000 Regular Bicycles and
3,000 Regular
Produce 800 Low Impact Bicycles
Bicycles
Regular
Regular Low Impact
(In)
(Out)
Bicycles
Total
$2,000,000 $1,000,000 $960,000 $3,960,000
600,000
-560,000
1,160,000
200,000
80,000
80,000
360,000
$1,200,000 $ 920,000 $320,000 $2,440,000
600,000
300,000
-X
-X
$1,540,000 X
Status Quo
Produced
In-house
$3,000,000
900,000
300,000
$1,800,000
600,000
300,000
-$ 900,000
Maximum payment = $640,000 (= $1,540,000 $900,000). Now the proposal should be accepted at a price
of $600.
Solutions
7-28
7.62
b.
Special
Order
Sales................................. $ 7,000
Less differential
costs.............................
6,250
Decrease in contribution margin...............
3,000
2,000
1,000
250
6,250
$
$
1,500
2,000
200
150
3,850
2,400
$ 10,000
1,500
2,000
150
200
3,850
6,150
Standard
$ 10,000
Differential
$ 3,000 Lower
3,850
2,400 Higher
$ 5,400 Lower
The special order should not be accepted because the contribution margin decreases.
7-29
Solutions
7.63
Solutions
7-30
62,500
(21,000)
(16,500)
25,000
7.64
7.65
7-31
Solutions
Working this case requires knowledge of how to calculate discounted cash flows.
a.
b.
Solutions
Alternative A: It is the status quo, i.e., Liquid Chemical Co. will continue making
the containers and performing maintenance.
Alternative B: Liquid Chemical Co. will continue making the containers, but will
outsource the maintenance contracting Packages, Inc.
Alternative C: Liquid Chemical Co. will buy containers from Packages, Inc., but will
perform the maintenance.
The incremental cash flow analyses were conducted assuming a five-year time horizon.
Appendices I, II, III, and IV present the cash flow analyses for Alternatives A, B, C, and D
respectively, as well as more detailed information on the calculations. General considerations
for the incremental cash flows are provided below.
The last day of Year 0 is when the decision on the alternatives is made. It can also be
considered the first day of Year 1.
The company has an after-tax cost of capital of 10% per year and uses an income tax
rate of 40% for decisions like this.
Rent on the container department and the proportion of general administrative overhead
allocated to the container department are the same independent of the alternative.
Therefore, they are not considered in the cash flow analyses.
7-32
7.65 continued.
The table below presents the net present values for the four alternatives. Note that all net
present values are negative, so the more attractive alternative for Liquid Chemical Co. is the
one with the smallest negative value, i.e., Alternative C. It means that, considering our
assumptions and the available information regarding costs, Liquid Chemical Co. should buy
containers from Packages, Inc., and keep performing the maintenance.
Alternative A
Make
Containers;
Perform
Maintenance
NPV ($)
c.
2,735,502
Alternative B
Make
Containers;
Buy
Maintenance
3,082,945
Alternative C
Buy
Containers;
Perform
Maintenance
2,619,684
Alternative D
Buy
Containers;
Buy
Maintenance
2,712,251
Although Alternative C seems to be the more attractive, its net present value is not
significantly different from the net present values of Alternatives A and D. This situation
requires a careful examination of facts and assumptions made. A brief discussion of some
points that should be reevaluated, as well as additional information that should be taken into
account, is presented below.
Administrative Overhead: A proportion of general administrative overhead is allocated to
the container department. Is this cost proportional to the number of employees in the
container department? Apparently the answer is yes, and in this case it is not the best
estimate because it is not considering the real administrative resources consumed by the
container department.
Quality of Outsource Services: Quality issues are always important when a company is
considering outsourcing some services. In this case, it is assumed that Packages, Inc. will
perform maintenance and/or make containers with a quality at least as good as Liquid
Chemicals quality. Due to the importance of quality, Liquid Chemical Co. should carefully
evaluate Package Inc.s ability to meet quality requirements imposed by Liquid Chemical.
Container Contract Terms: Does Packages Inc. have the ability to meet Liquid Chemicals
future container needs?
Time Horizon and Inflation: Is the price locked in for five years regardless of inflation?
Employees: The effect of eliminating some employees may have a detrimental effect on the
morale of remaining employees.
7-33
Solutions
7.65 continued
Incremental Cash FlowAlternative A:
Make Containers and Perform Maintenance
0
Buy GHL
Tax Savings on
Purchase
Cash Flow on
Purchase
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Maintenance
Other Expenses
Managers Salary
Total Costs
Tax Savings
Cash Flow due
to Costs
Year of Operation
2
3
5
$ (240,000)
96,000
$ (500,000) $ (500,000)
$ (144,000)
$ (500,000) $ (500,000) $ (500,000)
(50,000)
(450,000)
(50,000)
(450,000)
(50,000)
(450,000)
(50,000)
(450,000)
(50,000)
(450,000)
(85,000)
(36,000)
(157,500)
(85,000)
(36,000)
(157,500)
(85,000)
(36,000)
(157,500)
(85,000)
(36,000)
(157,500)
(85,000)
(36,000)
(157,500)
(80,000)
(80,000)
$(1,358,500) $(1,358,500)
543,400
543,400
(80,000)
(80,000)
(80,000)
$(1,358,500) $(1,358,500) $(1,358,500)
543,400
543,400
543,400
$ (815,100) $ (815,100)
Tax Effects of
Depreciation
60,000
60,000
60,000
60,000 $
--
Tax Effects
of GHL
Costs
80,000
80,000
80,000
80,000 $
--
Total Cash
Flow
Discount Rate
Factor
PV
NPV
$ (675,100) $ (675,100)
10%
1.0000
0.9091
0.8264
$
-- $ (613,727) $ (557,934)
$(2,735,502)
Considerations:
Under this alternative, GHL consumption is 40 tons per year. At the end of Year 4 the GHL stock is zero, and a purchase of
40 tons is necessary. At that time, the price will be $6,000 per ton.
There is no cash outflow due to GHL consumption from Year 1 to Year 4, just accounting expenses because the product is
in stock. Due to these GHL expenses, there is tax savings of $80,000 per year (= 40 tons X $5,000/ton X 40%) from Year 1
to Year 4.
It uses straight-line depreciation, resulting in depreciation expense of $150,000 per year (= $1,200,000/8 years). It generates
a cash inflow of $60,000 per year (= $150,000 X 40%) from Year 1 to Year 4 because the book value of the machinery at the
beginning of Year 1 is $600,000.
Solutions
7-34
7.65 continued
Incremental Cash FlowAlternative B:
Make Containers and Buy Maintenance
0
Buy GHL
Tax Savings on
Purchase
Cash Flow on
Purchase
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Maintenance
Other Expenses
Managers Salary
Maintenance
Contract
Total Costs
Tax Savings
Cash Flow due
to Costs
Year of Operation
2
3
5
$ (120,000)
48,000
$ (450,000) $ (450,000)
$ (72,000)
$ (450,000) $ (450,000) $ (450,000)
(50,000)
(360,000)
(50,000)
(360,000)
(50,000)
(360,000)
(50,000)
(360,000)
(50,000)
(360,000)
(85,000)
(36,000)
(92,500)
(85,000)
(36,000)
(92,500)
(85,000)
(36,000)
(92,500)
(85,000)
(36,000)
(92,500)
(85,000)
(36,000)
(92,500)
(80,000)
(80,000)
(80,000)
(80,000)
(80,000)
(375,000)
(375,000)
$(1,528,500) $(1,528,500)
611,400
611,400
(375,000)
(375,000)
(375,000)
$(1,528,500) $(1,528,500) $(1,528,500)
611,400
611,400
611,400
$ (917,100) $ (917,100)
Tax Effects of
Depreciation
60,000
60,000
60,000
60,000 $
--
Tax Effects
of GHL
Costs
72,000
72,000
72,000
72,000 $
32,000
Total Cash
Flow
Discount Rate
Factor
PV
NPV
$ (785,100) $ (785,100)
10%
1.0000
0.9091
0.8264
$
-- $ (713,727) $ (648,843)
$(3,082,945)
0.7513
0.6830
0.6209
$ (589,857) $ (536,234) $ (594,284)
Under this alternative, GHL consumption is 36 tons per year (= 40 X 90%). At the end of Year 4 the GHL stock is 16 tons,
and a purchase of 20 tons is necessary. At that time, the price will be $6,000 per ton.
Due to lower GHL consumption, during Year 5 there is still an accounting expense of $80,000 (= 16 tons X $5,000/ton). It
will generate tax savings of $32,000 (= $80,000 X 40%) at Year 5.
When the department contracts external maintenance, it decreases materials costs by 10%, and reduces employee expenses
by 20%. Other expenses total $92,500.
7-35
Solutions
7.65 continued
Incremental Cash FlowAlternative C:
Buy Containers and Perform Maintenance
Sell Machinery
Tax Savings on
Sale
Cash Flow on
Sale
Sell GHL
Tax Savings on
on Sale
Cash Flow on
Sale
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Severance Pay
Other Expenses
Managers Salary
Container Contract
Total Costs
Tax Savings
Cash Flow due
to Costs
0
200,000
Year of Operation
2
3
160,000
$
$
360,000
560,000
56,000
616,000
$ (50,000) $
(50,000)
(50,000)
(90,000)
(85,000)
-(65,000)
(16,000)
(50,000) $
(50,000) $
(50,000)
(50,000)
(90,000)
(50,000)
(90,000)
(50,000)
(90,000)
(50,000)
(90,000)
(85,000)
-(65,000)
(85,000)
-(65,000)
(85,000)
-(65,000)
(85,000)
-(65,000)
--
--
--
--
--
(1,250,000) (1,250,000)
(16,000) $(1,590,000) $(1,590,000)
6,400
636,000
636,000
Tax Effects of
Depreciation
--
--
--
-- $
--
Tax Effects
of GHL
Costs
8,000
8,000
8,000
8,000 $
8,000
Total Cash
Flow
Discount Rate
Factor
PV
NPV
Solutions
7-36
7.65 continued
Considerations:
Under this alternative, GHL consumption is 4 tons per year (40 X 10%), or 20 tons over five years.
Therefore, Liquid Chemical can sell 140 tons (= 160 20) at the end of Year 0 at $4,000 per ton.
Market Price =
$560,000
Loss on Sale =
$ 140,000
Book Value =
$700,000
Tax Savings on Sale =
$ 56,000
Machinery is not necessary for maintenance, and can also be sold at the end of Year 0.
Market Price =
$200,000
Loss on Sale =
$ 400,000
Book Value =
$600,000
Tax Savings on Sale =
$ 160,000
When the department performs maintenance and buys containers, it decreased materials costs by 90%,
and reduces employees by 80%. Other expenses total $65,000.
In this case, there is a severance pay of $16,000 (= $20,000 X 0.8). The supervisor is still necessary, but
Mr. Duffy can be transferred to another department.
Tax effects on GHL consumption are computed based on an expense of $20,000 per year (= 4 tons X
$5,000/ton). It results in savings of $8,000 per year (= $20,000 X 40%).
7-37
Solutions
7.65 continued
Incremental Cash FlowAlternative D:
Buy Containers and Buy Maintenance
Sell Machinery
Tax Savings on
Sale
Cash Flow on
Sale
Sell GHL
Tax Savings on
on Sale
Cash Flow on
Sale
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Severance Pay
Pension
Other Expenses
Managers Salary
Container Contract
Maintenance
Contract
Total Costs
Tax Savings
Cash Flow due
to Costs
0
200,000
Year of Operation
2
3
160,000
$
$
360,000
640,000
64,000
704,000
$
--
--
--$
---
--(30,000)
--
(20,000)
--(30,000)
--
--
(1,250,000)
---
--(30,000)
--
--
--
--
---
---
--(30,000)
--
--
(1,250,000)
-- $
--
(1,250,000)
(1,250,000)
--(30,000)
--(1,250,000)
(375,000)
(375,000)
(20,000) $(1,655,000) $(1,655,000)
8,000
662,000
662,000
(375,000)
(375,000)
(375,000)
$(1,655,000) $(1,655,000) $(1,655,000)
662,000
662,000
662,000
Tax Effects of
Depreciation
--
--
--
-- $
--
Tax Effects
of GHL
Costs
--
--
--
-- $
--
Total Cash
Flow
Discount Rate
Factor
PV
NPV
Solutions
7-38
Under this alternative, there is no GHL consumption. Therefore, Liquid Chemical can sell 160 tons at the
end of Year 0 at $4,000 per ton.
Market Price = $640,000
Loss on Sale =
$160,000
Book Value = $800,000
Tax Savings on Sale = $ 64,000
Machinery is not necessary for maintenance, and can also be sold at the end of Year 0.
Market Price = $200,000
Loss on Sale =
$400,000
Book Value = $600,000
Tax Savings on Sale = $160,000
There is a severance pay of $20,000 at Year 0, and a pension payment of $30,000 per year from Year 1 to
Year 5.
7-39
Solutions