10.2 Decision Making - Applying Marginal Analysis Flashcards
In order to avoid pitfalls in relevant-cost analysis, management should focus on
A. Variable cost item that differ for each alternative.
B. Long-run fixed costs of each alternative.
C. Anticipated fixed costs and variable costs of all alternative.
D. Anticipated revenues and costs that differ for each alternative.
D. Anticipated revenues and costs that differ for each alternative.
Gleason Co. has two products, a frozen dessert and ready-to-bake breakfast rolls, ready for introduction. However, plant capacity is limited, and only one product can be introduced at present. Therefore, Gleason has conducted a market study at a cost of $26,000, to determine which product will be more profitable.
The cost incurred by Gleason for the market study is a(n)
A. Incremental cost.
B. Prime cost.
C. Opportunity cost.
D. Sunk cost.
D. Sunk cost.
A sunk cost is a previously incurred cost that is the result of a past irrevocable management decision. Nothing can be done in the future about sunk costs. The market study cost is an example.
Gleason Co. has two products, a frozen dessert and ready-to-bake breakfast rolls, ready for introduction. However, plant capacity is limited, and only one product can be introduced at present. Therefore, Gleason has conducted a market study at a cost of $26,000, to determine which product will be more profitable.
Assuming that Gleason elects to produce the frozen dessert, the profit that would have been earned on the breakfast rolls is a(n)
A. Deferrable cost.
B. Sunk cost.
C. Avoidable cost.
D. Opportunity cost.
D. Opportunity cost.
An opportunity cost is the maximum return that could have been earned on the next best alternative use of a resource. In this case, the lost profit on the rolls is an opportunity cost.
Two months ago, a corporation purchased 4,500 pounds of Kaylene at a cost of $15,300. The market for this product has become very strong, with the price jumping to $4.05 per pound. Because of the demand, the corporation can buy or sell Kaylene at this price. The corporation recently received a special order inquiry that would require the use of 4,200 pounds of Kaylene. In deciding whether to accept the order, management must evaluate a number of decision factors. Without regard to income taxes, which one of the following factors is a relevant decision factor?
A. Purchase price of $3.40 per pound.
B. 4,500 pounds of Kaylene purchased.
C. Remaining 300 pounds of Kaylene.
D. Market price of $4.05 per pound.
D. Market price of $4.05 per pound.
The market price that the corporation must pay for Kaylene (or can sell its current stock for) is a relevant factor.
Jennilyn Jasper, whose annual salary as a flight instructor is $40,000, has just inherited $100,000 after taxes. She is considering quitting her job and opening a day-care center. Certificates of deposit at the local bank are currently paying 6%. Jennilyn estimates that she will have to pay $120,000 in salaries to employees per year, $20,000 to rent a building, $9,000 each for furniture and supplies, $80,000 for insurance, and $7,000 for utilities.
If Jennilyn’s projections are accurate and she earns $250,000 in revenue from the business, she will have incurred
A. Both an accounting profit and an economic profit.
B. An accounting profit but not an economic profit.
C. Neither an accounting nor economic profit.
D. An economic profit but not an accounting profit.
B. An accounting profit but not an economic profit.
An accounting profit is the excess of revenues over explicit costs, in this case ($250,000 revenue) - ($120,000 salaries + $20,000 rent + $9,000 furniture + $9,000 supplies + $80,000 insurance + $7,000 utilities) = $5,000. An economic profit is a significantly higher hurdle. It is not earned until the organization’s income exceeds not only costs as recorded in the accounting records, but the firm’s implicit costs as well. In this case, the most important implicit costs are Jennilyn’s forgone salary ($40,000) and the interest should could have earned by simply investing the inherence instead of plowing it into the business ($100,000 x 6%). Since the combined implicit costs of $46,000 exceed the accounting profit of $5,000, Jennilyn would incur an accounting profit but an economic loss.
Hermo Company has just completed a hydro-electric plant at a cost of $21,000,000. The plant will provide the company’s power needs for the next 20 years. Hermo will use only 60% of the power output annually. At this level of capacity, Hermo’s annual operating costs will amount to $1,800,000, of which 80% are fixed. Quigley Company currently purchases its power from MP Electric at an annual cost of $1,200,000. Hermo could supply this power, thus increasing output of the plant to 90% of capacity. This would reduce the estimated life of the plant to 14 years.
If Hermo decides to supply power to Quigley, it wants to be compensated for the decrease in the life of the plant and the appropriate variable costs. Hermo has decided that the charge for the decreased life should be based on the original cost of the plant calculated on a straight-line basis. The minimum annual amount that Hermo would charge Quigley would be
A. $990,000
B. $630,000
C. $450,000
D. Some amount other than those given.
B. $630,000
The minimum charge would include any variable costs incurred plus depreciation on a straight-line basis. Currently, variable costs are $360,000 at 60% of capacity ($1,800,000 x 20%). If Quigley purchases energy equal to an additional 30% of capacity, it can be assumed that the increase in total variable costs will be half of the variable costs for 60% of capacity, or $180,000. Also, allocating $21,000,000 over 14 years results in an annual depreciation of $1,500,000. Of this amount, 30% will relate to the capacity sold. Thus, the depreciation charge to Quigley is $450,000 ($1,500,000 x 30%). The total charge is $630,000 ($450,000 depreciation + $180,000 VC).
A corporation is considering the purchase of a new machine for $800,000. The machine is capable of producing 1.6 million units of product over its useful life. The manufacturer’s engineering specifications state that the machine-related cost of producing each unit of product should be $.50. The corporation’s total anticipated demand over the asset’s useful life is 1.2 million units. The average cost of materials and labor for each unit is $.40. In considering whether to buy the new machine, would you recommend that the corporation use the manufacturer’s engineering specification of machine-related unit production cost?
A. No, the machine-related cost of producing each unit is $.90.
B. No, the machine-related cost of producing each unit is $2.00.
C. No, the machine-related cost of producing each unit is $.67.
D. Yes, the machine-related cost of producing each unit is $.50.
C. No, the machine-related cost of producing each unit is $.67.
Dividing the cost of the machine ($800,000) by the anticipated lifetime production (1,200,000 units) results in a machine-related per-unit cost of $.67.
Hermo Company has just completed a hydro-electric plant at a cost of $21,000,000. The plant will provide the company’s power needs for the next 20 years. Hermo will use only 60% of the power output annually. At this level of capacity, Hermo’s annual operating costs will amount to $1,800,000 of which 80% are fixed. Quigley company currently purchases its power from MP Electric at an annual cost of $1,200,000. Hermo could supply this power, thus increasing output of the plant to 90% of capacity. This would reduce the estimated life of the plant to 14 years.
The maximum amount Quigley would be willing to pay Hermo annually for the power is
A. Some amount other than those given.
B. $600,000
C. $1,050,000
D. $1,200,000
D. $1,200,000
Since Quigley is currently paying $1,200,000, it would not want to pay any more for the same service.
Lazar Industries produces two products, crates and trunks. Per unit selling prices, costs, and resource utilization for these products are as follows.
Crates / Trunks
Selling price $20 / $30
Direct material costs 5 / 5
Direct labor costs 8 / 10
Variable overhead costs 3 / 5
Variable selling costs 1 / 2
Machine hours per unit 2 / 4
Production of crates and trunks involves joint processes and use of the same facilities. The total fixed factory overhead cost is $2,000,000, and total fixed selling and administrative costs are $840,000. Production and sales are scheduled for 500,000 crates and 700,000 trunks. Lazar has a normal capacity to produce a total of 2,000,000 units in any combination of crates and trunks, and it maintains no direct materials, work-in-process, or finished goods inventory.
Lazar can reduce direct material costs for crates by 50% per unit, with no change in direct labor costs. However, it would increase machine-hour production time by 1.5 hours per unit. For crates, variable overhead costs are allocated based on machine hours. What would be the effect on the total contribution margin if this change was implemented?
A. $300,000 increase
B. $125,000 increase
C. $1,250,000 increase
D. $250,000 decrease
B. $125,000 increase
Before the change, Lazar’s per-unit contribution margin on crates can be calculated as follows:
Selling price $20 - Direct materials 5 - Direct labor 8 - Variable overhead 3 - Variable S&A 1 = $3 contribution margin
If the change is made, Lazar’s direct materials cost will fall to $2.50 per unit ($5.00 x 50%). Since variable overhead is applied on the basis of machine hours, the application rate must be $1.50 per hour ($3 / 2 machine hours per unit). If the change is made, per-unit machine hours will increase to 3.5 (2 + 1.5) and per-unit variable overhead will thus increase to $5.25 ($1.50 x 3.5). Lazar’s per unit variable overhead will thus increase to $5.25 ($1.50 x 3.5). Lazar’s per-unit contribution margin on crates after the change can be calculated as follows:
Selling price $20 - Direct materials 2.50 - Direct labor 8 - Variable overhead 5.25 - Variable S&A 1 = $3.25 contribution margin.
The difference in the two per-unit amounts ($3.25 - $3.00 = $.25) multiplied by the product demand level results in an increase in total contribution margin of $125,000 (500,000 x $0.25)
In a management decision process, the cost measurement of the benefits sacrificed due to selecting an alternative use of resources is most often referred to as a(n)
A. Opportunity cost.
B. Differential cost.
C. Relevant cost.
D. Sunk cost.
A. Opportunity cost.
An opportunity cost is the cost of using a scarce resource for one purpose rather than another.
A car rental company uses a significant number of vehicles in its operations. The management has to decide if it would be more advantageous to acquire new vehicles utilizing a financial lease as opposed to ownership. Which one of the following factors would not be relevant to the decision?
A. The availability of credit to the company.
B. The operating cost of the vehicles.
C. The residual value of the vehicles.
D. The tax depreciation schedule related to the vehicles.
B. The operating cost of the vehicles.
The operating cost of the vehicles would not be a relevant consideration because that cost would be the same regardless of the decision.
A company wants to open a new store in one of two nearby shopping malls. In Mall A, the rent will be $250,000 per year. In Mall B, the rent will be 4% of gross revenues. Assuming that revenues and all other elements under consideration are the same for both malls, at what level of revenues will the company be indifferent between the two malls?
A. $1,000,000
B. $12,500,000
C. $4,000,000
D. $6,250,000
D. $6,250,000
The level of indifference is calculated by setting the equation for the first mall (a flat $250,000) equal to the equation for the second mall.
The sum of the costs necessary to effect a one-unit increase in the activity level is a(n)
A. Marginal cost.
B. Incremental cost.
C. Differential cost.
D. Opportunity cost.
A. Marginal cost.
A marginal cost is the sum of the costs necessary to effect a one-unit increase in the activity level.
An entrepreneur wants to rent store space in a new shopping mall for the 3-month holiday shopping season. The entrepreneur believes he has a new product available that has the potential for good sales. The product can be obtained on consignment at the cost of $20 per unit, and he expects to sell the item for $100 per unit. Due to other business ventures, the entrepreneur’s risk tolerance is low. He recognizes that, as the product is entirely new, there is an element of risk. The mall management has offered the entrepreneur three rental options: (1) a fixed fee of $8,000 per month, (2) a fixed fee of $3,990 per month plus 10% of the entrepreneur’s revenue, or (3) 30% of the entrepreneur’s revenues. Which one of the following actions would you recommend to the entrepreneur?
A. Choose the second option no matter what the entrepreneur expects the revenues to be.
B. Choose the second option only if the entrepreneur expects revenues to exceed $5,700.
C. Choose the first option no matter what the entrepreneur expects the revenues to be.
D. Choose the third option no matter what the entrepreneur expects the revenues to be.
D. Choose the third option no matter what the entrepreneur expects the revenues to be.
The entrepreneur recognizes that trying to sell the new product is risky. For this reason, fixed costs are to be avoided. If sales are low, relying on variable costs will keep total costs down.
An auto dealer employs 45 sales personnel to market its line of luxury automobiles. The average car sells for $23,000, and a 6% commission is paid to the salesperson. The auto dealer is considering a change to a commission arrangement that would pay each salesperson a salary of $2,000 per month plus a commission of 2% of the sales made by that salesperson. The amount of total monthly car sales at which the auto dealer would be indifferent as to which plan to select is
A. $1,250,000
B. $1,500,000
C. $2,250,000
D. $3,000,000
C. $2,250,000
Given that X equals the cars sold, the indifference equation and its solution are as follows:
($23,000 × 6%)X = ($23,000 × 2%)X + (45 × $2,000)
$920X = $90,000
X = 97.8261 cars
At a price of $23,000 each, 97.8261 cars sell for $2,250,000. Another approach is to determine the sales per person at which $2,000 is equal to a 4% commission. This amount is $50,000 ($2,000 ÷ .04) per person, or $2,250,000 (45 × $50,000) for the entire sales force.
Profits that are lost by moving an input from one use to another are referred to as
A. Out-of-pocket costs.
B. Opportunity costs.
C. Replacement costs.
D. Cannibalization charges.
B. Opportunity costs.
An opportunity cost is the cost of using a scarce resource for one purpose rather than another. The profit lost by applying a resource to a different product is one opportunity cost that must be considered.
A company plans to add a new product that would affect its indirect labor costs in two ways. First, the production manager from an existing product would serve as manager of the new product. Her current assistant manager would be promoted and assume her previous position. Second, the existing maintenance staff would provide facility and machine maintenance that would require 30 hours of labor each month, but no increase in their total weekly hours worked. The company production managers earn $60,000 annually, assistant production managers are paid $50,000 each year, and maintenance employees earn $20 per hour. No additional hiring is planned. The annual relevant indirect labor costs for adding the new product would total
A. $10,000
B. $60,600
C. $7,200
D. $67,200
A. $10,000
The only difference in pay that results from adding the new product is the newly promoted product manager’s raise of $10,000 ($60,000 manager salary - $50,000 assistant manager salary). All other costs will remain the same, regardless of whether the new product is added or not.
A company wants to open a new store in one of three nearby shopping malls. In Mall A, the rent will be $300,000 per year. In Mall B, the rent will be 4% of gross revenues. In Mall C, the rent will be $150,000 per year plus 3% of gross revenues. Assume that revenues and all other elements under consideration are the same for all three malls.
Which mall should the company choose if revenues are expected to be $6,000,000 per year?
A. Mall C.
B. The company will be indifferent between two of the choices.
C. Mall A.
D. Mall B.
D. Mall B.
The answer depends on the expected level of revenues. If the company expects revenues to be $6,000,000 per year, the calculation is as follows:
Mall A: $300,000
Mall B: $6,000,000 × 4% = $240,000
Mall C: $6,000,000 × 3% = $180,000 + $150,000 = $330,000
Thus, Mall B is preferable.
A very profitable company plans to introduce a new type of doll to its product line. The sales price and costs for the new dolls are as follows.
Selling price per doll $ 100
Variable cost per doll 60
Incremental annual fixed costs 456,000
Income tax rate 30%
If 10,000 new dolls are produced and sold, the effect on profit (loss) would be
A. $(39,200)
B. $(56,000)
C. $280,000
D. $(176,000)
The effect on net income from producing the new doll can be calculated as follows:
Sales revenue $1,000,000
Less: Variable costs (600,000)
Contribution margin $ 400,000
Less: Fixed costs (456,000)
Operating income $ (56,000)
Add: Income tax effect 16,800
Effect on net income $ (39,200)
A company produces a component that is popular in many refrigeration systems. Data on three of the five different models of this component are as follows:
Model A / B / C
Units of production 5,000 / 6,000 / 3,000
Manufacturing costs:
Variable direct costs $10 / $24 / $20
Variable overhead 5 / 10 / 15
Fixed overhead 11 / 20 / 17
Total manufacturing costs $26 / $54 / $52
Cost if purchased $21 / $42 / $39
The company applies variable overhead on the basis of machine hours at the rate of $2.50 per hour. Models A and B are manufactured in the Freezer Department, which has a capacity of 28,000 machine processing hours. Which one of the following options should be recommended to the company’s management?
A. The Freezer Department’s manufacturing plan should include 2,000 units of Model A and 6,000 units of Model B.
B. Manufacture all three products in the quantities required.
C. Purchase all three products in the quantities required.
D. The Freezer Department’s manufacturing plan should include 5,000 units of Model A and 4,500 units of Model B.
D. The Freezer Department’s manufacturing plan should include 5,000 units of Model A and 4,500 units of Model B.
The variable costs of producing all of the units of A and 4,500 units of B would be calculated as follows:
Variable costs of A: 5,000 × $15 = $ 75,000
Variable costs of B: 4,500 × $34 = 153,000
Purchase B: 1,500 × $42 = 63,000
Purchase C: 3,000 × $39 = 117,000
Total $408,000
If the company produced 2,000 units of Model A and 6,000 units of Model B, the calculations would be:
Variable costs of A: 2,000 × $15 = $ 30,000
Variable costs of B: 6,000 × $34 = 204,000
Purchase A: 3,000 × $21 = 63,000
Purchase C: 3,000 × $39 = 117,000
Total $414,000
Therefore, the first option is better than the second option.
Which of the following costs, when subtracted from accounting profit, yields economic profit?
A. Variable costs.
B. Opportunity costs of all inputs.
C. Recurring operating costs.
D. Fixed and variable costs.
B. Opportunity costs of all inputs.
Economic profit is defined as revenue minus all explicit and implicit costs. The implicit costs are generally referred to as opportunity costs. Accounting profits are calculated by deducting explicit costs from revenues. Thus, deducting implicit costs (opportunity costs) from accounting profits yields economic profit.
A restaurant chain has 30 different hamburger choices and has recently added the Come Hungry, a quadruple burger, to its menu for a 3-month trial period. The product’s partial income statement after 3 months is shown below.
Sales $ 550,000
Variable costs 375,000
Product advertising
(2/3 for product launch, 1/3 ongoing) 180,000
Allocated fixed direct restaurant costs 120,000
Profit (loss) before allocation of corporate costs $(125,000)
The effect on the company’s profit because of the addition of this new product was to
A. Increase income by $115,000.
B. Decrease income by $5,000.
C. Decrease income by $125,000.
D. Increase income by $175,000.
B. Decrease income by $5,000.
The addition of the new product will lead to the following new expenses:
Sales $ 550,000
Variable costs (375,000)
Advertising (180,000)
Total $ (5,000)
Allocated fixed costs are not included in the calculation because the fixed costs do not arise from the addition of the product. They are allocated to the new product but will be incurred regardless. Therefore, they are not a relevant cost for determining the new product’s profitability.
The definition of economic cost is
A. The difference between all implicit and explicit costs of the business firm.
B. The opportunity cost of all inputs minus the dollar cost of those inputs.
C. The sum of all explicit and implicit costs of the business firm.
D. All the dollar costs employers pay for all inputs purchased.
C. The sum of all explicit and implicit costs of the business firm.
Economic cost is defined as the sum of all costs, both implicit and explicit, of a firm. Explicit costs include direct expenditures made to those outside the firm, for example, the costs of labor, materials, and equipment. Implicit costs are the payments that would have been received if self-owned resources had been used outside the firm’s business. Thus, the lease payments forgone by not renting the firm’s building to others is an implicit cost. The return necessary to keep resources employed in a given enterprise (normal profit) is also an implicit cost.
What is the opportunity cost of making a component part in a factory given no alternative use of the capacity?
A. The total manufacturing cost of the component.
B. Zero.
C. The variable manufacturing cost of the component.
D. The total variable cost of the component.
B. Zero.
Opportunity cost is the benefit forgone by not selecting the best alternative use of scarce resources. The opportunity cost is zero when no alternative use for the production facility is available.
