Exercises. Differential Analysis Sell (Alt. 1) or Lease (Alt. 2)

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1 Chapter 24 and Product Pricing Study Guide Solutions Fill-in-the-Blank Equations 1. Differential revenue 2. Differential costs 3. Differential income (Loss) 4. Markup per unit 5. Estimated units produced and sold 6. Total selling and administrative expenses 7. Desired rate of return 8. Target cost 9. Production bottleneck hours per unit Exercises 1. Charleston Affair currently has a piece of equipment that is no longer needed. The current book value of the piece of the equipment is $12,000. The company has the option to lease the equipment for the next three years for $5,500 each year, or sell the equipment for $16,000. If leased, the equipment would have no residual value at the end of the lease. The company expects that maintenance and other expenses during the lease would total $2,000. If sold, Charleston Affair would pay a 5% commission. Prepare a differential analysis to determine if the company should sell (Alternative 1) or lease (Alternative 2) the equipment. Sell (Alt. 1) or Lease (Alt. 2) Sell (Alt. 1) Lease (Alt. 2) on Income (Alt. 2) Revenues $16,000 $16,500 $ 500 Costs (800) (2,000) (1,200) Income (loss) $15,200 $14,500 $ (700) Charleston Affair should sell the asset. 1

2 2 Chapter Wake Coffee Co. has a piece of equipment no longer needed for production. The company purchased the equipment for $75,000 and has accumulated depreciation of $10,000 related to the equipment. Wake Coffee Co. has determined it can either lease the equipment for the next ten years, for yearly revenues of $9,000, or sell the equipment for $70,000. If leased, the company expects to incur repairs and other expenses of $22,000 over the life of the lease. The equipment would also have a $3,500 salvage value. If sold, the broker requires a 4% broker commission. Prepare a differential analysis to determine if the company should sell (Alternative 1) or lease (Alternative 2) the equipment. Sell (Alt. 1) or Lease (Alt. 2) on Sell (Alt. 1) Lease (Alt. 2) Income (Alt. 2) Revenues $70,000 $ 93,500 $ 23,500 Costs (2,800) (22,000) (19,200) Income (loss) $67,200 $ 71,500 $ 4,300 Revenues if leased = $90,000 + $3,500 Wake Coffee Co. should lease the asset. 3. Blair Designs is considering two alternatives for an outdated piece of machinery: leasing the machinery for five years, which would produce revenue of $8,000 year or selling the machinery for $38,000. The asset has a current book value of $25,000. If leased, the company expects to incur $7,000 of expenses for maintenance and taxes, and the equipment will have a $4,000 salvage value. If sold, the broker charges a 5% commission fee. Prepare a differential analysis to determine if the company should sell (Alternative 1) or lease (Alternative 2) the machinery. Sell (Alt. 1) or Lease (Alt. 2) on Sell (Alt. 1) Lease (Alt. 2) Income (Alt. 2) Revenues $38,000 $44,000 $ 6,000 Costs (1,900) (7,000) (5,100) Income (loss) $36,100 $37,000 $ 900 Blair Designs should lease the asset.

3 and Product Pricing 3 Strategy: When determining whether to sell or lease an asset, first determine the revenues in each situation. If sold, the revenue is the selling price, and if leased, the revenue is the lease revenue and the salvage value, if any. Next determine the costs, which usually include a sales commission when selling and cost of upkeep when leasing. Determine the differential effect on income. If positive, the company should proceed with Alternative Product B at Charleston Affair generates sales of $59,000 for 10,000 units. Each unit has variable costs of $4.50 apiece and total fixed costs of $18,000. Prepare a differential analysis to determine if Product B should be continued (Alternative 1) or discontinued (Alternative 2) if the fixed costs are unaffected by the decision. Continue (Alt. 1) or Discontinue (Alt. 2) Product B Continue (Alt. 1) Discontinue (Alt. 2) on Income (Alt. 2) Revenues $ 59,000 $ 0 $(59,000) Costs: Variable $(45,000) $ 0 $ 45,000 Fixed (18,000) (18,000) 0 Total costs $(63,000) $(18,000) $ 45,000 Income (loss) $ (4,000) $(18,000) $(14,000) Product B should be continued because the income generated from the product will cover some of fixed costs.

4 4 Chapter Wake Coffee Co. incurs a loss from operations for the Standard Coffee line. Sales revenues for the line total $72,000, while incurring variable costs of goods sold of $19,500, variable selling expenses of $17,400, and fixed costs of $49,000. Prepare a differential analysis to determine if the Standard Coffee line should be continued (Alternative 1) or discontinued (Alternative 2). Assume the company will incur the fixed costs regardless of the decision. Continue (Alt. 1) or Discontinue (Alt. 2) Standard Coffee Continue (Alt. 1) Discontinue (Alt. 2) on Income (Alt. 2) Revenues $ 72,000 $ 0 $(72,000) Costs: Variable $(36,900) $ 0 $ 36,900 Fixed (49,000) (49,000) 0 Total costs $(85,900) $(49,000) $ 36,900 Income (loss) $(13,900) $(49,000) $(35,100) The Standard Coffee Line should be continued. 6. Product BW of Blair Designs generates sales revenue of $40,000. The product incurs variable costs of goods sold of $22,000, fixed selling costs of $22,000, and fixed factory overhead of $21,000. Use a differential analysis to determine if Product BW should be continued (Alternative 1) or discontinued (Alternative 2). Assume that the company will incur the fixed factory overhead regardless of the decision. Continue (Alt. 1) or Discontinue (Alt. 2) Product BW on Continue (Alt. 1) Discontinue (Alt. 2) Income (Alt. 2) Revenues $ 40,000 $ 0 $(40,000) Costs: Variable $(22,000) $ 0 $ 22,000 Fixed (43,000) (21,000) 22,000 Total costs $(65,000) $(21,000) $ 44,000 Income (loss) $(25,000) $(21,000) $ 4,000 Product BW should be discontinued.

5 and Product Pricing 5 Strategy: If the company continues the product line, the revenues and costs will be equal to the amounts expected. However, if the company discontinues the product line, no revenue will be earned and no variable costs will be incurred. However, the fixed costs may remain since the company will incur the costs regardless of the number of products finished. Determine the differential effect on income. If positive, the company should decide Alternative Charleston Affair currently makes the King Component, incurring variable costs of $18 per unit and fixed costs of $4 per unit. The company has the option to purchase the component for $20 per unit. Prepare a differential analysis to determine if the company should make (Alternative 1) or buy (Alternative 2) the King Component. Assume that the fixed costs will be incurred in each situation. Make (Alt. 1) or Buy (Alt. 2) King Component Make (Alt. 1) Buy (Alt. 2) on Income (Alt. 2) Unit costs: Purchase price $ 0 $(20) $(20) Variable costs (18) 0 18 Fixed costs (4) (4) 0 Income (loss) $(22) $(24) $ (2) Charleston Affair should make the King Component.

6 6 Chapter The Wake Coffee Co. currently produces the Sealable Coffee Bag and incurs the following costs per unit: direct materials, $2; direct labor, $3; variable factory overhead, $2.50; and fixed factory overhead, $3.50. The company also has the option to purchase the product for $9.50 per unit. The seller charges a $1.25 freight fee per unit. Prepare a differential analysis to determine if Wake Coffee Co. should make (Alternative 1) or buy (Alternative 2) the product, assuming that the fixed costs will be incurred regardless of the decision. Make (Alt. 1) or Buy (Alt. 2) Sealable Coffee Bag Make (Alt. 1) Buy (Alt. 2) on Income (Alt. 2) Unit costs: Purchase price $ 0 $ (5.75) $(5.75) Freight fee 0 (1.25) (1.25) Variable costs (7.50) Fixed costs (3.50) (3.50) 0 Income (loss) $(11.00) $(10.50) $ 0.50 Wake Coffee Co. should buy the Sealable Coffee Bag. 9. Blair Designs currently produces a Subcomponent, incurring variable direct costs of $4.25 per unit, variable factory overhead of $2.25 per unit, and fixed factory overhead of $5.00 per unit. The company could also buy the Subcomponent for $7.50 from an outside provider, which would also charge a freight fee of $2.00 per unit. Prepare a differential analysis to determine if Blair Designs should make (Alternative 1) or buy (Alternative 2) the Subcomponent, assuming that fixed factory overhead will be incurred if the product is made or sold. Make (Alt. 1) or Buy (Alt. 2) Subcomponent Make (Alt. 1) Buy (Alt. 2) on Income (Alt. 2) Unit costs: Purchase price $ 0 $ (7.50) $(7.50) Freight fee 0 (2.00) (2.00) Variable costs (6.50) Fixed costs (5.00) (5.00) 0 Income (loss) $(11.50) $(14.50) $(3.00) Blair Designs should make the Subcomponent.

7 and Product Pricing 7 Strategy: First, determine the costs associated with making the product, which usually include the variable and fixed costs. Next, determine the costs associated with buying the product, which include the costs to acquire the good (purchase price, freight fees, etc.), and fixed costs since the company will incur the costs regardless of the products produced. Then, determine the differential effect on income, and if positive, the company should proceed with Alternative Charleston Affair is considering replacing an outdated piece of machinery. Use the information below for the old piece of machinery and new machinery to prepare a differential analysis to determine if Charleston Affair should continue (Alternative 1) or replace (Alternative 2) the old machine. Old machine: Estimated annual variable manufacturing costs $18,000 Estimated selling price $10,000 Estimated residual value $6,500 Estimated remaining useful life 7 years New machine: Purchase price $110,000 Estimated annual variable manufacturing costs $5,000 Estimated residual value $1,500 Estimated useful life 7 years Continue with Old Machine (Alt. 1) or Replace Old Machine (Alt. 2) Continue (Alt. 1) Replace (Alt. 2) on Income (Alt. 2) Revenues: Proceeds from sale of old machine $ 0 $ 10,000 $ 10,000 Residual Value 6,500 1,500 (5,000) Costs: Purchase price $ 0 $(110,000) $(110,000) Variable manufacturing costs (7 years) (126,000) (35,000) 91,000 Total costs $(126,000) $(145,000) $ (19,000) Income (loss) $(119,500) $(133,500) $ (14,000) Charleston Affair should continue with the old machine.

8 8 Chapter Wake Coffee Co. has an outdated piece of machinery that the company is considering replacing. Use the information below for the two pieces of machinery. Prepare a differential analysis to determine if the company should continue with the old piece of machinery (Alternative 1) or replace the piece of machinery (Alternative 2). Old machine Estimated annual variable manufacturing costs $15,000 Estimated selling price $3,200 Estimated remaining useful life 5 years New machine Purchase price $42,000 Estimated annual variable manufacturing costs $6,000 Estimated residual value 0 Estimated useful life 5 years Continue with Old Machine (Alt. 1) or Replace Old Machine (Alt. 2) on Continue (Alt. 1) Replace (Alt. 2) Income (Alt. 2) Revenues: Proceeds from sale of old machine $ 0 $ 3,200 $ 3,200 Costs: Purchase price $ 0 $(42,000) $(42,000) Variable manufacturing costs (5 years) (75,000) (30,000) 45,000 Total costs $(75,000) $(72,000) $ 3,000 Income (loss) $(75,000) $(68,800) $ 6,200 Wake Coffee Co. should replace the old machine.

9 and Product Pricing Blair Designs has an old piece of equipment that management is considering replacing. Use the information below for the piece of equipment and its replacement to prepare a differential analysis to determine if the company should continue with the old piece of equipment (Alternative 1) or replace the piece of equipment (Alternative 2). Old equipment Estimated annual variable manufacturing costs $11,500 Estimated selling price $3,200 Estimated remaining useful life 10 years New equipment Purchase price $50,000 Estimated annual variable manufacturing costs $5,000 Estimated residual value $5,000 Estimated useful life 10 years Continue with Old Equipment (Alt. 1) or Replace Old Equipment(Alt. 2) Continue (Alt. 1) Replace (Alt. 2) on Income (Alt. 2) Revenues: Proceeds from sale of old equipment $ 0 $ 3,200 $ 3,200 Residual value 0 5,000 5,000 Costs: Purchase price $ 0 $ (50,000) $(50,000) Variable manufacturing costs (10 years) (115,000) (50,000) 65,000 Total costs $(115,000) $(100,000) $ 15,000 Income (loss) $(115,000) $ (91,800) $ 23,200 Blair Designs should replace the old piece of equipment. Strategy: First, determine the revenues for each alternative. If continued to use the piece of equipment, any residual value would be considered revenue. If replaced, the proceeds from the sale and any residual value of the new equipment would be considered revenue. Next, determine the costs, which include the variable manufacturing costs for both situations, or the costs to produce goods with the equipment. The cost to purchase the new equipment would be considered a cost if replaced. Then, determine the differential effect on income. If positive, the company should proceed with Alternative 2.

10 10 Chapter Charleston Affair produces Product K for $8 per pound, which can be sold for $15 per pound or processed into Product M, which sells for $30 per pound. Each pound requires an additional $12 to process into Product M. Prepare a differential analysis to determine if the company should sell Product K (Alternative 1) or process further into Product M (Alternative 2). Sell Product K (Alt. 1) or Process into Product M (Alt. 2) Sell (Alt. 1) Process Further (Alt. 2) on Income (Alt. 2) Revenues, per unit $15 $ 30 $ 15 Costs, per unit (8) (20) (12) Income (loss), per unit $ 7 $ 10 $ 3 Charleston Affair should process further into Product M. 14. Wake Coffee Co. processes Standard Coffee in batches of 5,000 pounds, which sell for $8 per pound and cost $10,000 to produce. The company can process the Standard Coffee into Deluxe Coffee for additional costs of $6,000 per 5,000 pound batch. Each batch of Deluxe Coffee produces 3,000 pounds, which sell for $15 per pound. Prepare a differential analysis to determine if Wake Coffee Co. should sell Standard Coffee (Alternative 1) or process further into Deluxe Coffee (Alternative 2). Sell Standard Coffee (Alt. 1) or Process into Deluxe Coffee (Alt. 2) Sell (Alt. 1) Process Further (Alt. 2) on Income (Alt. 2) Revenues $ 40,000 $ 45,000 $ 5,000 Costs (10,000) (16,000) (6,000) Income (loss) $ 30,000 $ 29,000 $(1,000) Wake Coffee Co. should sell Standard Coffee.

11 and Product Pricing Blair Designs produces 4,000 yards of Solid Fabric per batch, which sells for $5 per yard. Each batch of Solid Fabric produced incurs $12,000 of costs. The company can incur an additional $3,000 in costs to process the batch of Simple Fabric into 2,400 yards of Patterned Fabric, which sells for $12 per yard. Prepare a differential analysis to determine if the company should sell Solid Fabric (Alternative 1) or process further into Patterned Fabric (Alternative 2). Sell Solid Fabric (Alt. 1) or Process into Patterned Fabric (Alt. 2) on Sell (Alt. 1) Process Further (Alt. 2) Income (Alt. 2) Revenues $ 20,000 $ 28,800 $ 8,800 Costs (12,000) (15,000) (3,000) Income (loss) $ 8,000 $ 13,800 $ 5,800 Blair Designs should process further into Patterned Fabric. Strategy: The revenue in each situation would be the revenues produced by the goods. The costs are equal to the total costs incurred to produce the product. If processed further, the costs should include the costs to produce the original product and the costs to process further into the more finished good. Next, determine the differential effect on income. If positive, the company should proceed with Alternative Charleston Affair received a special purchase order for 5,000 units at a purchase price of $10 per unit, which are normally sold at $12 each. Each unit requires $6 of variable manufacturing costs. Each purchase order incurs processing costs of $2,000. Prepare a differential analysis to determine if the company should reject (Alternative 1) or accept (Alternative 2) the order, assuming there is sufficient capacity. Reject (Alt. 1) or Accept (Alt. 2) Order on Income (Alt. 2) Reject (Alt. 1) Accept (Alt. 2) Revenues $0 $ 50,000 $ 50,000 Costs: Variable manufacturing costs $0 $(30,000) $(30,000) Processing costs 0 (2,000) (2,000) Income (loss) $0 $ 18,000 $ 18,000 Charleston Affair should accept the special order.

12 12 Chapter Wake Coffee Co. normally sells finished goods for $8.50 per unit. The company received a special order to sell 4,000 units for $4.50 each. The variable manufacturing costs per unit is $3, and the company will incur an additional $2.50 per unit to rush the order. Prepare a differential analysis to determine if the company should reject (Alternative 1) or accept (Alternative 2) the order, assuming there is sufficient capacity to produce the goods. Reject (Alt. 1) or Accept (Alt. 2) Order on Income (Alt. 2) Reject (Alt. 1) Accept (Alt. 2) Revenues, per unit $0 $ 4.50 $ 4.50 Costs, per unit: Variable manufacturing costs $0 $(3.00) $(3.00) Rush order costs 0 (2.50) (2.50) Income (loss) $0 $(1.00) $(1.00) Wake Coffee Co. should reject the special order. 18. Blair Designs sells its finished goods in batches of 2,000 units for $4 per unit. The company has received a special order for three batches for a total selling price of $10,000. Each unit incurs variable manufacturing costs of $1.50 per unit and each batch incurs variable costs of $200. Prepare a differential analysis to determine whether Blair Designs should reject (Alternative 1) or accept (Alternative 2) the order, assuming there is sufficient capacity to produce the goods. Reject (Alt. 1) or Accept (Alt. 2) Order on Income (Alt. 2) Reject (Alt. 1) Accept (Alt. 2) Revenues $0 $10,000 $10,000 Costs: Variable manufacturing costs $0 $(9,000) $(9,000) Per batch variable costs 0 (600) (600) Income (loss) $0 $ 400 $ 400 Blair Designs should accept the special order. Strategy: If the company rejects the special order, no revenues will be earned and no variable costs incurred. However, if the company accepts the special order, the revenue and costs should be considered. If the differential effect on income is positive, the company should proceed with Alternative 2.

13 and Product Pricing Charleston Affair uses the product cost concept to price its goods. The company plans to release a new product in the upcoming month. Use the information shown below to determine: a. Product cost per unit $3.50 = $49,000/14,000 b. Desired profit $12,000 = $120,000 10% c. Markup percentage 90% = ($12,000 + $32,100)/$49,000 d. Markup per unit $3.15 = 90% $3.50 e. Normal selling price per unit $6.65 = $ $3.15 Total product cost $49,000 Total selling and administrative expenses $32,100 Total assets $120,000 Estimated units produced and sold 14,000 Desired rate of return on assets 10%

14 14 Chapter Wake Coffee Co. uses the product cost concept to price its goods. With the information shown, calculate each of the following for a new good: a. Product cost per unit $4.00 = $24,800/6,200 b. Desired profit $11,400 = $95,000 12% c. Markup percentage (round to the nearest percentage) 87% = ($10,200 + $11,400)/$24,800 d. Markup per unit $3.48 = 87% $4.00 e. Normal selling price per unit $7.48 = $ $4.00 Total product cost $24,800 Total selling and administrative expenses $10,200 Total assets $95,000 Estimated units produced and sold 6,200 Desired rate of return on assets 12% 21. Blair Designs plans the release of a new product in the upcoming year. Use the product cost concept and the information below to determine the following: a. Product cost per unit $1.28= $32,000/25,000 b. Desired profit $21,000 = $140,000 15% c. Markup percentage (round to the nearest percentage) 91%= ($21,000 + $8,000)/$32,000 d. Markup per unit (round to the nearest cent) $1.16 = 91% $1.28 e. Normal selling price per unit $2.44 = $ $1.16 Total product cost $32,000 Total selling and administrative expenses $8,000 Total assets $140,000 Estimated units produced and sold 25,000 Desired rate of return on assets 15%

15 and Product Pricing 15 Strategy: After estimating the costs, determine the product cost per unit, which is equal to the total product costs divided by the estimated number of units produced and sold. Next, determine the markup percentage, which is the sum of the desired profit and selling and administrative expenses divided by the total product cost, similar to the break-even calculation with a target profit. The desired profit is the amount of income the company expects to earn on its assets, calculated by multiplying the total assets by the desired rate of return. The markup per unit is calculated by multiplying the markup percentage by the product cost per unit. Add the markup and product costs per unit to determine the normal selling price per unit. 22. Charleston Affair currently sells 1,000 units of Product Z for $64.50 and expects the price to rise by 12% in the upcoming year. The balance sheet shows total assets of $200,000, and management has set a required rate of return of 15% on the assets. Use the target costing method to determine the total target cost the company should achieve. Selling price= $72.24 = $ Desired profit = $30,000 = $200,000 15% Target cost = $42,240 = ($ ,000 units) $30, Wake Coffee Co. expects for the price of Standard Coffee to be $12 per pound in 2016 and sell 2,000 pounds. The company owns $52,000 in assets, with a required rate of return on the assets of 12%. Determine the total target cost the company should achieve using the target costing method. Desired profit = $6,240 = $52,000 12% Target cost = $17,760 = ($12 2,000 units) $6, Blair Designs has a desired profit of $40 per unit of Product T in the upcoming year. Product T currently sells for $72 a unit, but the price is expected to increase 20% in the upcoming year. Use target costing to determine the target cost per unit the company should achieve. Selling price = $86.40 = $ Target cost = $46.40 = $86.40 $40 Strategy: The target costing method determines the maximum costs the company should incur if the product sells at a specified selling price and the company would like to earn a desired profit. The target cost is equal to the estimated selling price less the desired profit.

16 16 Chapter All products at Charleston Affair must pass through a sealing treatment. When operating at full capacity, the treatment is considered a production bottleneck. Use the information below to determine the most profitable product when using bottleneck resources. Product X Product Y Product Z Unit selling price $ 9 $ 12 $ 18 Unit variable cost Unit contribution margin $ 7 $ 6 $ 8 Sealing treatment hours per unit Unit contribution margin per production bottleneck hour $ 14 $ 8 $ 10 Product X is the most profitable product when using bottleneck resources. 26. All finished goods at Wake Coffee Co. must pass through a sanitizing wash, which is a production bottleneck when operating at full capacity. Use the information below to determine the most profitable product when using bottleneck resources. Standard Deluxe French Roast Unit selling price $ 100 $ 150 $ 200 Unit variable cost Unit contribution margin $ 60 $ 70 $ 80 Sanitizing wash hour per unit Unit contribution margin per production bottleneck hour $ 50 $ 56 $ 50 The Deluxe would be the most profitable product when using bottleneck resources. 27. When operating at full capacity at Blair Designs, the stitching process is considered to be a production bottleneck. Use the information below to determine which product is most profitable when using bottleneck resources. Round answers to the nearest cent. Solid Patterned Print Unit selling price $ 150 $ 210 $ 240 Unit variable cost Unit contribution margin $ 70 $ 115 $ 140 Stitching process hours per unit Unit contribution margin per production bottleneck hour $70.00 $67.65 $77.78 The Print product would be the most profitable when using bottleneck resources. Strategy: If a bottleneck exists, the company must determine which product will be most profitable for the amount of time it must spend in the production bottleneck. The unit contribution margin per production bottleneck hour is calculated by dividing the unit contribution margin by the time each unit spends in the production bottleneck.