Accounting Q and A

Ex 25-8 Make-or-buy decision

The Theater Arts Guild of Dallas (TAG-D) employs five people in its Publication Department. These people lay out pages for pamphlets, brochures, magazines, and other publications for the TAG-D productions. The pages are delivered to an outside company
for printing. The company is considering an outside publication service for the layout work. The outside service is quoting a price of $13 per layout page. The budget for the Publication Department for 2014 is as follows:

Salaries $224,000
Benefits 36,000
Supplies 21,000
Office expenses 39,000
Office depreciation 28,000
Computer depreciation 24,000
Total $372,000

The department expects to lay out 25,000 pages for 2014. The computers used by the department have an estimated residual value of $9,000. The Publication Department office space and equipment would be used for future administrative needs, if the department’s function were purchased from the outside.

a. Prepare a differential analysis dated February 22, 2014, to determine whether TAG-D should lay out pages internally (Alternative 1) or purchase layout services from the outside (Alternative 2).

b. On the basis of your analysis in part (a), should the page layout work be purchased from an outside company?

c. What additional considerations might factor into the decision making?

Answer:

a.
Differential Analysis
Lay Out Pages Internally (Alt. 1) or Purchase Layout Services (Alt. 2)
February 22, 2014
Lay Out
Pages
Internally
(Alternative 1)
Revenues:
Salvage of computer equipment $ 0 $ 9,000 $ 9,000
Costs:
Purchase price of layout work 0 –325,000* –325,000
Salaries –224,000 0 224,000
Benefits –36,000 0 36,000
Supplies –21,000 0 21,000
Office expenses –39,000 0 39,000
Office depreciation –28,000 –28,000 0
Computer depreciation –24,000 –24,000 0
Income (Loss) –$372,000 –$368,000 $ 4,000

* 25,000 pages × $13 per page
b. The benefit from using an outside service is shown to be $4,000 greater than
performing the layout work internally. The fixed costs (depreciation
expenses) in the budget are irrelevant to the decision. Thus, the work should
be purchased from the outside on a strictly financial basis.
c. Before electing to terminate the five employees, the guild should consider
the long-run impact of the decision. Specifically, future page layout rates
may grow faster than the cost of internal salaries, thus favoring the use of
employees over the long term. This would especially be the case if the
outside company provided a low bid in order to win the initial business. In
addition, the guild may wish to consider noneconomic factors, such as the
ability to more directly control the quality and timing of the layout work by
internal employees.

Ex 25-7 Make-or-buy decision

Eclipse Computer Company has been purchasing carrying cases for its portable computers at a delivered cost of $65 per unit. The company, which is currently operating below full capacity, charges factory overhead to production at the rate of 40% of direct labor cost. The fully absorbed unit costs to produce comparable carrying cases are expected

to be as follows:

Direct materials $30

Direct labor 25

Factory overhead (40% of direct labor) 10

Total cost per unit $65

If Eclipse Computer Company manufactures the carrying cases, fixed factory overhead costs will not increase and variable factory overhead costs associated with the cases are expected to be 15% of the direct labor costs.

a. Prepare a differential analysis, dated July 19, 2014, to determine whether the company should make (Alternative 1) or buy (Alternative 2) the carrying case.

b. On the basis of the data presented, would it be advisable to make the carrying cases or to continue buying them? Explain.

Answer:

a. Differential Analysis

Make Carrying Case (Alt. 1) or Buy Carrying Case (Alt. 2)

July 19, 2014

Make

Carrying

Case

(Alternative 1)

Carrying

(Alternative 2)

Costs:

Purchase price $ 0.00 –$65.00 –$65.00

Direct materials per unit –30.00 0.00 30.00

Direct labor per unit –25.00 0.00 25.00

Variable factory overhead per unit –3.751

ixed factory overhead per unit –6.252

ncome (Loss) –$65.00 –$71.25 –$ 6.25

$25.00 × 15%

$10.00 – $3.75

b. Assuming there were no better alternative uses for the spare capacity, it would

be advisable to manufacture the carrying cases because the cost savings would

be $6.25 per unit. Fixed factory overhead is irrelevant, since it will continue

whether the carrying cases are purchased or manufactured.

Ex 25-6 Decision to discontinue a product

On the basis of the following data, the general manager of Featherweight Shoes Inc. decided to discontinue Children’s Shoes because it reduced income from operations by $17,000. What is the flaw in this decision, if it is assumed fixed costs would not be materially affected by the discontinuance?

Featherweight Shoes Inc.

Product-Line Income Statement

For the Year Ended April 30, 2014

Children’s Shoes Men’s Shoes Women’s Shoes Total

Sales$235,000 $300,000 $500,000 $1,035,000

Costs of goods sold:

Variable costs$130,000 $150,000 $220,000 $ 500,000

Fixed costs 41,000 60,000 120,000 221,000

Total cost of goods sold $171,000 $210,000 $340,000 $ 721,000

Gross profit$ 64,000 $ 90,000 $160,000 $ 314,000

Selling and adminstrative expenses:

Variable selling and admin. expenses $ 46,000 $ 45,000 $ 95,000 $ 186,000

Fixed selling and admin. expenses 35,000 20,000 25,000 80,000

Total selling and admin. expenses $ 81,000 $ 65,000 $120,000 $ 266,000

Income (loss) from operations $ (17,000) $ 25,000 $ 40,000 $ 48,000

Answer:

The flaw in the decision is the failure to focus on the differential revenues and costs, which indicate that operating income would be reduced by $59,000 if Children’s Shoes were discontinued. This differential income from sales of Children’s Shoes can be determined from the following differential analysis:

Differential Analysis

Continue Children’s Shoes (Alt. 1) or Discontinue Children’s Shoes (Alt. 2)

Continue

Children’s

Shoes

(Alternative 1)

Revenues $235,000 $ 0 –$235,000

Costs:

Variable cost of goods sold –130,000 0 130,000

Variable selling and admin. expenses –46,000 0 46,000

Fixed costs –76,000* –76,000 0

Income (Loss) –$ 17,000 –$76,000 –$ 59,000

$41,000 + $35,000

Ex 25-5 Segment analysis

Charles Schwab Corporation is one of the more innovative brokerage and financial service companies in the United States. The company recently provided information about its major business segments as follows (in millions):

Investor

Services

Institutional

Services

Revenues $2,845 $1,403

Income from operations 780 443

Depreciation 93 52

a. How does a brokerage company like Schwab define the “Investor Services” and “Institutional Services” segments? Use the Internet to develop your answer.

b. Provide a specific example of a variable and fixed cost in the “Investor Services” segment.

c. Estimate the contribution margin for each segment, assuming depreciation represents the majority of fixed costs.

d. If Schwab decided to sell its “Institutional Services” accounts to another company, estimate how much operating income would decline.

Answer:

a. The “Investor Services” segment serves the retail customer, you and me. These are the brokerage, Internet, and mutual fund services used by individual investors. The “Institutional Services” segment includes the same services provided for financial institutions, such as banks, mutual fund managers, insurance companies, and pension plan administrators.

b. Variable costs in the “Investor Services” segment include:

1. Commissions to brokers

2. Fees paid to exchanges for executing trades

3. Transaction fees incurred by Schwab mutual funds to purchase and sell shares

4. Advertising

Fixed costs in the “Investor Services” segment include:

1. Depreciation on brokerage offices

2. Depreciation on brokerage office equipment, such as computers and computer networks

3. Property taxes on brokerage offices

c. Investor Institutional

Services Services

(in millions) (in millions)

Income from operations………………………………………… $780 $443

Plus depreciation………………………………………………… 93 52

Estimated contribution margin………………………………… $873 $495

d. If one assumes that the fixed costs that serve institutional investors (computers, servers, and facilities) would not be sold but would be used by the other sector, then the contribution margin of $495 million would be an estimate of the reduced profitability. If the fixed assets were sold, then the operating income decline would approach $443 million. Since the institutional and retail investors use nearly the same assets, the $495 million answer is probably the better estimate.

Ex 25-4 Differential analysis for a discontinued product

The condensed product-line income statement for Dish N’ Dat Company for the month of March is as follows:

Dish N’ Dat Company
Product-Line Income Statement
For the Month Ended March 31, 2014
Bowls Plates Cups
Sales$71,000 $105,700 $31,300
Cost of goods sold 32,600 42,300 16,800
Gross profit$38,400 $ 63,400 $14,500
Selling and administrative expenses 27,400 42,800 16,700
Income from operations $11,000 $ 20,600 $ (2,200)

Fixed costs are 15% of the cost of goods sold and 40% of the selling and administrative expenses. Dish N’ Dat assumes that fixed costs would not be materially affected if the Cups line were discontinued.

a. Prepare a differential analysis dated March 31, 2014, to determine if Cups should be continued (Alternative 1) or discontinued (Alternative 2).

b. Should the Cups line be retained? Explain.

Answer:

a. Differential Analysis
Continue Cups (Alt. 1) or Discontinue Cups (Alt. 2)
March 31, 2014

Continue
Cups
(Alternative 1)

Discontinue
Cups
(Alternative 2)
Revenues $31,300 $ 0 –$31,300
Costs:
Variable cost of goods sold –14,2801
V
ariable selling and admin.
expenses –10,020
2

Fixed costs –9,200
3
–9,200 0
Income (Loss) –$ 2,200 –$9,200 –$ 7,000

$16,800 × (1 – 15%)
$16,700 × (1 – 40%)
($16,800 × 15%) + ($16,700 × 40%)
b. The Cups line should be retained. As indicated by the differential analysis in part (a),
the income will decrease by $7,000 if the Cups line is discontinued.

Ex 25-3 Differential analysis for a discontinued product

A condensed income statement by product line for Celestial Beverage Inc. indicated the following for Star Cola for the past year:

Sales $290,000

Cost of goods sold 155,000

Gross profit $135,000

Operating expenses 207,000

Loss from operations $ (72,000)

It is estimated that 15% of the cost of goods sold represents fixed factory overhead costs and that 25% of the operating expenses are fixed. Since Star Cola is only one of many products, the fixed costs will not be materially affected if the product is discontinued.

a. Prepare a differential analysis, dated January 21, 2014, to determine whether Star Cola should be continued (Alternative 1) or discontinued (Alternative 2).

b. Should Star Cola be retained? Explain.

Answer:

a. Differential Analysis

Continue Star Cola (Alt. 1) or Discontinue Star Cola (Alt. 2)

January 21, 2014

Continue Star

Cola

(Alternative 1)

Discontinue

Star Cola

(Alternative 2)

Revenues $290,000 $ 0 –$290,000

Costs:

Variable cost of goods sold –131,7501

131,750

Variable operating expenses –155,250

0 155,250

Fixed costs –75,0003

–

75,000 0

Income (Loss) –$ 72,000 –$75,000 –$ 3,000

(1 – 15%) × $155,000

(1 – 25%) × $207,000

(15% × $155,000) + (25% × $207,000)

b. Star Cola should be retained. As indicated by the differential analysis in part

(a), the income would decrease by $3,000 if the product is discontinued.

Ex 25-2 Differential analysis for a lease or buy decision

Norton Corporation is considering new equipment. The equipment can be purchased from an overseas supplier for $4,600. The freight and installation costs for the equipment are $590. If purchased, annual repairs and maintenance are estimated to be $620 per year over the four-year useful life of the equipment. Alternatively, Norton can lease the equipment from a domestic supplier for $1,800 per year for four years, with no additional costs. Prepare a differential analysis dated August 4, 2014, to determine whether Norton should lease (Alternative 1) or purchase (Alternative 2) the equipment. Hint: This is a “lease or buy”

decision, which must be analyzed from the perspective of the equipment user, as opposed to the equipment owner.

Answer:

Differential Analysis

Lease Equipment (Alt. 1) or Buy Equipment (Alt. 2)

August 4, 2014

Lease

Equipment

(Alternative 1)

Costs:

Purchase price $ 0 –$4,600 –$4,600

Freight and installation 0 –590 –590

Repair and maintenance (4 years) 0 –2,480

Lease (4 years) –7,200I

ncome (Loss) –$7,200 –$7,670 –$ 470

$620 × 4 years

$1,800 × 4 years

The company should lease the equipment.