Question

E7-5 Analyzing Special-Order Decision, E7-6 Analyzing Make-or-Buy Decision, E7-7 Analyzing Keep-or-Drop Decision, E7-8 Analyzing Sell-or-Process-Further Decision

[The following information applies to the questions displayed below.]

Morning Sky, Inc. (MSI), manufactures and sells computer games. The company has several product lines based on the age range of the target market. MSI sells both individual games as well as packaged sets. All games are in CD format, and some utilize accessories such as steering wheels, electronic tablets, and hand controls. To date, MSI has developed and manufactured all the CDs itself as well as the accessories and packaging for all of its products.

The gaming market has traditionally been targeted at teenagers and young adults; however, the increasing affordability of computers and the incorporation of computer activities into junior high and elementary school curriculums has led to a significant increase in sales to younger children. MSI has always included games for younger children but now wants to expand its business to capitalize on changes in the industry. The company currently has excess capacity and is investigating several possible ways to improve profitability.

References

Section BreakE7-5 Analyzing Special-Order Decision, E7-6 Analyzing Make-or-Buy Decision, E7-7 Analyzing Keep-or-Drop Decision, E7-8 Analyzing Sell-or-Process-Further Decision

5.

Required information

E7-6 Analyzing Make-or-Buy Decision [LO 7-2, 7-4]

MSI is considering outsourcing the production of the handheld control module used with some of its products. The company has received a bid from Monte Legend Co. (MLC) to produce 8,000 units of the module per year for $18.00 each. The following information pertains to MSI’s production of the control modules:        

Direct materials	$	9
Direct labor		6
Variable manufacturing overhead		2
Fixed manufacturing overhead		5
Total cost per unit	$	22

MSI has determined that it could eliminate all variable costs if the control modules were produced externally, but none of the fixed overhead is avoidable. At this time, MSI has no specific use in mind for the space that is currently dedicated to the control module production.

Required:
1. Compute the difference in cost between making and buying the control module.

	Difference in Cost

2. Should MSI buy the modules from MLC or continue to make them?

	Make
	Buy

3-a. Suppose that the MSI space currently used for the modules could be utilized by a new product line that would generate $40,000 in annual profit. Recompute the difference in cost between making and buying under this scenario.

	Difference in Cost

3-b. Does this change your recommendation to MSI?

no

yes

6.

value:
2.00 points

Required information

E7-7 Analyzing Keep-or-Drop Decision [LO 7-2, 7-5]

MSI is considering eliminating a product from its ToddleTown Tours collection. This collection is aimed at children one to three years of age and includes “tours” of a hypothetical town. Two products, The Pet Store Parade and The Grocery Getaway, have impressive sales. However, sales for the third CD in the collection, The Post Office Polka, have lagged the others. Several other CDs are planned for this collection, but none is ready for production.

MSI’s information related to the ToddleTown Tours collection follows:

Segmented Income Statement for MSI’s
ToddleTown Tours Product Lines
	Pet Store Parade			Grocery Getaway			Post Office Polka				Total
Sales revenue	$	100,000		$	95,000		$	29,000			$	224,000
Variable costs		43,000			39,000			24,000				106,000
Contribution margin	$	57,000		$	56,000		$	5,000			$	118,000
Less: Direct Fixed costs		6,800			6,100			4,700				17,600
Segment margin	$	50,200		$	49,900		$	300			$	100,400
Less: Common fixed costs*		5,000			4,750			1,450				11,200
Net operating income (loss)	$	45,200		$	45,150		$	(1,150	)		$	89,200

      
*Allocated based on total sales dollars.

MSI has determined that elimination of the Post Office Polka (POP) program would not impact sales of the other two items. The remaining fixed overhead currently allocated to the POP product would be redistributed to the remaining two products.

Required:
1. Calculate the incremental effect on profit if the POP product is eliminated.

	Effect on Profit

2. Should MSI drop the POP product?

	Yes
	No

3-a. Calculate the incremental effect on profit if the POP product is eliminated. Suppose that $1,000 of the common fixed costs could be avoided if the POP product line were eliminated.

	Effect on Profit

3-b. Should MSI drop the POP product?

	Yes
	No

Answer 1

The marginal cost of producing a handheld control module- Total Cost - Unavoidable Fixed Costs = $22 - $5 = $17
Total Marginal Cost of producing = 8,000 * $17 = $136,000
(We will not include unavoidable fixed costs as part of the marginal cost as it will be incurred regardless of production, hence will not form part of the decision making)

Marginal Cost of purchasing a handheld module = $18
Total Marginal cost of purchasing = 8,000 units * $18 = $144,000

1) Hence Difference in cost = $8,000 ($144,000 - $136,000)

2) MSI should make the module as the marginal cost is less under that alternative.

3 (a) If space could be utilized to produce $40,000 annual profit, then such profit shall be added as opportunity cost under the production alternative.

Marginal Cost of production alternative = $136,000 + $40,000 = $176,000

Difference in cost = $32,000 ($176,000 - $144,000)

3(b) Yes, it changes the recommendation, as now marginal cost of production is greater than the marginal cost of purchasing and hence MSI should purchase the product rather than producing it.

1. Since common fixed costs are unavoidable, we will only consider the segment margin for calculating the change in profit.

Current segment margin = $300

Hence effect on profit if POP is eliminated = Decrease by $300 = $89,200 - $300= $88,900

2. Since POP is producing a marginal profit of $300, it should not be eliminated

3. (a) If a portion of the common cost is avoidable, then such portion is deducted while arriving at the marginal profit.

Marginal profit earned = $300 - $1,000 = ($700) (loss)

Hence, effect on profit = Increase by $700 = $89,200 + $700 = $89,900

3. (b) Yes, MSI should drop the POP product as currently its incurring marginal loss of $700.