Question

NOTE: Read the case below and calculate, explain, and write up your conclusion for your choice. There are 6 questions to be answered. An example of a side by side comparison follows question 6 for demonstrative purposes – you do not need to respond to the example.
Raider Red Company owns numerous facilities and production plants. The company routinely evaluates proposals as to whether they will improve operations. They are currently reviewing the four following proposals. One involves the suggestion to close the unprofitable store in the Depot District. Another is to outsource the acquisition of tortillas, rather than making them. Another proposal is to sell packaged beef to a non-competing restaurant chain under a private label. The last proposal is the throw out items with an old logo.
You are the controller for Raider Red Company and are to analyze staff reports for each proposal. For each proposal, perform a side by side comparison. On one side show the results of accepting the recommendation and on the other side show the rejection of the recommendation. (Hint: Spreadsheets would be very useful for the analysis). Write up your approach to your analysis and your conclusion (your decision and why) for each scenario. Show all your work.
Summary for each proposal are as follows:
1.   Depot District Proposal: Staff recommendation is that The Depot District store should be closed. The company is a consistent money loser. Below is a contribution margin income statement for the Depot District store for the past year. Half of the fixed expenses relate to the store’s rent under a 20 year non-cancelable lease. The lease costs cannot be avoided, and the location is not able to be subleased to another company. Perform a side by side comparison. On one side show the results of accepting the recommendation and on the other side show the rejection of the recommendation. Write up your approach to your analysis and your conclusion (your decision and why). Show all your work.
Depot District CM Income Statement
Sales Revenues        $1,400,000
Variable Expenses       1,000,000
Contribution Margin    400,000
Fixed Expenses        650,000
Income (loss)       $(250,000)

2.   Outsource Tortillas Proposal: The company spent a total of $2,000,000 producing tortillas during the past year. The tortillas are made at a company owned facility. A vendor has offered to supply a similar quantity and grade of tortillas for $2,200,000. Staff recommends continuing to make tortillas because the proposed purchase price is 10% higher than the cost of making tortillas. Staff believes it is inappropriate to consider that the tortilla facility could be leased to another company for $350,000, if it is diverted from tortilla production. Perform a side by side comparison. On one side show the results of accepting the recommendation and on the other side show the rejection of the recommendation. Write up your approach to your analysis and your conclusion (your decision and why). Show all your work.

3.   Sell Packaged Beef Proposal: Aggie Company offered to buy packaged beef at $4 per pound from Red Raider Company. The packing facility is well below full capacity and can accommodate the request without incurring any additional fixed costs. However, staff believes it would be inappropriate to price the beef below its own internal costs of $4.50 per pound, which consists of raw materials ($2.50), direct labor ($0.75), variable factory overhead ($0.25), and fixed factory overhead ($1.00). This transaction would result in no material amount of added selling, general or administrative costs. Compare accepting the recommendation versus the rejection of the recommendation. Write up your approach to your analysis and your conclusion (your decision and why). Show all your work.

4.   Scrap Items with Old Logo: Red Raider company spent $500,000 on items that are imprinted with an old logo. It is unlikely these items will ever be used. However, staff recommends against scraping because this will result in an immediate charge against net income. It costs only $2,000 per year to store the items. Compare accepting the recommendation versus the rejection of the recommendation. Write up your approach to your analysis and your conclusion (your decision and why). Show all your work.

5.   What are some issues that you might consider for each of the scenarios that could affect your conclusion?

6.   Give an example of a financial decision that you have made or may make and why you made the decision that you made? Include quantitative and qualitative factors and opportunity costs and sunk costs. For example, I purchased a truck with a trade in. I looked at the different brands and did not choose the least expensive truck because of ……. Explain why you made your decision.

Example side by side comparison:
Pure Company makes and sells bedding. They have been producing and selling 500,000 units per year. Each unit sells for $600, and there are no variable selling, general, or administrative costs. The company has been approached by a supplier who wishes to provide a component for $90 per unit. Total annual manufacturing costs, including is as follows.
Direct materials    $50,000,000
Direct labor        800,000
Variable factory OH   16,000,000
Fixed factory OH    35,000,000
If Pure outsources the component, it is expected that direct materials will be reduced by 20%, direct labor by 30%, and variable factory OH by 25%. There will be no reduction in fixed factory OH.
1.   Should Pure outsource the component?

   Internal   Outsource
DM   $50,000,000   $40,000,000
DL    80,000,000   56,000,000
Var. Factory OH   16,000,000   12,000,000
Fixed Factory OH   35,000,000   35,000,000
Outsourced component (500,000 X $90)   
---  
45,000,000
Total cost of each option   181,000,000   188,000,000

It appears that it will cost more to outsource. Based on this quantitative analysis the company would not outsource the component.
(Here is a side by side comparison of the options. For your essay, you would tell why you made this analysis, you would describe how you arrived at the outsource amounts, and you would explain why you would not outsource).

Answer 1

1) If store is closed

	Existing	Revised
Sales Revenues	1400000.00
Variable Expenses	1000000.00
Contribution Margin	400000.00
Fixed Expenses	650000.00	325000
Income (loss)	-250000.00	-325000

Based on the above information, the fixed expenses amounting to 50% of 650,000 = 325,000  would still be incurred and loss would increase from current 250,000 to 325,000 if the store is closed. Hence, the store should not be closed.

2) If tortillas are outsources:-

	Existing	Revised
Tortillas Purchased	$           2,000,000	$           2,200,000
Less:- Lease rent received		$              350,000
Net Cost	$           2,000,000	$           1,850,000

Based on the above analysis, it is clear that the cost of outsourcing is lower than the cost of producing and hence outsourcing should be done (keeping in mind other qualitative factors)

3) Selling packed beef.

For deciding wheather to undertake this transaction or not, first we need to find the relevant cost for decision making.This transaction would result in no material amount of added selling, general or administrative costs, so no such cost is relevant for decision making. Furthermore, fixed factory overhead is already fixed and is just being allocated, it would still be incurred irrespective of accepting this order and hence it is an irrelevant cost.

Thus relevant costs are raw materials ($2.50), direct labor ($0.75), variable factory overhead ($0.25) amounting to a total cost of $3.50 which is below the selling price of $4 and would result in a profit of $0.50 per pound.

Hence, the selling of packed beef should be undertaken.

4) Throw out items with an old logo.

The items of old logo cost $500,000 which would be immediately charged to Net Income in current year while cost of storing this is $2000 per year. However, the cost of $500,000 is sunk cost which has already been incurred and is irrelevant for decision making.

Thus the comparison is of relevant cost of $2000 for storing and Nil cost if disposed currently.

Since the old logos are of no used, it doesn't make sense to store then and incur the additional storage cost of $2,000 per year. These should be scrapped as soon as possible in order to save the storage costs.

5) The relevant costs and sunk costs and cost of funds are the main issues which guide through the decision making process.

6) I bought a car without trade in because i got better value by selling the old car to another buyer. The car i bought was not the cheapest one but the most durable one with long life and best average per gallon of fuel. I also avoided financing the vehicle as the cost of financing was more than the income i could have earned over my idle money.