Question

1.) Engines, Ltd., manufactures a variety of engines for use in heavy equipment. The company has always produced all of the necessary parts for its engines, including all of the carburetors. An outside supplier has offered to sell one type of carburetor to Troy Engines, Ltd., for a cost of $30 per unit. To evaluate this offer, Troy Engines, Ltd., has gathered the following information relating to its own cost of producing the carburetor internally:

	Per Unit				12,000 Units Per Year
Direct materials	$	12		$	144,000
Direct labor		8			96,000
Variable manufacturing overhead		2			24,000
Fixed manufacturing overhead, traceable		9	*		108,000
Fixed manufacturing overhead, allocated		12			144,000
Total cost	$	43		$	516,000

*One-third supervisory salaries; two-thirds depreciation of special equipment (no resale value).

Required:

1. Assuming the company has no alternative use for the facilities that are now being used to produce the carburetors, what would be the financial advantage (disadvantage) of buying 12,000 carburetors from the outside supplier?

2. Should the outside supplier’s offer be accepted?

3. Suppose that if the carburetors were purchased, Troy Engines, Ltd., could use the freed capacity to launch a new product. The segment margin of the new product would be $120,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 12,000 carburetors from the outside supplier?

4. Given the new assumption in requirement 3, should the outside supplier’s offer be accepted?

2.) The Happy Cycle Company manufactures three types of bicycles—a dirt bike, a mountain bike, and a racing bike. Data on sales and expenses for the past quarter follow:

	Total			Dirt Bikes			Mountain Bikes			Racing Bikes
Sales	$	922,000		$	264,000		$	408,000		$	250,000
Variable manufacturing and selling expenses		460,000			112,000			192,000			156,000
Contribution margin		462,000			152,000			216,000			94,000
Fixed expenses:
Advertising, traceable		69,700			8,800			40,300			20,600
Depreciation of special equipment		44,000			20,900			7,900			15,200
Salaries of product-line managers		113,600			40,300			38,000			35,300
Allocated common fixed expenses*		184,400			52,800			81,600			50,000
Total fixed expenses		411,700			122,800			167,800			121,100
Net operating income (loss)	$	50,300		$	29,200		$	48,200		$	(27,100)

*Allocated on the basis of sales dollars.

Management is concerned about the continued losses shown by the racing bikes and wants a recommendation as to whether or not the line should be discontinued. The special equipment used to produce racing bikes has no resale value and does not wear out.

Required:

1. What is the financial advantage (disadvantage) per quarter of discontinuing the Racing Bikes?

2. Should the production and sale of racing bikes be discontinued?

3. Prepare a properly formatted segmented income statement that would be more useful to management in assessing the long-run profitability of the various product lines.

3.) Makers manufactures and sells a gold bracelet for $400.00. The company’s accounting system says that the unit product cost for this bracelet is $263.00 as shown below:

Direct materials	$	142
Direct labor		82
Manufacturing overhead		39
Unit product cost	$	263

The members of a wedding party have approached Imperial Jewelers about buying 29 of these gold bracelets for the discounted price of $360.00 each. The members of the wedding party would like special filigree applied to the bracelets that would require Imperial Jewelers to buy a special tool for $467 and that would increase the direct materials cost per bracelet by $10. The special tool would have no other use once the special order is completed.

To analyze this special order opportunity, Imperial Jewelers has determined that most of its manufacturing overhead is fixed and unaffected by variations in how much jewelry is produced in any given period. However, $11.00 of the overhead is variable with respect to the number of bracelets produced. The company also believes that accepting this order would have no effect on its ability to produce and sell jewelry to other customers. Furthermore, the company could fulfill the wedding party’s order using its existing manufacturing capacity.

Required:

1. What is the financial advantage (disadvantage) of accepting the special order from the wedding party?

2. Should the company accept the special order?

Answer 1

Solution

Solution

Part 1

Troy Engines Ltd

1. Determination of financial advantage (disadvantage) of buying 12,000 carburetors from the outside supplier, assuming no alternative use for facilities:

	Per unit Differential Costs	Total for 12,000 units
	MAKE	BUY	MAKE	BUY
Cost of purchasing	$30		$360,000
Direct materials	$12		$144,000
Direct labor	$8		$96,000
Variable MOH	$2		$24,000
Fixed MOH Traceable	$3		$36,000
Total costs	$25	$30	$300,000	$360,000

Note: The 2/3rd portion of traceable fixed manufacturing overhead is depreciation. This is a sunk cost and hence not relevant. The 1/3rd portion ($9 x 1/3= 3) relates to the supervisory salary, which is avoidable. Hence, a relevant cost.

2. Based on the above calculations, the cost to MAKE 12,000 units is lower compared to cost to BUY 12,000 units. Hence the company should reject the order from outside supplier and continue production using the internal facilities.

3. Determination of financial advantage (disadvantage) of buying 12,000 carburetors from the outside supplier, assuming use for alternative facilities:

	MAKE	BUY
Cost of purchasing	$360,000
Cost of making	$300,000
Opportunity cost - segment margin foregone	$120,000
Total cost	$420,000	$360,000

The above computations indicate that total cost to MAKE is $60,000 higher compared to total cost to BUY. Hence, the company should accept the order from outside supplier and BUY the carburetor.            

Note: The total cost to make, $300,000, computations are shown in part 1.

4. Yes, the company should accept the outside supplier’s order under the assumption that facilities have alternative use resulting in segment margin of $120,000.

Part 2:

Happy Cycle Company

1. Determination of the financial advantage (disadvantage) per quarter of discontinuing the Racing Bikes:

Discontinue racing bikes -
contribution lost	($94,000)
avoidable fixed cost
advertising, traceable	$20,600
salaries of product lines manager	$35,300
		$55,900
financial disadvantage	($38,100)

Discontinuation of racing bikes would result in decrease of overall net operating income by $38,100.

Financial disadvantage per quarter of discontinuing the Racking Bikes is $38,100.

Notes:

a. All traceable fixed costs can be avoided, such as traceable advertising and salaries of line manager.

b. Depreciation is a sunk cost and hence not relevant for the decision.

c. Common fixed costs are not relevant as they are allocated and would continue regardless of the decision to continue or discontinue the racking bikes segment.

2. No, the production and sale of Racing Bikes should not be discontinued.

Explanation: The discontinuance of Racing Bikes would result in a contribution margin loss of $94,000 which makes the overall net operating income to decrease by $38,100.

3. Segmented Income Statement:

Segmented Income Statement
	Totals	Dirt Bikes	Mountain Bikes	Racing Bikes
Sales	$922,000	$264,000	$408,000	$250,000
Variable manufacturing and selling costs	$460,000	$112,000	$192,000	$156,000
Contribution Margin	$462,000	$152,000	$216,000	$94,000
Traceable fixed expenses
Advertising	$69,700	$8,800	$40,300	$20,600
Depreciation of special equipment	$44,000	$20,900	$7,900	$15,200
Salaries of product line managers	$113,600	$40,300	$38,000	$35,300
Total traceable fixed expenses	$227,300	$70,000	$86,200	$71,100
Product line segment margin	$234,700	$82,000	$129,800	$22,900
Common fixed expenses	$184,400
Net Operating Income	$50,300

Note: the segmented margin income statement indicates that Racing Bikes earns enough contribution margin to cover all its traceable fixed expenses and still leave a segment margin of $22,900. Hence, the product is profitable and is not advised to be discontinued.

Part 3:

Solution

Imperial Jewelers

Analysis of the effect of accepting a special order on the company’s net operating profit:

Particulars	Per unit	Total 29 Bracelets
Incremental Revenue	$360	$10,440
Incremental costs:
Variable costs:
Direct material	$152	$4,408
Direct labor	$82	$2,378
Variable manufacturing overhead	$11	$319
Total variable costs	$235	$7,105
Fixed cost:
Purchase of special tool		$467
Total incremental cost		$7,572
Incremental net operating income (loss)		$2,868

Should the special order be accepted at this price? --Yes

Accepting of special order would earn net operating income of $2,868. Imperial Jewelers can accept the special order for 29 gold bracelets at the sales price of $360 per unit.

Note:

The fixed costs are not considered for the accept/reject decision as they are period costs, however fixed cost pertaining to the special order (cost of special tool) is taken into consideration as this cost is directly associated to the making of the special order and would have no other use once the order is completed. The fixed manufacturing overhead per unit = 39 – 11 = $28

Variable manufacturing overhead = $11

The direct material cost per unit is increased by $10,

Original direct material cost per unit = $142

Add: increase of $10

Total direct material cost per unit = $152