Question

Wings Maju sells 3 different sets of child meals in its restaurants: M1, M2, and M3. Changes in product lines do not affect demand of other products. Results of July are below:  

     

	M1	M2	M3	Total
Units sold	4,000	2,500	2,600	9,100
Revenue	$32,000	$30,000	$26,000	$88,000
Variable departmental costs	19,200	16,500	10,400	46,100
Direct fixed costs	5,000	7,000	4,000	16,000
Allocated fixed costs	6,500	8,500	7,500	22,500
Net income	$1,300	($2,000)	$4,100	$3,400

Seventy percent of the allocated fixed costs are unavoidable.

Required:

a.	Prepare an incremental analysis to determine if M2 should be discontinued.
b.	Briefly explain costs allocation death spiral effect.
c.	Define opportunity costs and give an example / situation on when opportunity costs exist.

Answer 1

a. incremental analysis to determine if M2 should be discontinued;

	With M2	with out M2	incremental effect
units sold	9100	6600
Revenue	$88,000	(32,000+26,000)=>$58,000	($30,000)
variable department costs	46,100	(19,200+10,400)=>29,600	16,500
direct fixed costs	16,000	(5000+4000)=>9,000	7,000
allocated fixed costs	22,500	(6500+7500)=>14,000	8,500
avoidable costs of M2 (8500*(1-0.70))	nil	2,550	(2,550)
net income	$3,400	$2,850	($550)

since the net income reduced M2 shall not be discontinued.

b.Cost allocation death spiral effect.

Cost allocation death spiral effect occurs when fixed costs are allocated to products on basis of volume, but not on basis of activities.

For example; If two products x and y are produced by a firm, which allocates fixed costs on basis of number of units of the products.

Suppose 1000 units of X and 500 units of Y are produced.

The present allocation system will allocate 67% of fixed costs to product X (1000 units / 1500 units) and 33% of fixed costs to Y (500 / 1500 units).

Instead if fixed costs were allocated on basis of activities then most of the costs would have been allocated to Y.

This wrong allocation may result in discontinuing of product x , which would result in all the fixed costs to be absorbed by Y, due to which the price of product Y can be hiked, which may result in product Y becoming pricier than competition, which may result in closing down of business, this is the death spiral effect.

C.

Opportunity costs;

The cost of an alternative foregone in decision making is the opportunity cost.

Example:

You purchased a lot of land a few years ago, whose present market value is $100,000.

If you decide to use this land for opening a restaurant, the project cash outflows shall include this opportunity cost of land of $100,000.