11-40 Make or buy, unknown level of volume. (A. Atkinson, adapted) Denver Engineering manufactures small engines that it sells to manufacturers who install them in products such as lawn mowers. The company currently manufactures all the parts used in these engines but is considering a proposal from an external supplier who wishes to supply the starter assemblies used in these engines. The starter assemblies are currently manufactured in Division 3 of Denver Engineering. The costs relating to the starter assemblies for the past 12 months were as follows: Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for each starter assembly is $10 ($1,500,000  150,000). Further analysis of manufacturing overhead revealed the following information. Of the total manufacturing overhead, only 25% is considered variable. Of the fixed portion, $300,000 is an allocation of general overhead that will remain unchanged for the company as a whole if production of the starter assemblies is discontinued. A further $200,000 of the fixed overhead is avoidable if production of the starter assemblies is discontinued. The balance of the current fixed overhead, $100,000, is the division manager’s salary. If Denver Engineering discontinues production of the starter assemblies, the manager of Division 3 will be transferred to Division 2 at the same salary. This move will allow the company to save the $80,000 salary that would otherwise be paid to attract an outsider to this position. Required: 1. Tutwiler Electronics, a reliable supplier, has offered to supply starter-assembly units at $8 per unit. Because this price is less than the current average cost of $10 per unit, the vice president of manufacturing is eager to accept this offer. On the basis of financial considerations alone, should Denver Engineering accept the outside offer? Show your calculations. (Hint: Production output in the coming year may be different from production output in the past year.) 2. How, if at all, would your response to requirement 1 change if the company could use the vacated plant space for storage and, in so doing, avoid $100,000 of outside storage charges currently incurred? Why is this information relevant or irrelevant? SOLUTION (30–40 min.) 1. Make or buy, unknown level of volume. The variable costs required to manufacture 150,000 starter assemblies are Direct materials Direct manufacturing labor Variable manufacturing overhead Total variable costs $400,000 300,000 200,000 $900,000 The variable costs per unit are $900,000 ÷ 150,000 = $6.00 per unit. Let X = number of starter assemblies required in the next 12 months. The data can be presented in both “all data” and “relevant data” formats: Variable manufacturing costs Fixed general manufacturing overhead Fixed overhead, avoidable Division 2 manager’s salary Division 3 manager’s salary Purchase cost, if bought from Tutwiler Electronics Total costs All Data Relevant Data Alternative Alternative Alternative Alternative 1: 2: 1: 2: Buy Make Buy Make – $ 6X – $ 6X – – $300,000 300,000 – 200,000 – 200,000 $100,000 80,000 100,000 80,000 – 100,000 – 100,000 – $680,000 + $ 6X 8X $400,000 + $ 8X – $380,000 + $ 6X 8X $100,000 + $ 8X The number of units at which the costs of make and buy are equivalent is All data analysis: or Relevant data analysis: $680,000 + $6X = $400,000 + $8X 2X = 280,000 X = 140,000 $380,000 + $6X = $100,000 + $8X 2X = 280,000 X = 140,000 Assuming cost minimization is the objective, then • If production is expected to be less than 140,000 units, it is preferable to buy units from Tutwiler. • If production is expected to exceed 140,000 units, it is preferable to manufacture internally (make) the units. • If production is expected to be 140,000 units, Denver should be indifferent between buying units from Tutwiler and manufacturing (making) the units internally. 2. The information on the storage cost, which is avoidable if self-manufacture is discontinued, is relevant; these storage charges represent current outlays that are avoidable if self-manufacture is discontinued. Assume these $100,000 charges are represented as an opportunity cost of the make alternative. The costs of internal manufacture that incorporate this $100,000 opportunity cost are All data analysis: Relevant data analysis: $780,000 + $6X $480,000 + $6X Alternatively stated, we would add the following line to the table shown in requirement 1 causing the total costs line to change as follows: All Data Alternative 1: Alternative 2: Make Buy Outside storage charges Total costs Relevant Data Alternative 1: Alternative 2: Make Buy $100,000 $0 $100,000 $0 $780,0001 + 6X $400,000 + 8X $480,0002 + 6X $100,000 + 8X 1 $780,000 = $680,000 + $100,000 2 $480,000 = $380,000 + $100,000 The number of units at which the costs of make and buy are equivalent is All data analysis: Relevant data analysis: $780,000 + $6X = $400,000 + $8X 2X = 380,000 X = 190,000 $480,000 + $6X = $100,000 + $8X 2X = 380,000 X = 190,000 If production is expected to be less than 190,000, it is preferable to buy units from Tutwiler. If production is expected to exceed 190,000, it is preferable to manufacture the units internally. 11-41 Make versus buy, activity-based costing, opportunity costs. The Lexington Company produces gas grills. This year’s expected production is 20,000 units. Currently, Lexington makes the side burners for its grills. Each grill includes two side burners. Lexington’s management accountant reports the following costs for making the 40,000 burners: Lexington has received an offer from an outside vendor to supply any number of burners Lexington requires at $14.80 per burner. The following additional information is available: a. Inspection, setup, and materials-handling costs vary with the number of batches in which the burners are produced. Lexington produces burners in batch sizes of 1,000 units. Lexington will produce the 40,000 units in 40 batches. b. Lexington rents the machine it uses to make the burners. If Lexington buys all of its burners from the outside vendor, it does not need to pay rent on this machine. Required: 1. Assume that if Lexington purchases the burners from the outside vendor, the facility where the burners are currently made will remain idle. On the basis of financial considerations alone, should Lexington accept the outside vendor’s offer at the anticipated volume of 40,000 burners? Show your calculations. 2 For this question, assume that if the burners are purchased outside, the facilities where the burners are currently made will be used to upgrade the grills by adding a rotisserie attachment. (Note: Each grill contains two burners and one rotisserie attachment.) As a consequence, the selling price of grills will be raised by $48. The variable cost per unit of the upgrade would be $38, and additional tooling costs of $160,000 per year would be incurred. On the basis of financial considerations alone, should Lexington make or buy the burners, assuming that 20,000 grills are produced (and sold)? Show your calculations. 3. The sales manager at Lexington is concerned that the estimate of 20,000 grills may be high and believes that only 16,000 grills will be sold. Production will be cut back, freeing up work space. This space can be used to add the rotisserie attachments whether Lexington buys the burners or makes them in-house. At this lower output, Lexington will produce the burners in 32 batches of 1,000 units each. On the basis of financial considerations alone, should Lexington purchase the burners from the outside vendor? Show your calculations. SOLUTION (30 min.) 1. Make versus buy, activity-based costing, opportunity costs. Relevant costs under buy alternative: Purchases, 40,000  $14.80 $592,000 Relevant costs under make alternative: Direct materials Direct manufacturing labor Variable manufacturing overhead Inspection, setup, materials handling Machine rent Total relevant costs under make alternative $320,000 160,000 80,000 8,000 12,000 $580,000 The allocated fixed plant administration, taxes, and insurance will not change if Lexington makes or buys the burners. Hence, these costs are irrelevant to the make-or-buy decision. The analysis indicates that it is less costly for Lexington to make rather than buy the burners from the outside supplier. 2. Relevant costs under the make alternative: Relevant costs (as computed in requirement 1) Relevant costs under the buy alternative: $580,000 Costs of purchases (40,000  $14.80) Additional tooling costs Additional contribution margin from using the space where the burners were made to upgrade the grills by adding rotisserie attachments, 20,000  ($48 – $38) Total relevant costs under the buy alternative $592,000 160,000 (200,000) $552,000 Lexington should buy the side burners from an outside vendor and use its own capacity to upgrade its grills. 3. In this requirement, the decision on making the rotisserie attachments is irrelevant to the analysis because the rotisserie attachments increase operating income and they will be made whether the burners are purchased or made. Relevant cost of manufacturing burners: Variable costs, ($8 + $4 + $2 = $14)  32,000 Batch costs, $200/batcha 32 batches Machine rent Relevant cost of buying burners, $14.80  32,000 a $448,000 6,400 12,000 $466,400 473,600 $8,000  40 batches = $200 per batch In this case, Lexington should make the burners. 11-42 Product mix, constrained resource. Wechsler Company produces three products: A130, B324, and C587. All three products use the same direct material, Brac. Unit data for the three products are: The demand for the products far exceeds the direct materials available to produce the products. Brac costs $9 per pound, and a maximum of 5,000 pounds is available each month. Wechsler must produce a minimum of 200 units of each product. Required: 1. How many units of product A130, B324, and C587 should Wechsler produce? 2. What is the maximum amount Wechsler would be willing to pay for another 1,200 pounds of Brac? SOLUTION (25 min.) Product mix, constrained resource. 1. Selling price Variable costs: Direct materials (DM) Labor and other costs Total variable costs Contribution margin Pounds of DM per unit Contribution margin per lb. A130 $252 B324 $ 168 C587 $210 72 84 156 $ 96 ÷8 lbs. $ 12 per lb. 45 81 126 $ 42 ÷5 lbs. $8.40 per lb. 27 120 147 $ 63 ÷ 3 lbs. $ 21 per lb. First, satisfy minimum requirements. Minimum units Times pounds per unit Pounds needed to produce minimum units A130 200 ×8 lb. per unit 1,600 lb. B324 200 ×5 lb. per unit 1,000 lb. C587 200 ×3 lb. per unit 600 lb. Total 3,200 lb. The remaining 1,800 pounds (5,000 – 3,200) should be devoted to C587 because it has the highest contribution margin per pound of direct material. Because each unit of C587 requires 3 pounds of Brac, the remaining 1,800 pounds can be used to produce another 600 units of C587. The following combination yields the highest contribution margin given the 5,000 pounds constraint on availability of Brac. A130: 200 units B324: 200 units C587: 800 units (200 minimum + 600 extra) 2. The demand for Wechsler’s products exceeds the materials available. Assuming that fixed costs are covered by the original product mix, Wechsler would be willing to pay up to an additional $21 per pound (the contribution margin per pound of C587) for another 1,200 pounds of Brac. That is, Wechsler would be willing to pay $9 + $21 = $30 per pound of Brac for the pounds of Brac that will be used to produce C587.1 If sufficient demand does not exist for 400 units (1,200 pounds ÷ 3 pounds per unit) of C587, then the maximum price Wechsler would be willing to pay is an additional $12 per pound (the contribution margin per pound of A130) for the pounds of Wechsler that will be used to produce A130. In this case Wechsler would be willing to pay $9 + $12 = $21 pound. If all the 1,200 pounds of Brac are not used to satisfy the demand for C587 and A130, then the maximum price Wechsler would be willing to pay is an additional $8.40 per pound (the contribution margin per pound of B324) for the pounds of Brac that will be used to produce B324. Wechsler would be willing to pay $8.40 + $9 = $17.40 per pound of Brac. 1 An alternative calculation focuses on column 3 for C587 of the table in requirement 1. Selling price $210 Variable labor and other costs (excluding direct materials) 120 Contribution margin $ 90 Divided by pounds of direct material per unit ÷3 lbs. Direct material cost per pound that Wechsler can pay without contribution margin becoming negative $ 30 11-43 Product mix, special order. (N. Melumad, adapted) Gormley Precision Tools makes cutting toolsfor metalworking operations. It makes two types of tools: A6, a regular cutting tool, and EX4, a high-precisioncutting tool. A6 is manufactured on a regular machine, but EX4 must be manufactured on both the regularmachine and a high-precision machine. The following information is available: Additional information includes the following: a. Gormley faces a capacity constraint on the regular machine of 50,000 hours per year. b. The capacity of the high-precision machine is not a constraint. c. Of the $1,100,000 budgeted fixed overhead costs of EX4, $600,000 are lease payments for the high-precisionmachine. This cost is charged entirely to EX4 because Gormley uses the machine exclusively to produce EX4. The company can cancel the lease agreement for the high-precision machine at any time without penalties. d. All other overhead costs are fixed and cannot be changed. Required: 1. What product mix—that is, how many units of A6 and EX4—will maximize Gormley’s operating income? Show your calculations. 2. Suppose Gormley can increase the annual capacity of its regular machines by 15,000 machine hours at a cost of $300,000. Should Gormley increase the capacity of the regular machines by 15,000 machine-hours? By how much will Gormley’s operating income increase or decrease? Show your calculations. 3. Suppose that the capacity of the regular machines has been increased to 65,000 hours. Gormley has been approached by Clark Corporation to supply 20,000 units of another cutting tool, V2, for $240 per unit. Gormley must either accept the order for all 20,000 units or reject it totally. V2 is exactly like A6 except that its variable manufacturing cost is $140 per unit. (It takes 1 hour to produce one unit of V2 on the regular machine, and variable marketing cost equals $30 per unit.) What product mix should Gormley choose to maximize operating income? Show your calculations. SOLUTION (30–40 min.) Product mix, relevant costs. 1. A6 Selling price Variable manufacturing cost per unit Variable marketing cost per unit Total variable costs per unit Contribution margin per unit Contribution margin per hour of the constrained resource Total contribution margin from selling only A6 or only EX4 A6: $50  50,000; EX4: $60  50,000 Less Lease costs of high-precision machine to produce and sell EX4 Net relevant benefit $ 200 120 30 150 50 EX4 $ 300 200 70 270 30 $ $50 = $50 1 $ $30 = $60 0.5 $2,500,000 $3,000,000 0 $2,500,000 600,000 $2,400,000 Even though EX4 has the higher contribution margin per unit of the constrained resource, the fact that Gormley must incur additional costs of $600,000 to achieve this higher contribution margin means that Gormley is better off using its entire 50,000-hour capacity on the regular machine to produce and sell 50,000 units (50,000 hours  1 hour per unit) of A6. The additional contribution from selling EX4 rather than A6 is $500,000 ($3,000,000  $2,500,000), which is not enough to cover the additional costs of leasing the high-precision machine. Note that, because all other overhead costs are fixed and cannot be changed, they are irrelevant for the decision. Gormley produces 50,000 units of A6, which increases operating income by $2,500,000. 2. If capacity of the regular machines is increased by 15,000 machine-hours to 65,000 machine-hours (50,000 originally + 15,000 new), the net relevant benefit from producing A6 and EX4 is as follows: A6 EX4 Total contribution margin from selling only A6 or only EX4 A6: $50  65,000; EX4: $60  65,000 Less Lease costs of high-precision machine that would be incurred if EX4 is produced and sold Less Cost of increasing capacity by 15,000 hours on regular machine Net relevant benefit $3,250,000 $3,900,000 600,000 300,000 $2,950,000 300,000 $3,000,000 Adding 15,000 machine-hours of capacity for regular machines and using all the capacity to produce EX4 increases operating income by $3,000,000. Investing in the additional capacity increases Gormley’s operating income by $500,000 ($3,000,000 calculated in requirement 2 minus $2,500,000 calculated in requirement 1), so Gormley should add 15,000 hours to the regular machine. With the extra capacity available to it, Gormley should use its entire capacity to produce EX4. Using all 65,000 hours of capacity to produce EX4 rather than to produce A6 generates additional contribution margin of $650,000 ($3,900,000  $3,250,000), which is more than the additional cost of $600,000 to lease the highprecision machine. Gormley should therefore produce and sell 130,000 units of EX4 (65,000 hours  0.5 hours per unit of EX4) and zero units of A6. 3. Selling price Variable manufacturing costs per unit Variable marketing costs per unit Total variable costs per unit Contribution margin per unit A6 EX4 V2 $200 120 30 150 $ 50 $300 200 70 270 $ 30 $240 140 30 170 $ 70 $30 $70 $50 0.5 Contribution margin per unit of the constrained resource = $60; 1 = $70 1 = $50; The first step is to compare the operating profits that Gormley could earn if it accepted the Clark Corporation offer for 20,000 units with the operating profits Gormley is currently earning. V2 has the highest contribution margin per hour on the regular machine and requires no additional investment such as leasing a high-precision machine. To produce the 20,000 units of V2 requested by Clark Corporation, Gormley would require 20,000 hours on the regular machine resulting in contribution margin of $70 20,000 = $1,400,000. Gormley now has 45,000 hours available on the regular machine to produce A6 or EX4. Total contribution margin from selling only A6 or only EX4 A6: $50  45,000; EX4: $60  45,000 Less Lease costs of high-precision machine to produce and sell EX4 Net relevant benefit A6 EX4 $2,250,000 $2,700,000  $2,250,000 600,000 $2,100,000 Gormley should use all the 45,000 hours of available capacity to produce 45,000 units of A6. Thus, the product mix that maximizes operating income is 20,000 units of V2, 45,000 units of A6, and zero units of EX4. This optimal mix results in a contribution margin of $3,650,000 ($1,400,000 from V2 and $2,250,000 from A6). Relative to requirement 2, operating income increases by $650,000 ($3,650,000 minus $3,000,000 calculated in requirement 2). Hence, Gormley should accept the Clark Corporation business and supply 20,000 units of V2. 11-44 Theory of constraints, throughput margin, and relevant costs. Rush Industries manufactureselectronic testing equipment. Rush also installs the equipment at customers’ sites and ensures that it functions smoothly. Additional information on the manufacturing and installation departments is as follows (capacities are expressed in terms of the number of units of electronic testing equipment): Rush manufactures only 275 units per year because the installation department has only enough capacity to install 275 units. The equipment sells for $45,000 per unit (installed) and has direct material costs of $20,000. All costs other than direct material costs are fixed. The following requirements refer only to the preceding data. There is no connection between the requirements. Required: 1. Rush’s engineers have found a way to reduce equipment manufacturing time. The new method would cost an additional $50 per unit and would allow Rush to manufacture 20 additional units a year. Should Rush implement the new method? Show your calculations. 2. Rush’s designers have proposed a change in direct materials that would increase direct material costs by $2,000 per unit. This change would enable Rush to install 310 units of equipment each year. If Rush makes the change, it will implement the new design on all equipment sold. Should Rush use the new design? Show your calculations. 3. A new installation technique has been developed that will enable Rush’s engineers to install 7 additional units of equipment a year. The new method will increase installation costs by $55,000 each year. Should Rush implement the new technique? Show your calculations. 4. Rush is considering how to motivate workers to improve their productivity (output per hour). Oneproposal is to evaluate and compensate workers in the manufacturing and installation departments onthe basis of their productivities. Do you think the new proposal is a good idea? Explain briefly. SOLUTION (20 min.) Theory of constraints, throughput contribution, relevant costs. 1. It will cost Rush $50 per unit to reduce manufacturing time. But manufacturing is not a bottleneck operation; installation is. Therefore, manufacturing more equipment will not increase sales and throughput margin. Rush Industries should not implement the new manufacturing method. 2. Increase in throughput margin, $25,000  35 units, $ 875,000 Additional relevant costs of new direct materials, $2,000  310 units, 620,000 Increase/(Decrease) in operating income $ 255,000 The benefits from higher margin exceeds the additional incremental costs by $225,000 and, therefore, Rush Industries should implement the new design. Alternatively, compare throughput margin under each alternative. With the modification, throughput margin is $23,000  310 Current throughput margin is $25,000  275 Increase/(Decrease) in operating income $7,130,000 6,875,000 $ 255,000 The throughput margin resulting from the proposed change in direct materials is greater than the current throughput margin. Therefore, Nebraska Industries should implement the new design. 3. Increase in throughput margin, $25,000  7 units Increase in relevant costs Increase in operating income $ 175,000 55,000 $ 120,000 The additional throughput margin exceeds incremental costs by $120,000, so Rush Industries should implement the new installation technique. 4. Motivating installation workers to increase productivity is worthwhile because installation is a bottleneck operation, and any increase in productivity at the bottleneck will increase throughput margin. On the other hand, motivating workers in the manufacturing department to increase productivity is not worthwhile. Manufacturing is not a bottleneck operation, so any increase in output will result only in extra inventory of equipment. Rush Industries should encourage manufacturing to produce only as much equipment as the installation department needs, not to produce as much as it can. Under these circumstances, it would not be a good idea to evaluate and compensate manufacturing workers on the basis of their productivity. 11-45 Theory of constraints, contribution margin, sensitivity analysis. Talking Toys (TT) produces dollsin two processes: molding and assembly. TT is currently producing two models: Chatty Chelsey and Talking Tanya. Production in the molding department is limited by the amount of materials available. Production in the assembly department is limited by the amount of trained labor available. The only variable costs are materials in the molding department and labor in the assembly department. Following are the requirements and limitations by doll model and department: The following requirements refer only to the preceding data. There is no connection between the requirements. Required: 1. If there were enough demand for either doll, which doll would TT produce? How many of these dolls would it make and sell? 2. If TT sells three Chatty Chelseys for each Talking Tanya, how many dolls of each type would it produce and sell? What would be the total contribution margin? 3. If TT sells three Chatty Chelseys for each Talking Tanya, how much would production and contribution margin increase if the molding department could buy 900 more pounds of materials for $8 per pound? 4. If TT sells three Chatty Chelseys for each Talking Tanya, how much would production and contribution margin increase if the assembly department could get 65 more labor hours at $12 per hour? SOLUTION 11-45 (30-35 min.) Theory of constraints, contribution margin, sensitivity analysis. 1. Assuming only one type of doll is produced, the maximum production in each department given their resource constraints is: Chatty Chelsey Talking Tanya Molding Department 36,000 lbs = 18,000 2 lbs 36,000 lbs = 12,000 3 lbs Assembly Department 8,500 hours = 34,000 1/4 hours 8,500 hours = 25,500 1/3hours Contribution Margin $39 − 2 × $8 – 1/4 × $12 = $20 $50 − 3 × $8–1/3 × $12 = $22 For both types of dolls, the constraining resource is the availability of material because this constraint causes the lowest maximum production. If only Chatty Chelsey is produced, TT can produce 18,000 dolls with a contribution margin of 18,000 ×$20 = $360,000 If only Talking Tanya is produced, TTcan produce 12,000 dolls with a contribution margin of 12,000 ×$22 = $264,000. TT should produce Chatty Chelseys. 2. As shown in Requirement 1, available material in the Molding department is the limiting constraint. If TT sells three Chatty Chelseys for each Talking Tanya, then the maximum number of Talking Tanya dolls the Molding Departmentcan produce (where the number of Talking Tanya dolls is denoted as T) is: (T ×3 lbs.) + ([3 × T] × 2 lbs.) = 36,000lbs. 3T + 6T = 36,000 9T = 36,000 T = 4,000 The Molding Department can produce 4,000 Talking Tanya dolls, and 3 ×4,000 (or 12,000) Chatty Chelsey dolls. Because TT can only produce 4,000 Talking Tanyas and 12,000 Chatty Chelseys before it runs out of ingredients, the maximum contribution margin (CM) is: Contribution margin from Chatty Chelsey + Contribution margin from Talking Tanya = 12,000 × $20 + 4,000 × $22 = $240,000 + 88,000 = $328,000 3. With 900 more pounds of materials, TT would produce more dolls. Using the same technique as in Requirement 2, the increase in production is: (T×3 lbs.) + ([3×T] ×2 lbs.) = 900 lbs. 3T + 6T = 900 T = 100 TT would produce 100 extra Talking Tanya dolls and 300 extra Chatty Chelsey dolls. Contribution margin would increase by Contribution margin + Contribution margin = 300  $20 + 100  $22 from Chatty Chelsey from Talking Tanya = $6,000 + $2,200 = $8,200 4. With 65 more labor hours, production would not change. The limiting constraint is pounds of material, not labor hours. TT already has more labor hours available than it needs. 11-46 Closing down divisions. Ainsley Corporation has four operating divisions. The budgeted revenues and expenses for each division for 2017 follows: Closing down any division would result in savings of 40% of the fixed costs of that division. Top management is very concerned about the unprofitable divisions (A and B) and is considering closing them for the year. Required: 1. Calculate the increase or decrease in operating income if Ainsley closes division A. 2. Calculate the increase or decrease in operating income if Ainsley closes division B. 3. What other factors should the top management of Ainsley consider before making a decision? SOLUTION (25 min.) Closing down divisions. 1. and 2. Sales Variable costs of goods sold ($440,000 0.90; $930,000  0.80) Variable S,G & A ($96,000 0.50; $202,500  0.50) Total variable costs Contribution margin Fixed costs of goods sold ($440,000  0.10; $930,000  0.20) Fixed S,G & A ($96,000  0.50; $202,500  0.50) Total fixed costs Fixed costs savings if shutdown ($92,000 0.40; $287,250  0.40) Division A Division B $504,000 $948,000 396,000 48,000 444,000 $ 60,000 744,000 101,25 0 845,250 $102,750 Division A Division B $ 44,000 $186,000 48,000 $ 92,000 101,250 $287,250 $ 36,800 $114,900 Division A’s contribution margin of $60,000 more than covers its avoidable fixed costs of $36,800. The difference of $23,200 helps cover the company’s unavoidable fixed costs. Because $36,800 of Division A’s fixed costs are avoidable, the remaining $55,200 is unavoidable and will be incurred regardless of whether Division A continues to operate. Division A’s $32,000 loss is the rest of the unavoidable fixed costs ($55,200 – $23,200). If Division A is closed, the remaining divisions will need to generate sufficient profits to cover the entire $55,200 unavoidable fixed cost. Consequently, Division A should not be closed because it helps defray $23,200 of this cost. Division B earns a positive contribution margin of $102,750. Division B also generates $114,900 of avoidable fixed costs. Based strictly on financial considerations, Division B should be closed because the company will save $12,150 ($114,900 –$102,750). Division B is currently incurring $114,900 in fixed costs that it could have avoided while earning only $102,750 in contribution margin. An alternative set of calculations is as follows: Division A Division B Total variable costs Avoidable fixed costs if shutdown Total cost savings if shutdown Loss of revenues if shutdown $444,000 36,800 480,800 (504,000) $845,250 114,900 960,150 (948,000) Cost savings minus loss of revenues $ (23,200) $ 12,150 Division A should not be shut down because loss of revenues if Division A is shut down exceeds cost savings by $23,200. Division B should be shut down because cost savings from shutting down Division B exceeds loss of revenues by $12,150. 3. Before deciding to close Division B, management should consider the role that the Division’s product line plays relative to other product lines. For instance, if the product manufactured by Division B attracts customers to the company, then dropping Division B may have a detrimental effect on the revenues of the remaining divisions. Management may also want to consider the impact on the morale of the remaining employees if Division B is closed. Talented employees may become fearful of losing their jobs and seek employment elsewhere. 11-47 Dropping a product line, selling more tours. Mechum River Anglers, a division of Old Dominion Travel, offers two types of guided fly fishing tours, Basic and Deluxe. Operating income for each tour type in 2017 is as follows: Basic Deluxe Revenues (500 × $900; 400 × $1,650) $450,000 $660,000 Operating costs Administrative salaries 120,000 100,000 Guide wages 130,000 380,000 Supplies 50,000 100,000 Depreciation of equipment 25,000 60,000 Vehicle fuel 30,000 24,000 Allocated corporate overhead 45,000 66,000 Total operating costs 400,000 730,000 Operating income (loss) $50,000 $(70,000) The equipment has a zero disposal value. Guide wages, supplies, and vehicle fuel are variable costs with respect to the number of tours. Administrative salaries are fixed costs with respect to the number of tours. Brad Barrett, Mechum River Anglers’ president, is concerned about the losses incurred on the deluxe tours. He is considering dropping the deluxe tour and offering only the basic tour. Required: 1. If the deluxe tours are discontinued, one administrative position could be eliminated, saving the company $50,000. Assuming no change in the sales of basic tours, what effect would dropping the deluxetour have on the company’s operating income? 2. Refer back to the original data. If Mechum River Anglers drops the deluxe tours, Barrett estimates that sales of basic tours would increase by 50%. He believes that he could still eliminate the $50,000 administrative position. Equipment currently used for the deluxe tours would be used by the additional basic tours. Should Barrett drop the deluxe tour? Explain. 3. What additional factors should Barrett consider before dropping the deluxe tours? SOLUTION (30 min.) Dropping a product line, selling more tours 1. Barrett should not drop the deluxe tours, as follows: Lost revenues from deluxe tours Avoidable operating costs from dropping deluxe tours: Administrative salaries Guide wages Supplies Vehicle fuel Total avoidable costs Lost operating income from dropping deluxe tours $(660,000) 50,000 380,000 100,000 24,000 554,000 $(106,000) Note: Equipment depreciation, allocated corporate costs, and unavoidable administrative salaries are irrelevant to the decision. 2. Barrett should drop the deluxe tours, as follows: Change in revenues Change in operating costs: Administrative salaries Guide wages Supplies Vehicle fuel Total change in operating costs Change in operating income Basic $225,000 Deluxe $(660,000) Total $(435,000) 0 65,000 25,000 15,000 105,000 $120,000 (50,000) (380,000) (100,000) (24,000) (554,000) $(106,000) (50,000) (315,000) (75,000) (9,000) (449,000) $ 14,000 3. Barrett should consider if it is possible to increase the number of deluxe tours sold, or if it is possible to reduce the costs of those tours before dropping them. He could also investigate the possibility of increasing the price of the deluxe tours if customers would tolerate it.