CH-12 Financial and Cost-Volume-Profit Models – Cost Management: Strategies for Business Decisions : Book Guide

Chapter 12 Financial and Cost-Volume-Profit Models ANSWERS TO REVIEW QUESTIONS 12.1 Review the list of key terms at the end of the chapter and the definitions in the glossary. 12.2 A good financial model has the following characteristics: (a) It is flexible and allows a user to test the interaction of economic variables under a variety of different conditions. (b) It reliably predicts what will happen if a certain actions are taken in a controlled test environment. (c) It allows study of a particular action without having to experience the actual occurrence of that action (e.g., a simulated large financial loss rather than the real thing). (d) Its assumptions and parameters are evident, clearly explained and easily changed. 12.3 Financial models offer several benefits. Once the model is developed, a user can increase the amount of time spent on financial analysis without being overwhelmed by the related number crunching. In addition, an organization can study the impact of a possible business action by reviewing the potential results before that action really occurs. The result is that a good (or bad) project can be identified (and rejected) prior to its implementation. 12.4 The objectives of financial modeling are to reliably simulate relations among financial variables and to support business decisions. 12.5 The elements of a CVP model are prices, variable (or throughput) costs, quantities, and committed (or fixed) costs. The CVP model is a special financial model in which the only driver of costs, revenues, and profits is the quantity of product or service produced and sold. A more general model includes multiple cost and revenue drivers. This more general model has no generally accepted name, but it could be a cost-revenue-driver (CRD) model. We doubt that this more descriptive but awkward acronym will catch on. The basic CVP model has several other limitations. The following items, for example, are assumed to remain constant: sales mix, technology, efficiency, and management. The model is based on straight-line linear relationships, thus ignoring such factors as quantity discounts. 12.6 At the breakeven point, revenues equal costs and accounting profits are zero. At the target breakeven point, revenues exceed costs by the amount of the profit target. If the profit target is the opportunity cost of the resources used, one could say that the target breakeven point is an economic breakeven point. 12.7 A CVP graph is a financial model because it displays and communicates the effects of the cost and revenue driver (quantity of product or service) on elements of financial performance: revenues, costs, and profits. In some situations, a CVP graph can communicate these results more effectively than a formula, income statement, or table. 12.8 Two primary advantages of computerized financial models are, first, accuracy and, second, flexibility. Properly constructed computer models eliminate opportunities for numerical errors and permit rapid and extensive changes to elements of the model. Because of these advantages, the days of manual financial models are all but gone. 12.9 The main reasons for locating a computer model’s parameters in one location are to identify the model’s parameters (and assumptions) and to allow ready changes to any of the parameters. A related reason is that users of the model do not need to know where each parameter is used when they desire to test the effects of changes. Revisions of the model’s relations or formulas also are easier when parameters are located in one place. For example in Excel, it is easy to find where each parameter is used by clicking on it and using the program’s auditing feature to trace each use of the parameter. 12.10 The average (or effective) tax rate is a reasonable assumption about the effect of taxes on financial outcomes when projects are small enough that the overall average tax rate will not change much (with or without the project). If a project is large, the average rate may change significantly and should be revised to include the effects of the project. 12.11 The sales mix is assumed to remain constant (i.e., as predicted). This assumption is needed because the different models likely produce differing contribution margins for the firm. A change in sales mix will cause the weighted-average unit contribution margin to change, thus affecting the break-even point. Stated differently, a fluctuation in sales mix will influence the organization’s cost, volume, and profit relationships. 12.12 The weighted-average unit contribution margin is the average contribution margin from all products produced and sold at a given sales mix. It is the contribution margin per unit of the “average” product or service. Each “average” product contributes the calculated amount toward covering committed (or higher-level) costs. 12.13 Throughput is the difference between revenues and unit-level costs of products or services that can be sold in the current period. Contribution margin is the difference between revenues and variable costs used to produce products or services that can be sold. The difference between the measures is the difference between unit-level costs and variable costs. Unit-level costs are acquired and used for each unit produced during the period, whereas variable costs also can include traced uses of resources that are committed for the period. 12.14 An activity-based costing (ABC) system provides a more complete picture of cost-volume-profit (CVP) relationships than the basic model. ABC describes various activities (e.g., unit-level, batch-level, product-level, customer-level, and facility-level) that drive a company’s costs. The integration of ABC into a CVP model thus recognizes the existence of multiple cost drivers, resulting in the production of better information for management. 12.15 Both sensitivity analysis and scenario analysis are methods for modeling risk. Sensitivity analysis tests the effects on outcomes from changing one or more parameters by feasible amounts. Scenario analysis describes feasible or likely patterns of model parameters. These include best, worst, and most likely cases. 12.16 When production resources are limited, a firm should focus on the savings or contribution margin per unit of scarce resource (e.g., machine hours, direct labor hours, and so forth). If the firm is faced with multiple constraints, it should turn to linear programming to optimize results. 12.17 The theory of constraints models the effects of synchronizing all production to bottleneck capacity. This theory also encourages a cost management attitude of constantly looking for and loosening constraints on improvements to performance. The theory of constraints does not passively accept costs or limits as given, but challenges the status quo to change and improve. 12.18 Both executives might be in error or correct. If the company operates in competitive markets (i.e., they are price takers), it cannot unilaterally raise prices and expect to sell at anything close to past volumes. Buyers have opportunities to buy the same product or service at a lower price. Thus, raising prices could cause a rapid drop in sales levels and revenues. If the company’s market is less competitive, a price increase could be beneficial, but this requires modeling demand for the company’s products and services. This can be accomplished with sensitivity and scenario analysis based on market experience or the company’s estimated demand curve, which reflects the effects of price changes on sales volume (demand elasticity). This complexity can be part of the financial model. 12.19 Since the model is based on historical relationships, it can be tested on the basis of those same relationships. For example, the model, as designed, is used to predict inflows and outflows by integrating receivables collection patterns, outflows for inventory, and so forth. The actual variables from January, Year 1 can be processed through the model to produce expected total inflows and expected total outflows. The “expected” numbers can then be compared against actual experience. This process can be repeated for several different months, and if expected and actual results differ by more than an acceptable amount, the model would likely be fine-tuned before it is put in use. 12.20 CVP is based on several simplifying assumptions, including a constant sales mix, straight-line relationships among costs and revenues, and constant technology, efficiency, and management. Although most of these assumptions could be criticized as being unrealistic, many are valid over a short period of time. The CVP model can be a helpful short-run planning model, allowing a user to study the cost-volume-profit relationships of an organization over a limited time frame. Over a longer period of time, though, the model loses much of its relevance. 12.21 The model could be extended to performance evaluation by considering controllability of committed costs (i.e., controlled by the division managers and employees). The equation introduced in the chapter, Sales revenue - Variable cost - Committed cost = Profit, could be reformatted as: Sales revenue – Variable cost = Contribution margin; Contribution margin – Controlled committed costs = Controllable contribution margin Controllable contribution margin – Uncontrolled Committed costs = Segment margin Divisional managers could be evaluated on the basis of the controllable contribution margin because this measure considers all costs and revenues that the managers can control. Divisions, in contrast, can be evaluated on the basis of the segment margin, which takes into account all amounts that belong to the division. This latter measure can be used to help assess whether the division should be kept as a long-term operating unit of the firm. 12.22 Generally speaking, the first product will result in maximum profits if three conditions are met. First, we must consider sales volume. If the result of multiplying the first product’s unit contribution margin by the sales volume is greater than the amount obtained by performing the same mathematical procedure for the second product, profits will be maximized. (It is possible, of course, that a higher unit contribution margin on the first product will be more than offset by a large sales volume associated with the second product.) Second, the first product will be more attractive if resources such as machine time and labor time are readily available. Finally, even if constraints are present, the first product would be more attractive than the second if its contribution margin per unit of scarce resource is greater than that of the second product. 12.23 A negative contribution margin arises when variable cost exceeds the unit’s selling price—a common occurrence with the marketing procedure known as a loss-leader. With a loss-leader, the retailer may intentionally take a loss on selected products in hopes of generating additional store traffic and customers. The hoped-for result is an increase in sales of other items (e.g., tennis racquets, golf clubs, athletic wear) and profits. 12.24 Predictions from financial models depend on the assumptions, parameters, and estimated relations among parameters. Some users of models do not realize that different assumptions, parameter values, or scenarios may be as likely as those initially presented. The real power of financial models is their ability to vary the elements of the model to explore alternative outcomes. Any model should be presented (truthfully, we hope) as a valid representation of reality, but one that cannot predict the exact set of elements that will occur. Thus, users of the model must test the sensitivity of the model with alternative scenarios and judge which outcome best describes their beliefs about the future. In the case given, the modeler and the planning committee should test whether changes in parameters and scenarios affect the product’s profitability and the Omaha plant’s viability. 12.25 Garbage in usually does result in garbage out. If the organization’s CEO is equally skeptical, you should be prepared to present the steps taken to insure the model’s validity. These might include statistical analysis, interviews with knowledgeable personnel, tests to predict past outcomes, and descriptions of the model’s relations. 12.26 Potentially, cost managers could evaluate every task of the organization according to whether it helps the organization meet its goals. Tasks that fail this test are candidates for elimination. However and as a practical matter, most cost managers would not have the time for such exhaustive analyses. Instead, they would focus first on tasks that consume large amounts of resources. Eliminating large tasks that waste resources could have a larger, quicker beneficial effect than examining all tasks. Even if large tasks that waste resources are found, cost managers may decide that the costs of eliminating them by redesigning processes are greater than the benefits that would be realized. In this case, it may be less costly to waste resources on some tasks than to completely redesign a process. This finding may be suspect, however, since improving processes may have many benefits beyond eliminating wasteful tasks (such as, improving quality and delivery times). 12.27 The proper response is, “Yes, they should sweep floors and perform other maintenance activities if we do not have enough demand to use some processes at capacity.” The reason why “we” cannot meet demand for products is not because all processes operate at less than practical capacity. The reason is that there must be one or more bottlenecks that constrain overall throughput to less than demand. Before using non-bottleneck resources more fully, you must first identify the bottleneck or constraint on throughput. Only after increasing the use and/or capacity of the bottleneck should you increase the use of non-bottleneck resources, and then only as much as necessary to meet demand from the bottleneck. An exception might be when demand for the product is seasonal and it is more economical to build and inventory products in times of slack demand than to have sufficient capacity to meet seasonal demand. For example, Norway’s largest ice-cream manufacturer, Diplom-Is, makes ice cream all winter in anticipation of large summer demand. The company has found that it is cheaper to make ice cream during the long winter and store it at very low temperatures until demand materializes than to have enough capacity to make ice cream at a high enough rate to meet summer demand when it materializes. Otherwise its capacity (dairy and processing) would sit idle for much of the year. 12.28 Customers do appreciate expediting of their orders, but would (and do) bitterly complain if they find that their order is late because another customer’s order was expedited and placed ahead of theirs in the queue. It is generally more beneficial to the company and its customers to schedule completion of orders rationally so as to increase overall throughput. This leads to predictable delivery dates, and, if a customer really needs earlier delivery, arrangements may be made – at a fair price. The practice of expediting is common in some companies, but this practice often leads to tension in the workplace as sales and manufacturing personnel compete for places at the head of the line. Expediting also leads to wasted bottleneck time caused by unplanned downtime for too-frequent setups. Exceptions do happen, but organizations should strive to eliminate the practice of expediting customer orders – it should not be necessary, and is wasteful of scarce resources. 12.29 a. An employee in a bottleneck resource probably will welcome the TOC approach because it will “rationalize” work flow through the resource. On the other hand, the operators of a bottleneck resource may have accumulated power in the organization because they control the completion of orders, and they may be unwilling to give up that power. The practice of trading bottleneck processing for other favors may be difficult to change. b. An employee in a non-bottleneck resource may have difficulty understanding why he or she should not use the resource to its full capacity. Employees usually are reluctant to be obviously under-employed and should be given other duties when operation of the non-bottleneck is not needed. c. A salesperson may be used to being customers’ champion by successfully expediting orders through the organization. Under TOC, expediting is permitted only under unusual circumstances. On the other hand, under TOC, order completion times should be much more predictable, and customers should be able to plan when their orders will be delivered. This should lead to less need for expediting orders. d. Customer service representatives probably will see fewer complaints about late orders. They will have to coordinate reworking of faulty orders more carefully than before, because TOC will have synchronized all processing to bottleneck capacity. Many believe that TOC is not possible without simultaneous improvements in process quality that eliminate defects or faulty orders. Managing quality is covered in more detail in Chapter 7. SOLUTIONS TO EXERCISES 12.30 (20 min) Basic CVP Analysis. Canyon Escape. a. Break-even point (in tours): Committed cost ÷ Unit Contribution Margin $200,000 ÷ ($75 - $15) = 3,334 tours (rounded up) b. Number of tours: (Committed Cost + Target Operating Income)/Unit Contribution Margin ($200,000 + $42,000) ÷ ($75 - $15) = 4,034 (rounded up) 4,034 tours x $75 = $302,500 revenue c. Revised profit at 3,334 tours = 3,334 x ($75 -$20) – $200,000 = ($16,667) Therefore, committed costs must be reduced by $16,667 to breakeven with higher variable costs 12.31 (20 min) Basic CVP Analysis. Delta Safety Systems. a. Break-even point (in units): Committed cost ÷ Unit Contribution Margin $3,000,000 ÷ ($5,000 - $3,000) = 1,500 components b. The company could raise selling price, decrease the variable cost per unit, and/or decrease committed costs. c. $4,500 price: Profits = ($4,500 - $3,000) x 3,000 total contribution margin – $3,000,000 committed cost = $1,500,000 income $5,000 price: Profits = ($5,000 - $3,000) x 2,000 total contribution margin – $3,000,000 committed cost = $1,000,000 income The price cut probably should be made, because projected operating income will increase. However, cutting prices could backfire if volume does not increase. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.32 (15 min) CVP Relationships, Cost Analysis a. Break-even point (in gauges): Committed cost ÷ Unit Contribution Margin ($200,000 + 180,000 + 600,000) ÷ [$42 – ($600,000 + 150,000) ÷ 50,000 gauges] = 36,296 gauges b. Sales (50,000 gauges x $42) – $750,000 variable costs – $980,000 Committed costs = $370,000 income c. The company has a theoretical capacity to produce 62,500 gauges (50,000 gauges ÷ 0.80). Thus, it must operate at 58 percent of capacity (36,926  62,500, rounded) to achieve a break-even operation. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.33 (10 min) CVP Analysis, Multiple Choice Question 1: a—The firm must convert the negative contribution margin to a positive figure. Of the choices listed, only “a” can accomplish this result. But, can the firm do so? Question 2: b—This result occurs because contribution margin minus Committed costs equals operating profit. Question 3: d—An increase in variable cost will reduce the contribution margin and thus raise the break-even point. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.34 (20 min) CVP Analysis, Income Taxes a. Variable costs are 74 percent of revenue ($740,000 ÷ $1,000,000). Thus, to break even: Service Revenue – Variable Cost – Committed cost = 0 Service Revenue – (0.74 x Service Revenue) - $200,000 = 0 Service Revenue x (1 - 0.74) = $200,000 Service Revenue = $200,000 ÷ (1 - 0.74) Service Revenue = $769,231 (rounded) b. Before-tax income – Tax = After-tax Income Before-tax income – (Before-tax income x 0.35) = $100,000 Before-tax income (1 - 0.35) = $100,000 Before-tax income = $100,000 ÷ (1 - 0.35) Before-tax income = $153,846 c. Service Revenue – Variable Cost – Committed cost = Before-tax Income Service Revenue – (0.74 x Service Revenue) - $200,000 = $153,846 Service Revenue (1 - 0.74) = $153,846 + $200,000 Service Revenue = ($153,846 + $200,000) ÷ (1 - 0.74) Service Revenue = $1,360,947 d. A change in the tax rate will have no effect on the firm’s break-even point. At the break-even point, a firm has no profit and does not have to pay any income taxes. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.35 (20 min) CVP Analysis, Sales Mix a. The shop anticipates selling 500 bicycles, of which 300 will be medium quality and 200 will be high quality. The sales mix is therefore 60 percent medium quality (300÷500) and 40 percent (200÷500) high quality. b. Bicycle Type Sales Price Unit Variable Cost Unit Contribution Margin High-quality $700 $515 ($375 + .2 x $700) $185 Medium-quality 500 335 ($235 + .2 x $500) 165 Weighted-average unit contribution margin = ($185  0.4) + ($165  0.6) = $173.0050 Break-even point: Committed cost/Weighted-average Unit Contribution Margin $80,000÷$173 = 463 bicycles, consisting of 185 high-quality (463 x 0.4) and 278 medium-quality (463 x 0.6). Break-even sales therefore amounts to $268,540 [(185 high-quality x $700) + (278 medium-quality x $500)]. c. Required sales volume: (Committed costs + Target Income)/Weighted-average Unit Contribution Margin ($80,000 + $50,000)÷$173 = 752 bicycles, consisting of 301 high-quality (752 x 0.4) and 451 medium-quality (752 x 0.6). EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.36 (15 min) Multiple Cost Drivers a. The basic CVP model assumes the use of a single cost driver. In a more realistic situation, a number of items cause costs to change. In an activity-based costing framework, for example, cost may vary because of unit-level activities, batch-level activities, product-level activities, and so forth. b. Assume that the same higher-level activities are necessary. c. Operating income = ($40 - $25) x 20,000 units - $205,000 = $95,000 d. A screen capture of an example spreadsheet that uses Excel’s Solver (see the Tools menu). One could use a trial-and-error approach by guessing at the breakeven volume until the calculated profit is zero. First shown is the Solver wizard; next is the solution. Note that if Concord must produce 1,000 unit batches, no exact solution to the breakeven problem exists. The solution assumes that Concord would be interested in the closest volume with a non-negative income. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.37 (15 min) Multiple Cost Drivers a. The basic CVP model assumes the use of a single cost driver. In a more realistic situation, a number of items cause costs to change. In an activity-based costing framework, for example, cost may vary because of unit-level activities, batch-level activities, product-level activities, and so forth. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE Operating income = ($12,000 x 100 seminars) - $805,000 = $395,000 b. A screen capture of an example spreadsheet model follows. Note that this assumes CCG will offer seminars that are partially filled. This seems like a reasonable assumption. 12.38 (20 min) Sensitivity analysis a. The change in tax rate does not affect the breakeven level of ticket sales, but the increase in committed costs of $10,000 does. Breakeven volume = Committed costs ÷ Contribution margin per ticket Breakeven volume = ($450,000 + 10,000) ÷ $5 = 92,000 tickets per season c. The target volume is affected by both changes. Before tax profit target = $400,000 ÷ (1 – 0.18) = $487,805 Target volume = ($460,000 + 487,805) ÷ $5 = 189,561 tickets per season d. The breakeven volume increases by 2,000 tickets per season because the additional volume is necessary to cover the increase in committed costs ($10,000 = $5 x e. 2,000). The reduction in average tax rate appears to be cost-effective because the target volume declines slightly (a decrease of 439 tickets per season). The increase in committed costs is offset by lower tax payments. f. At a sales volume of 183,600 tickets per season, expected after-tax profits increase by slightly over $1,000, as follows. After-tax profit = ($7x183,600 - $2x183,600 - $460,000)x(1 – 0.18) = $375,560 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.39 (15 min) Scarce resource a. Quicksilver could produce 240 necklaces (120  0.5 hours) in the available production time. This will yield $4,800 of contribution margin (240 x $20) and a profit of $2,300 ($4,800 - $2,500). b. Since manufacturing time is limited, the firm should strive to make the best possible use of the available hours. This outcome is achieved by focusing on production of the item that has the greatest contribution margin per machine hour. As the following figures show, Quicksilver should manufacture bracelets. Necklaces: $20  0.5 hours = $40.00 per hour Bracelets: $15  0.25 hours = $60.00 per hour Rings: $10  0.30 hours = $33.33 per hour Notice that since demand for each item far exceeds the company’s ability to manufacture, bracelets are the only product to produce. The maximum profit = 120 mach hrs x $60/hr -$2,500 = $4,700 12.40 (15 min) Scarce resource a. With only 30,000 hours available, Baltimore cannot satisfy all of the demand. Product no. 543 requires 24,000 hours (6,000 units x 4) and no. 789 requires 16,000 hours (8,000 units x 2), for a total of 40,000 hours. b. Baltimore should focus on the production of No. 789 because of the higher per-hour contribution margin: No. 543: $2.00  4 hours = $0.50 per hour No. 789: $1.50  2 hours = $0.75 per hour The company requires 8,000 units of No. 789 and has the time to produce all units needed, consuming 16,000 hours in the process (8,000 x 2 hours). With the remaining 14,000 hours (30,000 – 16,000), Baltimore can manufacture 3,500 units of No. 543 (14,000 hours  4 hours per unit). 12.41 (15 min) Linear Programming (Appendix) a. First, define the decision variables: S = number of units of "smalls" to be produced L = number of units of "larges" to be produced Second, write the objective function (the contribution margin to be maximized): Maximize $3S + $4L The coefficients of S and L are the unit contribution margins for Smalls and Larges, respectively. Third, write the constraints (the limitations on machining and polishing capacities): Machining time constraint: 1S + 4L  100 Polishing time constraint: 2S + 3L  90 b. Linear programming finds the optimal levels of sales and production of each product; that is, the product mix is one of the outputs of the analysis. The derived product mix is the one that maximizes expected profits. Linear programming also explicitly models capacity constraints. Profit planning with an assumed product mix regards the product mix as an input. Profit planning analysis can search for an optimal product mix using a trial-and-error method, but this an inefficient approach because it does not directly model capacity constraints. If the information to use linear programming is available, analysts should use it as one input to the planning process. 12.42 (20 min.) The process in row 4, “investigate and settle claim,” has the largest negative excess capacity, which indicates that it is the most likely bottleneck. If the company increases the capacity of this process to meet average demand, the process in row 5, “issue payment and close claim,” will become the bottleneck. Both of these processes are being used in excess of practical capacity, which could lead to excessive stress and mistakes that could lead to higher costs for the company. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE A B C D E F G 1 Process Available hours per week Value-adding cycle time (hours per claim) Theoretical capacity (claims per week) = B/C Practical capacity 85% = 0.85 * D Ave. Demand Excess capacity = E - F 2 Receive claim 40 0.08 hr 500 425 400 25 3 Route claim to adjuster 80 0.16 hr 500 425 400 25 4 Investigate and settle claim 400 1.2 hr 333 283 400 (117) 5 Issue payment and close claim 50 0.12 hr 417 354 400 (46) 12.43 (20 min.) This small company has identified many potential bottlenecks. The most pressing problem appears to be in row 7, “invoicing and billing,” where the company is probably missing opportunities to improve its cash flow by billing its customers promptly. To meet its marketing opportunities, the company needs to increase its resources for most of its processes. A B C D E F G 1 Process Available hours per week Value-adding cycle time Theoretical capacity (units per week) = B/C Practical capacity 0.80 * D Ave. Demand Excess capacity= E - F 2 Advertising (ads) 5 0.5 10 8 5 3.00 3 Bill collecting (bills) 10 0.2 50 40 40 0 4 Service installations 60 0.25 240 192 150 42 5 Credit analyses 10 0.25 40 32 150 (118.00) 6 Purchases of phone service from Southwestern Bell 5 0.15 33.33 26.67 150 (123.33) 7 Invoicing and billing (bills) 10 0.02 500 400 1,000 (600.00) 8 Business planning and analysis (plans) 5 5 1 0.8 2 (1.20) EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.44 (30 – 60 min) Theory of constraints. Individual assignment; each case differs. Written descriptions should use the problem’s five points as major paragraph headings. Oral presentations should be supported by visuals (eg, transparencies or PowerPoint slides) that have bullet points to describe findings for each of the problem’s major points. 12.45 (20 min.) This could be an interesting, in-class exercise, depending on how the instructor chooses to use groups. Many instructors, the authors included, have found that short, in-class group exercises are dynamic teaching tools. Prof. Larry Michaelson has published evidence on the effectiveness of using small groups within class times to enhance learning. If this is an out-of-class exercise, groups should research criticisms of “cost accounting mentality” by referencing journal articles and websites devoted to TOC. SOLUTIONS TO PROBLEMS 12.46 (20 min) CVP. a. Break-even point (in units): Committed cost  Unit Contribution Margin $400,000  [$200 – ($2 + $2)] = 2,041 DVDs (rounded) b. New break-even quantity = ($440,000) ÷ ($200 – 1.4 – 2.00) = 2,238 DVDs Target break-even = ($440,000+$40,000) ÷ ($200 – 1.4 – 2.00) = 2,442 DVDs Target revenues = 2,442 x $200 = $488,301 Expected profit = 2,200 x ($200 – 1.40 – 2.00) – 440,000 = ($7,480) EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.47 (20 min if students given electronic version of Exhibit 12-5, 50 min otherwise) Multiple products and sensitivity analysis. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE a. WAUCM = 0.20 x ($15 – 1.50) + 0.80 x ($6 – 1.50) = $6.30 b. Breakeven volume: Batch-level costs = 54 x $3,000 + 6 x ($3,000 + 20,000) = $300,000 Product-level costs = $200,000 + 10,000 = $210,000 Customer-level costs = 20 x $800 = $16,000 Facility-level costs = $150,000 + 79,500 = $229,500 Total higher-level costs = $755,500 Breakeven volume = $755,500 ÷ $6.30 = 119,921 tickets per season c. Target volume Target profit before tax = $400,000 ÷ (1-0.20) = $500,000 Plus higher-level costs = $500,000 + 755,500 = $1,255,500 Target volume = $1,255,500 ÷ $6.30 = 199,286 tickets per season d. Planned income Sales revenues Box seating 200,000x$15x0.20 $ 600,000 Regular seating 200,000x$6x0.80 960,000 Total ticket revenues $ 1,560,000 Less: Unit-level costs 200,000x$1.5 300,000 Batch-level costs 54x$3,000+6x($3,000+20,000) 300,000 Product-level costs $200,000+10,000 210,000 Customer-level costs 20 x $800 16,000 Facility-level costs $150,000 + 79,500 229,500 Total operating costs $ 1,055,500 Pre-tax profit (loss) $ 504,500 Less taxes at average tax rate 20% 100,900 Profit (loss) after tax $ 403,600 Target profit after tax 400,000 Excess (deficiency) of profit $ 3,600 12.48 (35 min) CVP Analysis EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE b. Break-even point (in units): Committed Cost  Unit Contribution Margin c. The point of indifference will produce equal levels of profitability. On the basis of the information presented in part (a), the Basic system has a unit contribution margin of $30 ($40 – 6.00 – 4.00), and the Deluxe system has a unit contribution of $33 ($40 -3.00 – 4.00). Thus, if X = the volume level that equates profits, at the point of indifference profits are equal as follows: $30X - $600,000 = $33X - $800,000 $3X = $200,000 X = 66,667 units per year 12.49 (30 min) CVP Analysis a. The breakeven point of each method is computed as follows: Manual-method breakeven: 0 = $(23-4.20)Q – $60,000 Q = 60,000 ÷(23 -4.20) = 3,191 units Automated-method breakeven: 0 = $(23-2.10)Q - $130,000 Q = 130,000 ÷ (23-2.10) = 6,220 units b. The point of indifference will produce equal levels of profitability. On the basis of the information presented in the problem, the manual method has a unit contribution margin of $18.80 ($23 - $4.2), and the automated method has a unit contribution of $20.90 ($23 - $2.10). Thus, if X = the volume level that equates profits, at the point of indifference profits are equal as follows: $18.80X - $60,000 = $20.90X - $130,000 $2.10X = $70,000 X = 33,333 units per year EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.50 (45 min) CVP Analysis, Income Taxes, Product Mix c. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE d. To find the new sales mix, let X = the proportion of each product: X + X +3X = 1.00; 5X = 1.00; X = 0.20; 3X = 0.60 12.51 (30 min) Financial Planning and Activity-Based Costing (1) $9,870,000 = 30,000 units x $329 (2) $10,857,000 = 30,000 units x $329(1.10) (3) $4,860,000 = 30,000 units x $162 (4) $4,131,000 = 30,000 units x $162 (.85). This reflects the 15% decrease in unit-level manufacturing costs. (5) $120,000 = 300 setups x $400 (6) $48,000 = 600 setups x $400(.20). Reflects twice as many setups at an 80% cost reduction per setup. (7) $437,500 = 3,500 hrs. x $125 (8) $503,125 = 3,500 hrs. (1.15) x $125 (9) $350,000 = 1,000 inspections x $350 (10) $35,000 = 1,000(.10) x $350 (11) $3,393,500 = $2,610,000(1.30) (12) Profit after tax = profit before tax (1 - .40) The automated equipment and JIT will substantially increase profits according to these calculations. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.52 (60 min) Financial Modeling with Multiple Cost Drivers a. A screen capture of an example spreadsheet model follows. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE b. Let D = the number of discount tickets. 300,000($75 - $4.20) + D($40 - $4.20) - $23,690,000* = $2,622,000 $21,240,000 + $35.80D = $2,622,000 + $23,690,000 $35.80D = $2,622,000 + $23,690,000 - $21,240,000 = $5,072,000 D = 141,676 discount tickets * $23,690,000 is the sum of the higher-level costs listed in part a. Costs driven by number of passengers, $4.20, are subtracted from the ticket prices of $75 and $40. c. We replace the 300,000 tickets in b with the reduced number of $75 tickets. For a 10% reduction in tickets, now Boing would expect to sell 270,000 tickets. 270,000($75 - $4.20) + D($40 - $4.20) - $23,690,000* = $2,622,000 $19,116,000 + $35.80D = $2,622,000 + $23,690,000 $35.80D = $2,622,000 + $23,690,000 - $19,116,000 = $7,196,000 D = 201,006 discount tickets A 30,000 decrease in $75 tickets requires almost 60,000 additional discount tickets. Here is where one wants the marketing people to provide good information about the demand for discount tickets. 12.53. (25 min) Managing scarce resources. a. The machining time necessary to fill the maximum monthly sales orders is 5x15,000 + 3x10,000 = 105,000 hours, which exceeds the time available. b. The guideline when a single production constraint exists is to maximize the value produced from the scarce resource. This is indicated by the contribution margin generated per hour (assuming all production can be sold). S109 T678 Unit contribution margin $8 $6 Machine hours per unit 5 hours 3 hours Maximum monthly sales 15,000 units 10,000 units Contribution margin per hour $1.60 $2.00 Although S109 has a higher unit contribution margin, T678 generates more contribution margin per hour of scarce resource. Thus, using the scarce resource to produce as much T678 as can be sold will generate more profit than focusing on S109. c. A schedule follows. Product T678 S109 Total Machine hours avail. 90,000 60,000 90,000 Sales 10,000 60,000 ÷ 5 = 12,000 Machine hours used 3 x 10,000 = 30,000 5 x 12,000 = 60,000 90,000 Machine hours avail. 90,000 – 30,000 = 60,000 60,000 – 60,000 = 0 0 Contribution margin $6 x 10,000 = $60,000 $8 x 12,000 = $96,000 $156,000 12.54 (20 min, given Exhibit 12-5) Scenario analysis EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE Scenario 1: concerts = 10, average concert attendance = 0.9x85% = 76.5% (shown rounded on the spreadsheet to 77%) Scenario 2: concerts = 4, average concert attendance = 1.25x85% = 106.25; shown rounded on the spreadsheet to 100%, which is the maximum attendance. Scenario 3: concerts = 10, increase box seating = 1.25x20% = 25% c. The memorandum should address: 1) underlying assumptions about changes (or consistency) of parameters, 2) the likelihood of each scenario, 3) relative profitability of each scenario, 4) encouragement to consider additional scenarios. Base profit excess = $134,160 Scenario 1 excess = $117,968 Scenario 2 excess = $146,064 Scenario 3 excess = $214,800 12.55 (25 min) TOC in non-profit organization a. Limited floor space constrains the amount and variety of merchandise that the bookstore can display effectively. It is possible that increasing the floor space devoted to fast-selling items could increase the bookstore’s throughput, but only if the bookstore can increase the number of its customers. This seems to be precisely the problem facing the general merchandise department. Whereas textbook and computer products turn over about four times per year, general merchandise turns over just more than once per year. This lower inventory turnover rate indicates that general merchandise carries too much inventory for its level of sales compared to the other departments. Something is constraining this department’s throughput and perhaps the throughput of the entire store. Constraints on throughput can exist both inside and outside of the organization. For example, a limiting factor (or bottleneck) on general merchandise throughput may be ineffective marketing – including marketing research, advertising, and promotion. If so, then no increase in floor space for general merchandise will increase its throughput. However, re-allocating floor space from general merchandise to other departments, that may be short of space, could increase overall throughput. b. Though TOC has had most applications in manufacturing firms, managers of most types of organizations could apply TOC principles to improve throughput. Bottlenecks may be more difficult to identify in non-manufacturing organizations, because they may be in the form of misapplied resources or forgone opportunities rather than limited ability to transform materials into products. For example, if the bookstore seeks to increase its sales and profitability (perhaps it does not, though), its managers must understand the factors that drive and limit sales. If they are competing with other bookstores or general merchandise retailers who appear to be more efficient, perhaps they can learn improved practices from competitors. c. The report should consider how to identify bottlenecks, manage bottlenecks, synchronize other processes to bottlenecks, and work to relieve bottlenecks in the bookstore. 12.56 (45 min) Financial planning software. Reports or presentations will vary, but should use each of the problem’s criteria as a major heading or bullet point. 12.57 (60 min) Financial modeling. Models will vary greatly. An example is at the following link. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 12.58 (20 min) Linear programming. a. Objective function: 12.59 (15 min) CVP. a. The new compensation plan will reduce fixed or committed costs by the amount of salary reduction and will raise unit or variable costs by the amount of the sales commission. It is possible that placing incentives on ticket revenue will increase ticket sales and revenues. This would have to happen sufficiently to offset the planned increase in costs, or it would backfire and result in lower profits. b. An increase in property taxes will raise the breakeven point because more committed cost must be covered before breaking even. This reflects an increase in operating leverage. c. A simple increase in ticket price increases the unit contribution margin. This is obvious. However, the greater problem is the effect on demand, ticket sales and profits. Is demand price elastic or inelastic? Fairfield Blues really should model these effects before instituting a price increase. 12.60 (30 min) Linear programming. a. Objective function: Maximize: 12xBaubles + 8xBangles + 14xBeads Constraints: Materials: 22xBaubles + 8xBangles +13xBeads < 800 Design: 4xBaubles + 1xBangles + 5xBeads < 120 Machining: 2xBaubles + 1xBangles + 2xBeads < 80 Bangles sales: Bangles 10 b. The model: Row 12 = the optimal sales quantities of each product and in total. Row 13 = contribution margins of each product and in total. Row 14 = use of materials of each product at optimal solution and in total Row 15 = use of design of each product at optimal solution and in total Row 16 = use of machining of each product at optimal solution and in total Row 17 = sales of Bangles Row 18 = sales of Beads EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE SOLUTIONS TO CASES 12.61 (60 min) Group Project, Break-Even Load Factors a. Continental is a global carrier, with major hubs in Houston, Cleveland, and Newark. The company has over 300 aircraft in its fleet and was once known as a doormat in the airline industry. A new management team has turned things around such that Continental is a recent recipient of numerous performance awards. COMAIR, on the other hand, is part of the Delta Connection program. Considered a regional airline, the firm flies over 5 million passengers each year along with tons of U.S. mail and cargo. Its major hub is the Cincinnati/Northern Kentucky International Airport. COMAIR currently operates the largest fleet of regional jets in the world. b. Disclosures from Continental’s operating statistics reveal recent break-even load factors around 60 percent. COMAIR’s break-even load factors are much lower, generally averaging around 43 - 44 percent. c. The break-even point is a function of sales prices, variable costs, Committed costs, and sales mix. Airlines measure a number of these factors in terms of available seat miles (ASM)—the number of seats available for passengers multiplied by the number of scheduled miles those seats are flown. Continental recently reported an operating cost per ASM of 9.07 cents whereas COMAIR reported 16.2 cents. Variations in salaries, union agreements, fuel contracts, maintenance outlays, travel agency commissions, and depreciation would likely explain a portion of the variation. In this particular case, however, the difference in break-even seems to be more a function of revenue yield rather than cost. Both carriers have disclosed yield statistics—the average revenue received for each mile that a passenger is carried. Continental disclosed a yield of 12.96 cents; COMAIR reported a much higher payoff: 37.9 cents. 12.62 (30 min) Managing Constraints- Part 1. a. It is interesting that Winfield did not turn to traditional accounting measures of efficiency to help bring order to TBU. He reasoned that this was a job for TOC. He set about to apply TOC’s five steps for improving process throughput, first by educating his staff. He bought copies of The Goal by Eliyahu Goldratt for each of his key staff and asked them to read it within two weeks (it’s a quick read). Afterward in a staff meeting, Dave asked his staff if the situation described in The Goal seemed familiar. The parallels seemed obvious to the staff, and they agreed to try to implement the seemingly commonsense TOC guidelines. b. TOC’s five guidelines are applicable here: 1. Identify the bottleneck(s) – because of the exacting tolerances needed for most of TBU’s products, the large CNC machines are likely bottleneck candidates. 2. Use the bottleneck(s) properly – expediting practices at TBU confound rational use of bottlenecks. Bottlenecks should be used to maximize throughput, not to make parts that could be made on other machines and not to favor an especially persuasive expediter. 3. Synchronize all other processes to the bottleneck(s) – it makes sense to schedule all other processes to match processing through the bottlenecks. Otherwise partially completed orders stack up needlessly and create opportunities for expediters to exercise their influence. 4. Increase the capacity of the bottleneck – if the previous steps are not enough to increase throughput satisfactorily, then TBU needs more bottleneck capacity. CNC machines are expensive and costly to install. If capacity demands are variable, it may make sense to outsource some production slated for the bottleneck as a way to increase capacity. 5. Avoid inertia and return to the first step – eliminating one bottleneck may inevitably expose another. Thus, TOC must be continually re-applied to achieve continuous improvement. 12.63 (60-120 min+) Financial modeling. This is an interesting case because of the need to model external factors. Models will vary greatly, but good models will reflect the important variables and parameters of this semi-structured case as simply as possible. Furthermore, modeling will require a number of assumptions that should be clearly labeled and modeled. A real danger for students and instructors is that interested students may be tempted to spend too much time. Stress the importance of following the sequence of the case’s requirements and using the answers to those requirements as the bases for model building. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE (example only) 12.64 (120+ min) Financial modeling. This is an interesting case because many students hold credit cards without understanding the economics of the business. They might be shocked by the magnitudes of the numbers they model, and they probably won’t be far off. Models will vary greatly, but good models will reflect the important variables and parameters of this semi-structured case. Furthermore, modeling will require a number of assumptions that should be clearly labeled and modeled. A real danger for students and instructors is that interested students may be tempted to spend too much time. Stress the importance of following the sequence of the case’s requirements and using the answers to those requirements as the bases for model building. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE (student example only – used as a final project) Solution Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533