UNIVERSITY OF SANTO TOMAS

AMV-COLLEGE OF ACCOUNTANCY
MANAGERIAL ACCOUNTING-3MA3
DIFFERENTIAL COSTING
M.M.D.
PROBLEMS

PROBLEM

1.
Effect of Special Order on Profits. Markham Modems, Inc. recently received a special order to manufacture
10,000 units for a Brazilian company. This order specified that the selling price per unit should not exceed $50.
Because the order was received without the effort of the Sales Department, no commission would be paid.
However, an export-handling charge of $2 per unit would be incurred. Management anticipates that acceptance
of the order will have no effect on other sales.

The company is operating at 80% of capacity, or 80,000 units, and expects to continue at this level for the coming
year, without the Brazilian order. Unit selling price and costs, based on estimated actual capacity for the coming
year, are:

Selling price............................................................................................................................................... $65.00

Expenses
Direct materials .................................................................................................................................. $15.00
Direct labor ........................................................................................................................................ 20.00
Variable factory overhead ................................................................................................................. 7.50
Fixed factory overhead ...................................................................................................................... 3.00
Sales commissions ............................................................................................................................. 5.00
Other marketing expenses (75% variable) ......................................................................................... 2.00
General expenses (25% fixed) ............................................................................................................ 4.00
Total ........................................................................................................................................... $56.50

Required: Prepare an analysis showing the effect on profits if the company accepts the special order.

SOLUTION

Markham Modems, Inc.

Effect of Special Order on Profits
Per Unit
Differential costs .......................................................................................................................................
Direct materials .................................................................................................................................. $ 15.00
Direct labor ........................................................................................................................................ 20.00
Variable factory overhead ................................................................................................................. 7.50
Other marketing expenses ................................................................................................................. 1.50
Export-handling charge ...................................................................................................................... 2.00
General expenses (75% variable) ....................................................................................................... 3.00
Total ........................................................................................................................................... $ 49.00
Differential selling price ............................................................................................................................ 50.00
Profit per unit ........................................................................................................................................... $ 1.00

Profit per unit x Units sold = $1 x 10,000 = $10,000 increase in profit

PROBLEM

2.
Effect of New Order on Profits. Island Cyclery, Inc. manufactures trail bikes. Management is considering the
expansion of its sales to the tourist market. All sales for this market would be made to a rental agency in St. John,
and the rental agent would receive a discount. An investigation of the trail-bike market reveals the following data:

Trail bikes sold year-to-date ..................................................................................................................... 1,000

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Production capacity of trail bikes ............................................................................................................. 2,000
Costs for this year (at standard):
Materials ............................................................................................................................................ $200,000
Direct labor ........................................................................................................................................ 275,000
Factory overhead
Variable ...................................................................................................................................... 100,000
Fixed .......................................................................................................................................... 175,000
Sales commissions ............................................................................................................................. 45,000
Packing and shipping.......................................................................................................................... 25,000
Advertising ......................................................................................................................................... 85,000
Administrative expenses .................................................................................................................... 190,000

A trail bike regularly wholesales for $800, but the St. John transaction calls for a selling price of $700. There would
be no sales commission. Because the St. John rental agency will pay cash, the allowance for doubtful accounts
(which usually amounts to 2% of sales and is included in administrative expenses) will not be required. However,
packing and shipping costs would increase by $25 per unit to compensate for transpacific freight. All other selling
and administrative expenses are fixed. The company estimates that 500 trail bikes will satisfy the St. John tourist
market.

Required: Prepare an analysis showing the effect on profits if the new order is accepted by the company. (Show
both per-unit selling price and costs and total sales and costs for the new order.)

SOLUTION

Per Unit Total

Sales .............................................................................................................................. $ 700 $ 350,000
Differential costs
Materials ($200,000  1,000 units) ......................................................................... $ 200 $ 100,000
Direct labor ($275,000  1,000 units) ..................................................................... 275 137,500
Variable factory overhead ($100,000  1,000 units) .............................................. 100 50,000
Packing and shipping [($25,000  1,000) + $25] ..................................................... 50 25,000
Total ................................................................................................................ $ 625 $ 312,500
Increase in profit........................................................................................................... $ 75 $ 37,500

PROBLEM

3.
Decision to Add New Product Line. The management of Banter Inc. is considering the entry of its new Jokes
product line in the market. Because its existing product line, Riddles, has similar characteristics to the new product
line, management expects the Jokes sales to require a minimum of additional expense. It is also anticipated that
Riddles sales will increase if both product lines are offered in a package deal. The Jokes product line would be
manufactured in a company-owned facility that is now being rented to another firm for $600,000 per year.
Depreciation on this facility and all other building expenses are presently $100,000 per year. In addition, the
company will need to rent equipment to manufacture the new product line at an additional cost of $150,000 per
year. The contribution margin for the Jokes product line would be $50 per unit, and annual sales are estimated at
10,000 units. Last year, sales for the Riddles product line amounted to 40,000 units. Other relevant per unit sales
and cost data were:

Selling price.................................................................................................................................................... $100

Variable cost of goods sold ............................................................................................................................ 25
Fixed cost of goods sold ................................................................................................................................. 20
Variable marketing and administrative expenses ......................................................................................... 10
Fixed marketing and administrative expenses .............................................................................................. 15

If the new Jokes product line is undertaken, the company expects a 10% increase in Riddles sales. Otherwise,
Riddles sales will remain unchanged. Additional facilities will not be needed to manufacture the additional Riddles
units.

Required: Prepare an analysis showing the effect on profit if this new product line is accepted by the company.

SOLUTION

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Contribution from:
Jokes contribution margin (10,000 units @ $50) ............................................ $ 500,000
Riddles sales (40,000 units x 10%):
Sales (4,000 units @ $100) ..................................................................... $ 400,000
Variable cost of goods sold (4,000 units @ $25) .................................... (100,000 )
Variable marketing and administrative expenses
(4,000 units @ $10) ............................................................................ (40,000 ) 260,000
Total ........................................................................................................ $ 760,000
Less:
Rental foregone on company-owned facility .................................................. $ 600,000
Depreciation of new equipment ..................................................................... 150,000 750,000
Increase in profits .................................................................................................. $ 10,000

PROBLEM

4.
Decision to Eliminate a Division. Major League Company has two operating divisions CAmerican and National.
The January income statements for each division and the company as a whole are:

American National
Division Division Total
Sales ................................................................................................ $ 112,500 $ 60,000 $ 172,500
Cost of goods sold:
Prime cost ................................................................................ $ 20,000 $ 15,000 $ 35,000
Variable factory overhead ....................................................... 15,000 12,000 27,000
Fixed factory overhead ............................................................ 22,500 18,000 40,500
Total ................................................................................. $ 57,500 $ 45,000 $ 102,500
Gross profit ..................................................................................... $ 55,000 $ 15,000 $ 70,000
Other expenses:
Sales commissions ................................................................... $ 10,000 $ 5,000 $ 15,000
Packing and shipping................................................................ 9,000 7,000 16,000
Advertising ............................................................................... 12,000 8,000 20,000
Administrative .......................................................................... 16,000 8,000 24,000
Total ................................................................................. $ 47,000 $ 28,000 $ 75,000
Operating income (loss).................................................................. $ 8,000 $ (13,000 ) $ (5,000 )

Company creditors recently informed management that the company must attain more profitable operations
before further credit will be extended. One possible move that would aid this situation would be to sell the
National Division. One prospective buyer would buy this division for $200,000; the money from the sale could be
invested at 8% interest.

One effect of the sale of the National Division would be that all of its variable manufacturing costs could be
eliminated; however, none of the fixed factory overhead expenses would be avoided. The sales commissions and
packing and shipping expenses are completely variable. The advertising expenses for the company as a whole
would be $15,000 after the elimination of the National Division. Finally, half of the administrative expenses
charged to the National Division would be eliminated if the division were sold.

Required:

(1) Prepare a revised income statement for the company as a whole for the month of January if the National
Division is eliminated to improve the credit rating.
(2) Should the National Division be eliminated to improve profits?

SOLUTION

(1)
Major League Company
Income Statement
For Month Ended January 31, 19--

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Sales ....................................................................................................................... $ 112,500
Cost of goods sold:
Prime cost ....................................................................................................... $20,000
Variable factory overhead .............................................................................. 15,000
Fixed factory overhead ................................................................................... 40,500
Total ........................................................................................................ 75,500
Gross profit ............................................................................................................ $ 37,000
Other expenses:
Sales commissions .......................................................................................... $10,000
Packing and shipping....................................................................................... 9,000
Advertising ...................................................................................................... 15,000
Administrative ................................................................................................. 20,000
Total ........................................................................................................ $ 54,000
Operating loss ........................................................................................................ $ (17,000 )
Nonoperating income:
Interest income ............................................................................................... 1,333 1,333*
Loss before taxes ................................................................................................... $ (15,667 )
*(200,000 x .08)  12

(2)
No, the National Division should not be eliminated. The company will incur $10,667 less loss if the division is
continued because the fixed overhead cannot be eliminated.

PROBLEM

5.
Make-or-Buy Decision. TGIF Inc. manufactures party games. Most games are played on boards that are
purchased from an outside supplier at the cost of $1 each. The company uses 50,000 boards a year. Management
requests that an analysis be made to determine the profitability of producing the boards internally.

The materials required to manufacture each board cost $.15 per board. To print the game pattern and to glue the
pattern to the board includes a direct labor cost of $.20 per board. The company would also have to lease a board
press costing $20,000 for a four-year lease. Presently, there is adequate space in the Producing Department for
the manufacture of 20,000 boards per year.

If the company were to produce all of its boards internally, it would be necessary to cease its manufacture of
checkers and to purchase these pieces from the outside, resulting in an additional $25,000 cost. Also, a checker
caster costing $8,000 with a $4,000 book value would have to be scrapped without a salvage value.

Required: Prepare a recommendation to management to aid in the make-or-buy decision for the game boards; use
an analysis of the differential costs required for the manufacture of 20,000 and then 50,000 boards vs. the cost of
purchasing each quantity from an outside supplier.

SOLUTION

20,000 50,000
Boards Boards
Cost to purchase from outside .............................................................................. $ 20,000 $ 50,000
Manufacturing costs:
Direct materials ($.15 per board).................................................................... $ 3,000 $ 7,500
Direct labor ($.20 per board) .......................................................................... 4,000 10,000
LeaseCnew board press ($20,000/4 yrs.) ....................................................... 5,000 5,000
Cost to purchase checkers from outside......................................................... -- 25,000
Total ........................................................................................................ $ 12,000 $ 47,500
Differential profit (loss) from manufacturing ........................................................ $ 8,000 $ 2,500

The recommendation to management would be to make 20,000 game boards and purchase 30,000 from the
outside because it results in more differential profit than producing 50,000 boards. The cost of the checker caster
is irrelevant to the make-or-buy decision because it is a sunk cost.

PROBLEM

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6.
Sell or Process Further. From a particular joint process, Gusher Company produces three productsCKerosene,
Gasoline, and Fuel Oil. Each product may be sold at the point of split-off or processed further. Additional
processing requires no special facilities, and the production costs of further processing are entirely variable and
traceable to the products involved. In 19--, these products were processed beyond split-off. Joint production
costs for the year were $60,000. Sales values and costs needed to evaluate Gusher's 19-- production policy follow:

Additional Costs
and Sales Values
if Processed Further
Gallons Sales Values Sales Added
Product Produced at Split-Off Values Costs
Kerosene ........................................................ 6,000 $25,000 $42,000 $12,000
Gasoline ......................................................... 4,000 41,000 45,000 6,000
Fuel Oil ........................................................... 2,000 24,000 32,000 8,000

Joint costs are allocated to the products based on the percentage of the individual product's sales value to the
total sales value of all products.

Required:

(1) For gallons of Kerosene, compute the unit production cost most relevant to a "sell" or "process further"
decision.
(2) Determine which products the company should subject to additional processing in order to maximize
profits.

SOLUTION

(1) Added costs/Gallons produced = $12,000/6,000 = $2.00. Two dollars is the most relevant Kerosene unit
production cost for a "sell" or "process further" decision.
(2) Gusher Company should subject only Kerosene to additional processing in order to maximize profits
because the added sales value exceeds the added costs. For Gasoline, the added costs exceed the added
sales value; for Fuel Oil, the added sales value equals the added cost, so other factors would be dominant.

Kerosene Gasoline Fuel Oil

Sales value if processed further ........................................................ $ 42,000 $ 45,000 $ 32,000
Sales value at split-off ....................................................................... 25,000 41,000 24,000
Added sales value ............................................................................. $ 17,000 $ 4,000 $ 8,000
Added costs ...................................................................................... $ 12,000 $ 6,000 $ 8,000

MULTIPLE CHOICE

B 1. Additional output that results in a positive difference between differential revenues and differential
costs is beneficial to a company if and only if:
A. other sales are affected
B. other sales are unaffected and other unit costs are unaffected
C. other unit costs are increased and idle capacity is decreased
D. other sales are unaffected but other unit costs are increased
E. there is no idle capacity

C 2. The effect of discontinuing a department with a contribution to overhead of $30,000 and allocated
overhead of $48,000, of which $26,000 cannot be eliminated, would be to:
A. increase profit by $8,000
B. decrease profit by $26,000
C. decrease profit by $ 8,000
D. decrease profit by $22,000
E. increase profit by $ 4,000

SUPPORTING CALCULATION:

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 ($48,000 - $26,000) - $30,000 = ($8,000)

D 3. Gizmo Manufacturing is considering dropping a product line. It currently produces a multipurpose

woodworking clamp in a simple manufacturing process that uses special equipment. Variable costs
amount to $6.00 per unit. Fixed factory overhead costs, exclusive of depreciation, have been
allocated to this product at a rate of $3.50 a unit and will continue whether or not production ceases.
Depreciation on the special equipment amounts to $20,000 a year. If production of the clamp is
stopped, the special equipment can be sold for $18,000; if production continues, however, the
equipment will be useless for further production at the end of one year and will have no salvage
value. The clamp has a unit sales price of $10. Ignoring income tax effects, the minimum number of
units that would have to be sold in the current year to make it worthwhile to keep the equipment (on
a cash-flow basis) is:
A. 20,000
B. 5,000
C. 3,000
D. 4,500
E. 36,000 SUPPORTING CALCULATION:
x ($10 - $6) = $18,000
$4x = $18,000
x = 4,500

B 4. The costing method used to determine the lowest price that could be quoted for a special order that
would use idle capacity within a production area is:
A. process
B. direct
C. standard
D. absorption
E. job order

E 5. In deciding whether to manufacture a part or buy it from an outside vendor, a cost that is irrelevant
to the short-run decision is:
A. indirect materials
B. direct labor
C. variable factory overhead
D. fixed factory overhead that will be avoided if the part is bought from an outside vendor
E. fixed factory overhead that will continue even if the part is bought from an outside vendor

C 6. Faced with a long-run make-or-buy decision, the manager should do all of the following except:
A. compare the making of the parts with alternative uses that could be made of the firm's own
facilities if the parts are purchased
B. compare the cost of making the parts with the cost of buying them
C. use a cost study with only the differential costs and with no allocation of existing fixed
overhead or profit
D. consider differences in the required capital investment and the timing of cash flows
E. consider the quantity and quality of the parts as well as the technical know-how required

E 7. An opportunity cost is:

A. a cost that may be saved by not adopting an alternative
B. a cost that may be shifted to the future with little or no effect on current operations
C. a cost that cannot be avoided because it has already been incurred
D. the difference in total costs that results from selecting one alternative instead of another
E. the profit foregone by selecting one alternative instead of another

E 8. The term "differential cost" refers to:

A. the profit foregone by selecting one alternative instead of another
B. a cost that does not entail any dollar outlay but that is relevant to the decision-making process
C. a cost that continues to be incurred even though there is no activity
D. a cost common to all alternatives in question and not clearly or practically allocable to any of
the alternatives
E. the difference in total costs that results from selecting one alternative instead of another

A 9. In a make-or-buy decision:
A. fixed costs that can be avoided in the future are relevant
B. only variable costs are relevant

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 C. only prime costs are relevant
D. fixed costs that will continue regardless of the decision are relevant
E. only conversion costs are relevant

D 10. For the past 12 years, the Jolt Company has produced the small electric motors that fit into its main
product line of dental drilling equipment. As materials costs have steadily increased, the controller of
the Jolt Company is reviewing the decision to continue to make the small motors and has identified
the following facts:
1. The equipment used to manufacture the electric motors has a book value of $150,000.
2. The space now occupied by the Electric Motor Manufacturing Department could be used to
eliminate the need for storage space now being rented.
3. Comparable units can be purchased from an outside supplier for $59.75.
4. Four of the people who work in the Electric Motor Manufacturing Department would be
terminated and given eight weeks of severance pay.
5. A $10,000 unsecured note is still outstanding on the equipment used in the manufacturing
process.

Which of the items above are relevant to the decision that the controller has to make?
A. 1, 2, 4, and 5
B. 1, 3, 4, and 5
C. 1, 3, and 4
D. 2, 3, and 4
E. 2, 3, 4, and 5

D 11. Ely Electronics has the following standard costs and other data:

Part A4 Part B5
Direct materials ........................................................................................... $ .40 $ 8.00
Direct labor .................................................................................................. 1.00 4.70
Factory overhead ......................................................................................... 4.00 2.00
Unit standard cost ....................................................................................... $ 5.40 $ 14.70

Units needed per year ................................................................................. 6,000 8,000

Machine hours per unit ............................................................................... 4 2
Unit cost if purchased .................................................................................. $ 5.00 $ 15.00

In past years, Ely has manufactured all of its required components; however, this year only 30,000
hours of otherwise idle machine time can be devoted to the production of components. Accordingly,
some of the parts must be purchased from outside suppliers. In producing parts, factory overhead is
applied at $1.00 per standard machine hour. Fixed capacity costs that will not be affected by any
make-or-buy decision represent 60% of the applied overhead.

The 30,000 hours of available machine time are to be scheduled so that Ely realizes maximum
potential cost savings. The relevant unit production costs that should be considered in the decision
to schedule machine time are:
A. $5.40 for A4 and $14.70 for B5
B. $5.00 for A4 and $15.00 for B5
C. $1.40 for A4 and $12.70 for B5
D. $3.00 for A4 and $13.50 for B5
E. none of the above

SUPPORTING CALCULATION:

A4 = $.40 + $1.00 + .40($4.00) = $3.00

B5 = $8.00 + $4.70 + .40($2.00) = $13.50

E 12. Production of a special order will increase the contribution margin when the additional revenue from
the special order is greater than:
A. the nonvariable costs incurred in producing the order
B. the direct materials and labor costs in producing the order
C. the fixed costs incurred in producing the order
D. the indirect costs of producing the order
E. the marginal cost in producing the order

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C 13. In considering a special order that will enable a company to make use of present idle capacity, which
of the following costs would be irrelevant?
A. fixed factory overhead that can be avoided
B. materials
C. depreciation of the factory building
D. direct labor
E. variable overhead

E 14. In deciding whether to manufacture a part or buy it from an outside vendor, a cost that is relevant to
the short-run decision is:
A. direct labor
B. variable overhead
C. fixed overhead that will be avoided if the part is bought from an outside vendor
D. direct materials
E. all of the above

D 15. A company owns equipment that is used to manufacture important parts for its production process.
The company plans to sell the equipment for $10,000 and to select one of the following two
alternatives: (1) acquire new equipment for $80,000, or (2) purchase the important parts from an
outside company at $4 per part. To select the best alternative, the company should compare the
cost of manufacturing the parts:
A. plus $80,000 to the cost of buying the parts less $10,000
B. to the cost of buying the parts less $10,000
C. less $10,000 to the cost of buying the parts
D. plus $80,000 to the cost of buying the parts
E. none of the above

C 16. The following standard costs pertain to a component part manufactured by Rob Co.:

Direct materials ........................................................................................................................... $ 4

Direct labor .................................................................................................................................. 10
Factory overhead ......................................................................................................................... 40
Standard cost per unit ................................................................................................................. $ 54

Factory overhead is applied at $1 per standard machine hour. Fixed capacity cost is 60% of applied
factory overhead and is not affected by any make-or-buy decision. It would cost $49 per unit to buy
the part from an outside supplier. In the decision to make or buy, what is the total relevant unit
manufacturing cost?
A. $54
B. $38
C. $30
D. $5
E. none of the above

SUPPORTING CALCULATION:

$4 + $10 + .40($40) = $30

E 17. The Reno Company manufactures Part No. 498 for use in its production cycle. The cost per unit for
20,000 units of Part No. 498 are as follows:

Direct materials ........................................................................................................................... $ 6

Direct labor .................................................................................................................................. 30
Variable overhead........................................................................................................................ 12
Fixed overhead applied ............................................................................................................... 16
.......................................................................................................................................... $ 64

The Tray Company has offered to sell 20,000 units of Part No. 498 to Reno for $60 per unit. Reno will
make the decision to buy the part from Tray if there is a savings of $25,000 for Reno. If Reno accepts
Tray's offer, $9 per unit of the fixed overhead applied would be totally eliminated. Furthermore,
Reno has determined that the released facilities could be used to save relevant costs in the
manufacture of Part No. 575. In order to have a savings of $25,000, the amount of relevant costs

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 that would be saved by using the released facilities in the manufacture of Part No. 575 would have to
be:
A. $80,000
B. $60,000
C. $125,000
D. $140,000
E. $85,000

SUPPORTING CALCULATION:

$60 - ($6 + $30 + $12 + $9) = $3

$3(20,000) + 25,000 = $85,000

C 18. At December 31, Zar Co. had a machine with an original cost of $84,000, accumulated depreciation of
$60,000, and an estimated salvage value of zero. On December 31, Zar was considering the purchase
of a new machine having a five-year life, costing $120,000, and having an estimated salvage value of
$20,000 at the end of the five years. In its decision concerning the possible purchase of the new
machine, how much should Zar consider to be a sunk cost at December 31?
A. $120,000
B. $100,000
C. $24,000
D. $4,000
E. none of the above

SUPPORTING CALCULATION:
$84,000 - $60,000 = $24,000

B 19. Stewart Industries has been producing two bearings, components B12 and B18, for use in production.
Data regarding these two components are:

.................................................................................................. B12 B18

Machine hours required per unit .............................................................. 2.5 3.0

Standard cost per unit

Direct material ................................................................................... $ 2.25 $ 3.75
Direct labor ........................................................................................ 4.00 4.50
Manufacturing overhead
Variable1 .................................................................................... 2.00 2.25
Fixed2......................................................................................... 3.75 4.50
.................................................................................................. $ 12.00 $ 15.00

1
Variable manufacturing overhead is applied on the basis of direct labor hours.

2
Fixed manufacturing overhead is applied on the basis of machine hours.

Stewart's annual requirement for these components is 8,000 units of B12 and 11,000 units of B18.
Recently, Stewart's management decided to devote additional machine time to other product lines
resulting in only 41,000 machine hours per year that can be dedicated to the production of the
bearings. An outside company has offered to sell Stewart the annual supply of the bearings at prices
of $11.25 for B12 and $13.50 for B18. Stewart wants to schedule the otherwise idle 41,000 machine
hours to produce bearings so that the company can minimize its costs (maximize its net benefits).

The net benefit (loss) per machine hour that would result if Stewart Industries accepts the supplier's
offer of $13.50 per unit for component B18 is:
A. $.50
B. $(1.00)
C. $1.50
D. $(1.75)
E. some amount other than those given above

SUPPORTING CALCULATION:

($3.75 + $4.50 + $2.25) - $13.50 = ($3.00)  3 = ($1.00)

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