Balakrishnan MGRL Solutions Ch06

CHAPTER 6
DECISION MAKING IN THE SHORT TERM

SOLUTIONS
REVIEW QUESTIONS
6.1 The temporary gaps between the demand and supply of available capacity.
6.2 The maximum volume of activity that a company can sustain with available
resources.
6.3 Because organizations make capacity decisions based on the expected volume of
operations over a horizon spanning many years. They build plants, buy
equipment, rent office space, and hire salaried personnel in anticipation of the
demand for their products and services.
6.4 (1) Decisions that deal with excess supply. Examples include reducing prices to
stimulate demand, running special promotions, processing special orders, and
using extra capacity to make production inputs in-house; (2) Decisions that deal
with excess demand. Examples include increasing prices to take advantage of
favorable demand conditions, meeting additional demand by outsourcing
production, and altering the product mix to focus on the most profitable ones.
6.5 This method focuses only on those costs and revenues that differ from the
benchmark option.
6.6 This method considers the gross revenues and costs associated with each option,
rather than the incremental amounts relative to the benchmark option.
6.7 The totals approach requires more computations because it includes some
noncontrollable benefits and costs.
6.8 In decisions involving many costs and benefits – it helps us ensure that we do not
“forget” to include a relevant cost or benefit.
6.9 Excess supply – usually, the firm cuts prices to stimulate demand.
6.10 In a make or buy decision, the firm is deciding whether to make a product, or
piece thereof, internally or outsource and buy them from a supplier.
6.11 When demand is high and a resource is in short supply.
6.12 To maximize profit when capacity is in short supply, maximize the contribution
margin per unit of capacity.
6.13 Typically on a qualitative basis – by considering how customers, suppliers, and

competitors might respond to the decision being made.
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DISCUSSION QUESTIONS
6.14 Yes, the definition of what is short-term and what is long-term depends on the
business context. For General Motors anywhere from few weeks to a few months
may be considered short-term, as pricing and promotion decisions depend on how
fast different models of cars and trucks are moving from the dealers’ inventories.
For a baker, a day or two days may be too long as baked goods do not retain their
“freshness’’ for long. Thus, product characteristics often play a critical role in
determining how “long” the short-term horizon is.
6.15 The reason why the lots are overflowing is that vehicles are not being sold at the
expected rate. Unsold vehicles occupy space in the lot. Thus, it is not correct to
define capacity in terms of the lot space available. Rather, capacity should be
defined in terms the number of vehicles that can potentially be sold per day. When
demand falls short of supply based on the anticipated number of vehicles to be sold
per day, lots overflow, and price-cutting and other promotions become necessary to
move the vehicles.
6.16 Raising prices, when unexpected demand for any product or service creates
temporary shortages, can often hurt businesses in the long run because such actions
can create customer ill will and lead to a loss in reputation. This is especially the
case when it comes to emergency situations. Think of how you will feel when a
grocery store that you frequent in your neighborhood raises prices on bottled water
as you prepare to deal with an approaching Category 4 hurricane!
6.17 Most of us drive to work, and so the demand for gasoline is fairly stable. One way
to economize on gasoline consumption is to car pool effectively with your
colleagues or others that work near where you work.
6.18 Yes, it is. The gross method considers all cash inflows and cash outflows that are
associated with the options being considered in the context of a particular decision,
even though some of them may be non-controllable. But, it does not consider cash
flows associated with many other decisions that the companies may be considering.
From an overall organizational standpoint, each decision has an incremental effect,
and, therefore, the gross method is also incremental when viewed in this context.
6.19 Increasing prices is a natural way of decreasing demand. In fact, in most market
settings, demand for a product decreases as its price increases. When a firm does
not have enough capacity to meet a sudden spurt in demand, it can reduce the
demand by increasing prices and “turning away” some customers to a point where
the demand can be met. The airline industry is a good example. In peak times, an
increase in airfare induces some travelers to seek other means of travel or postpone
their travels. Only those that are able to afford the higher prices, or have rigid and
noncancelable schedules, will continue to travel.
Airline companies usually face no long-term adverse implications from increasing

prices to deal with peak demand situations. Air travelers usually understand this
Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

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behavior and plan their travel accordingly. On the other hand, consulting companies
rely on longstanding relationships with their customers. Raising their rates when
their business is good usually backfires because it hurts reputation and goodwill in
the long-run.
6.20 Yes, it does. This is typically referred to as “production smoothing” and makes good
business sense as long the product is storable for sale in the future period, and as
long as inventory carrying costs are manageable. The toy industry and the apparels
industry are good examples.
6.21 Companies can produce and stock up during periods of lean demand to be ready for
peak periods whenever demand outstrips capacity. However, such use of inventory
is beneficial when demand follows reasonably predictable cycles of high and low
demand. On the other hand, whenever demand is low and there is considerable
uncertainty as to whether demand would rise again, producing and stocking for
future may backfire.
6.22 One strategy is to invest less in capacity and rely more on outsourcing. By doing so,
the company would embrace a cost structure with less fixed costs and more variable
costs i.e., a cost structure with lower operating leverage. Another strategy to find
other uses for capacity so that excess capacity can be put to profitable alternate use
during periods of lean demand (such as accepting special custom jobs, turn key
projects and so on).
6.23 The idea is to make the most profitable use of critical and most expensive resources.
The opportunity cost of such a resource is by assumption, high. Any situation in
which such a resource has to wait because some other “cheaper” resource is in short
supply is undesirable. To avoid such situations, it makes more economic sense to
install excess capacity in other resources.
6.24 When a resource is in short supply, and it is used in a lumpy manner, calculating
contribution margin per unit of the resource to allocate its use to various products is
at best approximate and can often lead to wrong decisions. Advanced techniques
such as integer programming may have to be employed to come up with the right
way to allocate scarce resources to products in such settings.
6.25 Products requiring minimum production quantities involve committing requisite

amounts of capacity to these products if they are chosen production. Whenever
capacity is in short supply, such products may well necessitate leaving out products
with higher contribution margins per scarce capacity unit in order to meet their
minimum production requirements. The alternative is to not lock up capacity by
scheduling such products, but instead use the capacity to schedule products that
yield lower contribution margins per unit of the scarce capacity resource. The
consequent trade-off will determine whether it is profitable to make products with
minimum production requirements.

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6.26 Outsourcing reduces the amount of capital that needs to be invested in capacity
resources. It reduces the fixed costs in the cost structure, but increases the variable
costs. In other words, outsourcing increases the operating leverage. Unit variable
costs are usually higher with outsourcing relative to in-house production because
the profit margins of suppliers are part of the variable costs with outsourcing.
Therefore, unit contribution margins are usually lower with outsourcing. However,
outsourcing helps companies respond quickly to competitive pressures and to
advances in technology. Investing in capacity resources commits a company to a
certain technology over the longer term. If the technology becomes obsolete and the
demand drops, it is much costlier for the company to divest its assets and change
course.
6.27 Test marketing is a way to minimize risk associated with large investments.
Offering a new product often involves putting in place and committing to various
organizational resources. Once the product is launched it is often extremely costly
to cut back should the product fail. Plants and offices have to be closed down and
people have to be fired and so on. Risk of failure is an inherent part of business, and
products do fail. But one way to reduce this risk is to do a small scale launch aimed
at representative customers. If this test marketing effort fails, then a larger scale
launch is unadvisable. Moreover, feedback from the test market is often useful in
redesigning the product to reduce the risk of failure subsequently.
6.28 Employee morale is an important factor in outsourcing decisions, especially if

outsourcing is a sign of things to come. Loss of morale leads to a loss in
productivity which might make outsourcing even more attractive. The company
may lose talented and experienced personnel, who may prefer jobs elsewhere to
being fired. Managers therefore have to be clear about the impact of outsourcing on
employee morale so that they can make the appropriate trade-off between
immediate cost savings from outsourcing and longer-term adverse impact of a loss
in morale. Certain critical activities are better done in-house for strategic reasons,
while others can be outsourced. However, decision making with respect to
outsourcing has to be clearly communicated to the employees to avoid
disgruntlement.

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EXERCISES
6.29
a. Ajay’s decision deals with excess demand. Due to the holidays, Ajay expects a
surge in gift-wrapping needs. To handle this surge, Ajay is considering hiring
a helper. This is akin to a manufacturing firm outsourcing some production in
periods of high demand.
b. Let us calculate profit = revenues – variable costs – fixed costs. We can
construct the entire CVP model for Ajay. We then compare the profit under
each option, selecting the option with the higher profit. With the information
provided, we have:
Without Helper With Helper

60 packages 110 packages
Per day per day
Daily revenue ($3  60; $3  110) $180.00 $330.00
Daily variable costs ($1  60; $1  110) 60.00 110.00
Daily pay for help (0; $8.50  10) 0.00 85.00
Daily contribution Row 1– rows 2 & 3 $120.00 $135.00
Total contribution Row 4  30 $3,600.00 $4,050.00
Total fixed costs Given 600.00 600.00
Profit $3,000.00 $3,450.00
Comparing the total profit, we find that Ajay’s profit increases by $450 ($3,450 –
$3,000) for the season, if he hires the helper. Accordingly, if he wishes to
maximize profit then Ajay should hire the helper.
In constructing the income statement for each option, we could leave out the non-
controllable fixed costs of $600. While the absolute profit numbers would change,
the difference in profit would be preserved. Thus, the gross approach provides
decision makers some flexibility in terms of what is included and excluded from
the income statement.
c. Under this approach, we compute only the incremental revenues and costs
associated with a particular decision option relative to the status quo. Since
operating without the helper is the status quo, we have:
Incremental revenue 50 packages per day  $3 $150

Incremental variable cost (packages) 50 packages per day  $1 50
Incremental cost (helper) $8.50  10 hours 85
Incremental profit per day $15
Value of hiring helper $15  30days $450

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Again, we see that Ajay increases monthly profit by $450 if he hires a helper. The
difference in profit derived with controllable cost analysis exactly equals the
difference in profit under the gross approach. This underscores the equivalence of
the two approaches. However, controllable cost analysis usually requires fewer
calculations.
d. Assuming Ajay seeks to maximize profit, the change in fixed costs will not
alter his decision to hire the helper. The fixed costs are equal under each
option and, as a result, they are not relevant for this particular problem.
Moreover, we see that (by inspection) controllable costs analysis ignores fixed
costs as they are non-controllable. However, even though the gross approach
uses fixed costs, they “wash” because they are included in the total cost for
both options.
Note: The magnitude of the fixed costs would be relevant if Ajay were deciding
whether to pursue this business venture. This relevance is because Ajay would not
incur the fixed costs if he did not pursue the venture. Generally, we need to define
the time frame for the decision before we can classify a cost as a fixed cost.
Consequently, the relevance of a fixed cost depends on the decision’s horizon.
Ajay’s costs are fixed for the short-term decision of whether to hire a helper, but
are not fixed for the longer-term decision of whether to stay in the gift-wrapping
business.
6.30
a. Magic Maids’ decision appears to feature both excess supply and excess
demand. It is likely that Magic Maids fixed overhead costs (rent and
administrative salaries) will not change due to the special job – it appears that
there is enough administrative capacity to handle the job. There is excess
demand for cleaning supplies; if the current jobs do not use up available stock,
the firm could store the supplies for use later. Finally, there might be limited
excess capacity for some resources. If 60% of the job could be completed
during normal business hours, then the company clearly has some slack and
excess capacity in terms of labor hours. For the remaining 40% of the job,
however, Magic Maids’ employees will have to work overtime – thus, there is
excess demand for this input. This shows us that different resources in the
firm have differing capacity levels – a decision may impose constraints on one
resource but not another. We have to consider the opportunity cost of each
resource when computing the total cost of a job.
Note: A precise definition of capacity is at the level of individual resources. Thus,

when computing the cost of an option, we have to consider opportunity costs at the
level of individual resources.
b. The following table details the incremental cost associated with cleaning the
150 offices, compared to the status quo of not cleaning the offices:

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Item Detail Amount

Cleaning materials 150 offices × £12.50 per office £1,875
Labor1 150 × 3 × .40 × 15 × 1.5 £4,050
Variable overhead 150 offices × £7.50 per office £1,125
Incremental cost £7,050
1
: There are 150 offices that need to be cleaned, and each office requires 3 hours
to clean. Since 60% of the job could be completed during regular business
hours, Magic Maids will only have to provide extra remuneration for 40% of
the hours. Further, employees are paid 1.50 times their hourly wage of £15 for
each overtime hour worked.
Note that fixed overhead, which is comprised of rent and administrative salaries,
is not relevant as it is very unlikely that the total amount of fixed overhead will
change if Magic Maids accepts the engagement.
Magic Maids incremental costs associated with cleaning the conglomerates 150
offices amount to £7,050.
c. Magic Maids can use the cost number for pricing the local conglomerate’s
request to clean the 150 offices. £7,050/150 = £47 per office likely would
represent the minimum price that Magic Maids would charge. This price is
well below Magic Maids normal price of £120.
The actual price charged will consider other factors. For instance, the client’s
other options become relevant. If this is a one-time deal with no prospect of repeat
business, then Magic Maids might well charge a premium over the normal price.
The prospect of “getting a foot in the door” to bid for future business would push
the price downward. Long-term implications also matter. If the conglomerate
becomes part of Magic Maids client base, then the company likely would wish to
make sure that the price charged in the long term would cover all incremental
costs (measured over the long term), and not only the incremental costs measured
over the short-term.
6.31
a. While set in a service setting, this is a classic example of an organization that
has excess capacity and is attempting to figure out how to price a special
order. It is like having open seats at a sporting event – it appears that the
rooms would otherwise remain idle if Erin and Kyle do not accept the
customer’s offer.
b. Because the rooms would otherwise remain idle, the lost profit associated with
turning down the customer is $200 – (3  $10) = $170 per customer, for a total
of $170  4 = $780 for four customers. Notice that the standard rate of $180

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per day is not relevant for computing this amount.
Erin and Kyle might be concerned that renting the rooms for a substantial
discount will tarnish the image of their Inn or adversely affect weekend (or other)
rentals. It is unlikely that this will occur because “time-based’ pricing is very
common. Hotels, airlines, and utility companies all charge more when demand is
expected to be high and less when demand is expected to be low. (Think about the
cost of renting a hotel room in New Orleans during Mardi Gras versus renting the
same hotel room in mid-August when the temperatures and humidity are high!) In
other words, customers naturally expect prices to reflect demand.
All things considered, Erin and Kyle would be hard pressed not to accept the offer
or to at least make a reasonable counter-offer (e.g., ask for $250 per person or
require the customers to share a room). Moreover, Erin and Kyle probably should
consider running weekday specials, perhaps reducing the rate to $100 a night
during the week to increase occupancy and maximize contribution margin.
However, we also note that such strategies might tarnish the “exclusive” nature of
the facility, depressing Erin’s ability to charge premium rates during the weekend.
Also, there would be higher wear-and-tear costs in the long run if occupancy were
to increase substantially. Erin’s decision turns on whether she considers this to be
a one-time deal or if this is the start of a new business strategy.
6.32
a. Jen’s decision deals with excess supply – due to the reduced demand for her
work, Jen finds herself with time to spare.
b. Jen’s variable cost of framing her own work is $300 = $10  30. Her
payments to the framing shop would be $750 = $25  30.
Thus, Jen will save $450 if she does her own framing. Notice that this
estimate is over-stated because it ignores the cost of the additional time it will
take Jen to frame her prints. The additional time has value because Jen could use
it for other activities that she might enjoy more than framing.
c. Jen’s problem is now more complex. By outsourcing the framing, Jen is able
to produce and sell an additional 15 prints; in turn, these prints generate an
additional contribution margin of $75 – $25 – $ 8 = $42 per print or $42  15
= $630 in total. Rightfully, we should add this amount to the cost of framing
of $100 per print or $100  15 = $150 for 15 prints, to obtain a total framing
cost of $150 + $630 = $780. Now, we see that Jen prefers to use the framing
shop rather than do her own framing.
What does our answer change? Compared to part [b], Jen does not have enough
idle time to keep up her current volume of prints and do her own framing. Thus,

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the problem switches from one of excess supply (where we assumed the
opportunity cost of Jen’s time to be $0) to one with excess demand, where we find
the opportunity cost of Jen’s time to be $630. The nature of the imbalance drives
Jen’s preferred solution.
Note: A superior option is to frame some but not all of the prints. Using the
notion of allocating time per the contribution margin per unit of the scarce
resource, we could derive this formally.
6.33
a. The following table provides the estimated profit impact at the two prices
considered:
Item Price for valet

parking
$5 per $10 per
month month
Revenue from service $2,000 $3,000
(400 × $5; 300 × $10)
Revenue from new members 2,000 1,000
(20 × $100; 10 × $100)
Cost of new members 700 350
(20 × $35; 10 × $35)
Cost of valet service 2,500 2,500
(given)
Net profit $800 $1,150
Based on the above estimates alone, Tom and Lynda should offer the valet service
and price it at $10 per month (not $5).
Please note the tradeoff between price and quantity. At a lower price, the feature
has more takers. This tradeoff depends on how much demand (for different
products) changes as price changes. The tradeoff from increasing price is
favorable if we consider the revenue from current members only. However, the
effect on new members is unfavorable and large. Also taking into consideration
the increases in variable costs due to additional membership, it appears that
asking for $10 provides the best tradeoff.
Please also note that we are not considering any change in the club’s fixed costs
from adding new members. As we know from the earlier chapters, Hercules has
been losing members to Apex, meaning that it has excess capacity in terms of
members.
b. There are several qualitative considerations. First, we need to consider the

effect on other members. Valet parking means reserving a section (usually a
desirable section) of the parking lot. This means that other members would be

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inconvenienced, leading to some lost memberships. Second, we have to

consider if the service sets the club on the path of tiers of members, which
feature has both costs and benefits. However, this is a move with long-term
consequences for the club’s clientele. Third, Tom and Lynda must consider
that demand for valet parking is not likely even through the day. Even if they
adjust staffing somewhat, it is likely that some patrons will encounter delays
in getting a valet to attend to them. Such delays might prompt complaints,
create ill will and otherwise detract from a positive experience (and consume
managerial time). Overall, the decision is not clear cut, particularly because
the monetary benefit is not very large.
6.34
a. Tom and Lynda’s decision turns on alternate uses for the space, or its
opportunity cost. The problem indicates the room is unused during this time.
There is minimal disruption of operations. Increases to direct costs, if any, are
small. Thus, the $600 offered by Marjorie would flow directly to profit.
Qualitatively, the service might even attract new members…for example, the
expectant women might wish to use the swimming pool or the sauna to relax,
and see Hercules as a one-stop shop. Overall, Tom and Lynda should accept
the offer.
b. The change in class timings changes the problem from one of excess supply to
one of excess demand. During the peak evening hours, there is considerable
demand for the room (which is why scheduling Marjorie’s class will displace
existing classes). Tom and Lynda therefore need to consider the best use of the
space during the evening hours. Using it for regular classes benefits the
membership, and prevents loss of members. Using it for Marjorie’s classes
generates additional revenue. But, the opportunity cost is the loss of members,
valued at 8 × ($100 - $35) = $520 per month. The net gain from accepting
Marjorie’s offer is $700 - $520 = $180 per month.
However, qualitative factors are salient in this case. Members might get upset at
seeing a big part of the club reserved for use by non-members during peak times.
The perception that Hercules is not really a gym for fitness buffs might lead to
long-term erosion of reputation, and consequent loss of membership. Overall, it
seems unwise to risk such reputation losses for less than $200 per month.
c. We have:
Incremental fee due to evening class $100 $700-$600

Incremental membership fee lost ($800) 8 × $100
Incremental variable costs saved $280 8 × $35
Incremental profit ($420)
Based on the above, adding the evening class is an unwise move.

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Notice that the value of the daytime only option is $600 (as calculated in part [a].)
The incremental value of the evening class, relative to the daytime class, is a loss
of $420, as calculated above. Adding these two numbers together, leads to $180,
the value (relative to status quo or doing nothing) for the evening option.
6.35
Similar to the Superior Cereals problem in the text, the key to this problem is to
realize that the variable costs associated with manufacturing the greeting cards are
sunk – thus, they are not relevant to Déjà Vu’s decision. Additionally, Déjà Vu’s
fixed costs are non-controllable for the decision, as they are not expected to
change. Thus, the problem is one of revenue maximization.
At a 50% off sale, Déjà Vu’s profit increases by $0.50 × 1,500 = $750.
At an 80% off sale, Déjà Vu’s profit increases by $0.20 × 4,000 = $800.
Thus, Déjà Vu maximizes its profit by holding the 80% off sale, even though the
resulting price is below the $0.23 (= $0.15+$0.08) in variable costs associated
with producing and selling a card. What we need to remember is that this is the
variable cost of a card yet to be produced, not a card that has already been
produced.
Note: This problem links to a common business practice. Specifically, we often

observe stores employing a staggered discounting strategy – the store starts with,
for example, a 25% discount and increases the discount rate over time (perhaps by
as much as 15-25% a week). In this way, the store attempts to capture as much
consumer surplus (gross revenue) as possible by grouping customer types
according to their willingness to wait and run the risk of having the item selling
out. Such a strategy may work quite well for Déjà Vu – i.e., the company could
sell the first 1,500 cards at $0.50 and 4,000 – 1,500 = 2,500 cards at $0.20. By
employing such a strategy, Déjà Vu could earn:
Expected Profit = ($0.50 × 1,500) + ($0.20 × 2,500) = $1,250.
This amount represents a $450 (= $1,250 - $800) increase over its best option.
6.36
a. Under the gross approach, we include all of the costs connected with each
decision. We do not worry too much about whether they are controllable or
not. However, all of the costs listed in the problem appear to be related to the
trip and are controllable – costs such as apartment or dormitory rent and
tuition, which are not mentioned in the problem, clearly would not be related
to the decision being made. That said, we could include them under the gross
approach as they would preserve the rank ordering of options.

6-12
Using the gross approach, we arrive at the following per-person, round-trip cost of
driving:
Cost per
Item Detail Total Cost Person
Automobile-related costs $0.30 per mile × 800 miles $480 $96
× 2 segments
Cost of refreshments $20 per person per $200 $40
segment × 5 persons × 2
segments
Total Cost $680 $136
The following table summarizes the per-person, round-trip cost of flying:
Cost per
Detail Total Cost Person
Item
Airline ticket $169 × 5 persons $845 $169
Cost of refreshments $5 per person per segment $50 $10
× 5 persons × 2 segments
Cost of travel to and $6 per person per segment $60 $12
from airport × 5 persons × 2 segments
It is $191 – $136 = $55 per person cheaper to drive than to fly. From a cost
structure perspective, the bulk of the savings obtain because the auto-related costs
are fixed. The automobile operating costs will be $0.30 per mile, or $480 in total
for the round-trip, regardless of the number of persons traveling. Splitting this
cost five ways results in a relatively low cost per person. In contrast, the cost of
airfare is variable with respect to the number of persons traveling. There is no
“scale economy” that results.
Alternatively, with the airline trip, the cost is $191 for each person traveling,
regardless of the number of people. In contrast, the additional cost for person #2
in the auto trip is only $20 each way – the remainder of the cost is committed
even if only one person is traveling. The scale economy for driving results
because the cost structure contains more fixed and less variable cost (per person)
than the amounts for flying.
Note: This problem also highlights the subtle distinction between the timing of
cash flow and cost. The immediate cash outflow connected with flying will equal
the number computed above. However, the current cash outflow connected with
driving is likely lower. This is because the $0.30 cost per mile includes an
allowance for depreciation, repairs, insurance and so on. These costs eventually
will be paid out in cash (e.g., when you actually pay for repairs) but the timing

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need not coincide with the duration of the trip. Naturally, costs related to gas
(which are included in the $0.30 per mile rate) will lead to immediate cash
outflows.
b. The key here is to realize that the per-person cost of flying will not change
even though the group’s size has changed. The entire cost of flying is variable
with respect to the number of persons traveling. Thus, the total cost will
change, but the per-person cost ($191) will be the same regardless of group
size. This can readily be seen in the following table:
Cost per
Airline ticket $169 × 2 persons $338 $169
Cost of refreshments $5 per person per segment $20 $10
× 2 persons × 2 segments
Cost of travel to and $6 per person per segment $24 $12
from airport × 2 persons × 2 segments
The per-person cost of driving, however, will change. Here, the fixed costs of
driving will be spread over two rather than five people. In essence, the per-person
cost of driving will increase substantially because the total cost of driving does
not decrease much (it only decreases by the round trip cost of refreshments for 3
people). The following table provides the revised computations:
Cost per
Automobile-related costs $0.30 per mile × 800 miles $480 $240
× 2 segments
Cost of refreshments $20 per person per $80 $40
segment × 2 persons × 2
segments
It is now cheaper to fly than to drive. The logic essentially is the same as in part
[a]. From a cost structure perspective, the cost of driving is essentially fixed – in
other words, it will be $0.30 per mile, or $480 in total for the round-trip,
regardless of the number of persons traveling. Splitting this cost only two ways,
rather than five ways, results in a relatively high cost per person. In contrast to
part [a], you are not taking advantage of the potential scale economies associated
with driving.
Note: Instructors also can relate the above discussion to the rationale for a
monopoly, as discussed in students’ economics courses. What is the scale
economy associated with a cable company or an electric utility?

6-14
c. There are numerous other factors that might come into play regarding this
decision, including the following three:
 From an enjoyment perspective, the trip is potentially a great deal more

fun, if you drive together rather than fly separately (i.e., road trip!).
 Each method offers differing types of flexibility. Driving allows the group
to plan around the weather, while internet-only tickets come with
numerous restrictions and change penalties. Driving also provides you
with available transportation at home over winter break. However, unlike
flying, driving also requires that you and your friends coordinate your
schedules.
 From a safety perspective, statistics show that flying is safer than driving.
Indeed, many parents might worry about five college students taking a
long road-trip over the winter months.
d. We characterize this problem as one of excess demand. Money is the resource

in short supply. Then, because the “revenue” is the same for both options, we
wish to find the option that uses the smallest amount of the scarce resource, or
equivalently, has the lowest cost.
6.37
a. Let us begin by calculating relative sales values.
Gravel: 9,000 tons × 0.8 × $30 $216,000

Sand: 9,000 tons × 0.2 × $40 $72,000
Total $288,000
Thus, 75% of the joint cost (=$216,000/$288,000) would be allocated to gravel

and the 25% to sand. We have the cost allocated as 0.75 × $225,000 = $168,750
and 0.25 × $225,000 = $56,250.
Alternatively, we can calculate the rate per sales $ at the split off as
$225,000/$288,000 = $0.78125. We then allocate $216,000 × $0.78125 =
$168,750 to gravel and $72,000× 0.78125 = $56,250 to sand.
b. We know that only incremental revenues and costs are important for this
decision. Let us therefore calculate the net gain from processing the sand
further.
Value of sandbox quality 900 tons × $160 $144,000

Lost value at split off 9,000 tons × 0.2 × $40 $72,000
Net gain in revenue $72,000
Cost of additional processing given ($18,000)
Net value $54,000

6-15
Thus, Myers should process the sand at split off into sandbox quality sand
because it increases profit by $126,0001 - $72,000 = $54,000.
Note: The important point to note is that the joint cost, or how it is allocated, is
not relevant for the decision in [b]. That joint cost is sunk for this decision. These
allocations are usually done only for the purpose of valuing inventory.
6.38
Mihir has two options: (1) run the promotion or (2) do not run the promotion.
Option (1), or not running the promotion, is the status quo. We can then answer
the question regarding whether Mihir should run the promotion by calculating the
incremental costs and revenues associated with running the promotion. Based on
the information provided, the incremental revenues and costs are:
Decreased ticket sales (200 tickets @ $3.95 per ticket) ($790)

Increased profit from concession stand:
Number of customers 250 = 50% of 500
Average revenue $6.00 per patron
Increased concessions sales (250 patrons @ $6.00 per patron) $1,500
Average cost $0.90 = 0.15  $6.00
Increased concessions cost (250 patrons @ $0.90 per patron ($225)
Net profit $1,275
Value of promotion $485
Mihir should run the promotion as weekly profit is expected to increase by $485.
Note: This problem is one of excess supply as Mihir has available seats during the
matinee shows.
6.39
a. One approach is to construct a profit model for the laser tag arena, a profit
model for the video arcade, and a profit model for LazerLite as a whole. This
problem, though, lends itself nicely to employing an incremental approach.
Because we know the status quo, we can figure out controllable costs and
revenues.
From Greg’s perspective, we can delineate the following incremental benefits and
costs:
Increase in contribution margin from customers attracted by after-school special =

500 × ($5.00 – $3.00) = $1,000
Decrease in contribution margin from losing customers paying normal price = 300
× ($7.50 – $3.00) = $1,350
1
$126,000 = Value of sandbox quality minus further processing costs = $144,000 - $18,000.

6-16
Incremental fixed costs = $150
The overall effect is to decrease the laser tag arena profitability by $500 per
week = $1,000 – $1,350 – $150.
Thus, from Greg’s standpoint the after-school special probably is not such a hot
idea. The annual profit of the laser tag arena will decrease by $500 × 52 weeks =
$26,000.
Note: It is also possible to solve the problem by computing the profit under two
options. That is, we could employ the gross approach. Under this approach, the
profit reported decreases from $3,800 per week to $3,300 per week.
b. From LazerLite’s perspective, we also need to consider the effect of the after-
school special on the video arcade. The effect on the video arcade can be
calculated as follows:
Incremental profitarcade = (net increase in laser tag customers × .75) × [6.00 – (.10
× 6.00)]
= (200 × .75) × (6.00 – .60) = $810 increase per week.
Thus, LazerLite as a whole increases weekly profits by $310 per week = $810
– $500, or approximately $310 × 52 weeks = $16,120 per year. Consequently, the
after-school special is a profitable move for LazerLite as a whole.
The key point of this exercise is to emphasize that we cannot look at each product
in isolation (e.g., laser tag sales only) when the business model has considerable
product interdependencies. Moreover, numerous laser tag operations attempt to
lure customers in with the hopes that they will spend considerable sums of money
on video games and other ancillary activities. Other examples of this behavior
include software firms giving away the reader (e.g., Adobe Acrobat) in the hope
of making money selling the writing software. This idea of a loss leader, covered
in microeconomics, often occurs in casinos (cheap food and free drinks) and
supermarkets (low milk prices) or restaurants (kids eat free).
Note: Greg’s compensation arrangement appears to be misaligned with the

company’s goals. To this end, LazerLite probably is better off if Greg’s
compensation is linked to overall company profitability. In this way, Greg will not
believe that he is competing for customers with the video arcade.

6-17
6.40
a. Based on the problem data, Gerry has two options: (1) Continue with the
current arrangement of using the upstairs space for music lessons, or (2)
Converting the upstairs space to retail space. Option (1) is the status quo, and
evaluating option (2) relative to the status quo yields:
Item Detail Total

Revenue from new space 150 square feet × $5,000 per $750,000
square foot
Variable costs from new space $750,000 × 75% variable costs $562,500
Contribution margin from retail $750,000 × 25% contribution
space per $1 of revenue $187,500
- Revenue from cubicle rentals 6 cubicles × 40 rentals per
week × 50 weeks per year × $5 60,000
per rental
- Cost of additional sales persons 2 × 50,000 100,000
- Additional fixed costs $10,000 – $7,500 2,500
Increase in profit $25,000
Our calculations reveal that Gerry’s profit will increase by $25,000 if he decides
to convert the upstairs to retail space. In arriving at this solution, notice that the
contribution margin from the existing retail space is not included because it is
assumed to be the same with and without the remodel. Additionally, the cost of
existing sales persons is also constant in the decision to remodel as are the
downstairs fixed costs of $92,500 (= $100,000 – $7,500).
b. Oftentimes, decision makers need to consider the implicit assumptions

contained in the numerical computations. The following assumptions seem
particularly important:
 The lessons must surely generate a lot of goodwill and traffic through the
store. They also help Gerry keep himself in the “loop” of the music
business in the city. Closing the cubicles likely will trigger a loss in sales.
It is unlikely that the new space will have the same sales per square foot.
Indeed, closing the cubicles may lower the sales in the existing space as
well.
 The above computations also ignore the one-time cost of the remodel.
Gerry’s decision has to incorporate whether the remodel will cost $5,000,
$15,000, or $50,000. The latter involves a much riskier gamble.

6-18

6.41
a. The key is to realize that Justin has excess demand as the pumps currently use
all available capacity. Thus, taking the order requires Justin to give up some
pumps. At 500 valves x 3 hours per valve, the valve order will consume 1,500
hours. Dividing the total 10,000 hours available by the total production of
2,500 pumps, Justin calculates that it takes 4 hours to produce a pump. At this
rate, 1,500 hours can be used to make 375 pumps. Justin divides the $125,000
in monthly contribution by 2,500 pumps to calculate that each pump yields
$50 in contribution margin. Thus, we have:
Contribution from Valves 500 valves × $30 per valve $15,000

Less: Lost contribution from pumps 375 pumps × $50 per pump 18,750
Net change in profit ($3,750)
Justin will lose $3,750 if it takes the order. The fixed costs of $75,000 (CM of
$125,000 – profit of $50,000) are not relevant for this decision.
Alternate approach
We could also solve the problem by examining the contribution per labor hour.
Each pump yields a contribution of $50 / 4 hours = $12.50 per labor hour. In turn,
each valve yields a contribution of only $30/3 hours = $10 per labor hour.
Accepting the valve order diverts resources toward less profitable uses. Because
1,500 hours would be diverted, the loss is 1,500 hours × ($12.50 – $10.00) per
hour = $3,750.
b. Profit will be unchanged if valves also contributed $18,750 to profit. Thus, the
price per valve should be $18,750/500 valves = $37.50 per valve.
Alternately, profit will be unchanged if valves also contribute $12.50 per labor
hour. As each valve consumes three hours, the minimum price is $12.50 x 3 hours
= $37.50 per valve.
c. There are many potential qualitative factors. First, Justin’s management has
been trying to diversify into valves. This order might give them an
opportunity to test out their production methods and establish their reputation
for quality valves. The order might also help them learn the process and reap
the cost gains from such learning. Second, the order might be the precursor to
a larger order at better prices. Third, this might be an order from a large
customer (for pumps), prompting Justin to accommodate the order even it
means losing money. It is difficult to estimate the monetary value of these
considerations. Nevertheless, managers routinely make such tradeoffs
everyday.

6-19
6.42
a. The “traditional” allocation of a sales person’s 125 hours would lead to the
following revenue per month for a typical sales territory:
Customer
Type # of Time Total Time Revenue Total
Customers per Visit Time* Left** per Visit Revenue
Large 10 5 hours 50 hours 75 hours $45,000 $450,000
Medium 25 2 hours 50 hours 25 hours $30,000 $750,000
Small 25 1 hour 25 hours 0 $15,000 $375,000
$1,575,000
Total Revenue
* = (# of customers)  (Time per visit).

** = 125 hours – cumulative total time.
Thus, the typical sales person generates monthly revenue of $1,575,000.
b. The key to Trey’s success is to realize that time is a scarce resource. Since
sales persons cannot visit all potential customers, the revenue-maximizing
strategy prioritizes customers by their revenue per hour of time (spent in
visits). As shown below, this ranking changes the traditional ordering of
customers:
Customer Time Revenue Revenue per
Type per Visit per Visit Hour of Time
Large 5.0 hours $45,000 $9,000
Medium 2.0 hours $30,000 $15,000
Small 1.0 hours $15,000 $15,000
Thus, medium and small customers should get top priority because they generate
$15,000 in revenue per hour of time spent whereas large customers generate only
$9,000 in revenue per hour of time spent.
Such an allocation leads to the following revenue per month:
Customer
Type # of Time Total Time Revenue Total
Customers per Visit Time* Left** per Visit Revenue
Medium 25 2 hours 50 hours 75 hours $30,000 $750,000
Small 50 1 hour 50 hours 25 hours $15,000 $750,000
Large 5* 5 hours 25 hours 0 $45,000 $225,000
$1,725,000
Total Revenue
* = (# of customers)  (Time per visit).
** = 125 hours – cumulative total time.

6-20
Thus, we see why Trey is SuperSound’s top sales person – he generates revenue
of $1,725,000, or $1,725,000 – $1,575,000 = $150,000 more than other sales
persons. Moreover, Trey optimally allocates his time across SuperSound’s
customer base.
Note: Does prioritizing by sales per visit hour maximize not only revenue but also
company profit? The answer is “it depends” – such a strategy also maximizes
profit only if the contribution margin ratio is the same for all three customer types.
If different customer groups order a different mix of products (resulting in
different contribution margin ratios), the firm needs to prioritize customers by
their contribution per visit hour to maximize profit.
Note (advanced): Instructors could also use this problem to underscore the agency
conflict and choice of performance measures. For instance, the provided solution
of maximizing revenue might be optimal from the sales person’s perspective if
their incentives are based on revenue. However, the effort allocation might not be
optimal from the firm’s perspective. The store can manage this discrepancy by
compensating the sales person based on contribution margin. However, there is
more room for dispute in measuring contribution margin, which reduces its value
as a performance measure. Formally, while contribution margin aligns incentive
more (is more congruent), it also is harder to measure (has greater noise) than
revenue.
6.43
a. The following table summarizes the quantitative analysis, or the net monetary
benefit associated with accepting the assignment (compared to the status quo
of not accepting the assignment):
Item Detail Amount

Fee from new assignment Given $50,000
- Additional tuition cost Given 8,000
- Salary given up due to $10,000 per month 40,000
delayed graduation × 4 months
Net benefit to accepting offer $2,000
From a purely financial perspective, Christine should accept the assignment. In

this context, notice that:
 Christine’s savings prior to entering the MBA program and the amount of
her loan are not relevant as they do not differ between her two decisions.
 The $2,000 a month in living expenses (e.g., rent, utilities, and groceries)
is not relevant as Christine will incur this cost regardless of her decision.
That is, Christine expects to spend $2,000 a month in living expenses
regardless of whether she is working or in college.

6-21
b. The net [immediate] monetary benefit associated with accepting the assignment
is somewhat small and likely is not large enough for Christine to accept the
assignment. Consequently, Christine’s decision likely will hinge on qualitative
considerations. Some qualitative considerations include:
 Does Christine desire to return to her old employer upon graduating? If so,
the prospects for doing so certainly increase if she accepts the assignment.
 Will the assignment help Christine land a better job by, for example,
demonstrating how her MBA degree has allowed her to go solo on
projects?
 Will this assignment provide a nice change of pace from the grind of
schoolwork?
 Will accepting the assignment unduly disrupt Christine’s MBA studies?

Christine may worry about getting off track and/or being able to even take
the same classes next trimester (i.e., some classes are only offered
periodically) and/or graduating with her cohort (classmates and friends she
developed in the first 2 trimesters).
All in all, Christine’s decision is not clear cut. Her presumed friendly relationship
with her ex-employer, the reputation value of being known as a team player, and
her desire to be a partner in a consulting firm might propel Christine toward
accepting the assignment.
6.44
a. Charlie’s decision deals with excess demand. There are competing demands
for Charlie’s time this evening, as he could either attend the Knick’s game or
have dinner with the important client. Charlie cannot perform both activities
this evening, giving rise to his dilemma.
b. The price paid for the two tickets is sunk and is not relevant to Charlie’s
decision. The $600 is spent regardless of whether Charlie attends the game or
has dinner with the client. Moreover, Charlie faces the same tradeoff if he had
found the tickets on the street or if he had paid $2,000 for the tickets.
Note: In such decisions, many people do consider the price paid for the
tickets, in seeming contradiction to the idea that a sunk cost is not relevant.
One explanation could be that the price paid is a good measure of the
minimum opportunity cost of attending the game. (Charlie must expect to get
at least $600 worth of joy from the game. Why else would he pay that much
for the tickets?). From a psychological perspective, having a readily available
estimate of the lower bound for a qualitative cost may cause people to focus
on the number as the opportunity cost.

6-22
c. Unless Charlie can sell the tickets under the “dinner with the client” option,
his decision hinges on qualitative factors. Charlie needs to weigh the lost
enjoyment from not being able to attend the Knicks game against the cost of
upsetting the client if Charlie chooses to go to the game (and not have dinner
with the client). Both of these factors are qualitative – the enjoyment from the
game is a function of Charlie’s interest in sports, who he is going with, the
Knicks’ chances of winning the series, and so on. Similarly, the cost of
upsetting the client depends on the client’s personality, the volume of
business, the client’s options, and so on. Essentially, Charlie has to
subjectively determine which option has the greater utility per hour. Charlie
has a difficult decision to make.
PROBLEMS
6.45
a. In this problem, it perhaps is easiest to construct an entire income statement
for Pete’s Pets assuming he drops the birds and fish line and compare overall
profit to that reported in the problem text.
The following table computes the profit associated with the choice to discontinue
selling birds and fish, and use the space to expand dog and cat offerings.
Dogs Cats Total

Revenue1 $244,160 $159,600 $403,760
Variable costs2 97,664 47,880 145,544
Contribution margin $146,496 $111,720 $258,216
Traceable fixed costs3 44,000 30,600 74,600
Common fixed costs4 52,500 52,500 105,000
Profit $49,996 $28,620 $78,616
1
: Dog revenue = $218,000  1.12 = $244,160; Cat revenue = $142,500  1.12 =
$159,600.
2
: Dog variable costs = $87,200  1.12 = $97,664; Cat variable costs = $42,750 
1.12 = $47,880.
3
: Dog traceable fixed costs = $31,500 + $12,500 = $44,000; Cat traceable fixed
costs = $22,600 + $8,000 = $30,600.
4
: The common fixed rental cost would not decrease as Pete would incur this cost
whether or not he chooses to discontinue selling birds and fish. However, the
traceable fixed costs associated with this product line are avoidable. For instance,
Pete would not need aquariums and equipment for cleaning fish tanks.

6-23
Based on our analysis, Pete should not discontinue selling Birds and Fish as
doing so lowers his profit by $11,584, from $90,200 to $78,616.
This problem helps reinforce that, while change can be good, oftentimes
individuals and organizations are often doing better than we think we are doing!
Hopefully, this will help students remember that the “grass is not always greener
on the other side…”
b. As alluded to in the problem, Pete organizes his data at a very broad level,
classifying all revenues and costs vis-à-vis the type of pet (i.e., is the item
related to dogs, cats, or birds and fish). While this presents one snapshot of the
business, it is possible that Pete would benefit from organizing the data
differently. For example, the current format does not lend itself to examining
whether certain types of dogs or dog supplies are losing money. It may be that
the overall profitability of dogs is hiding losses on a certain types of dog
treats, dog apparel, etc. To examine such issues, Pete may opt to report data at
a finer level – for example, in the “dogs” category he may wish to report data
by breed of dog and type of supply. In such a way, it may be possible for Pete
to perform a more comprehensive evaluation of his business. Naturally, Pete
needs to balance the benefits of more detailed reporting against the increased
costs of collecting and reporting more disaggregated data. For instance, detail
might lead to more classification errors (e.g., it may be difficult to parse out
the direct fixed costs associated with a particular breed of dog or dog supply).
In turn, this error may lead Pete to draw an incorrect inference about the
profitability of a particular breed or supply).
6.46
a. Since fixed costs are unlikely to change, the criterion is that the incremental
contribution margin should be at least equal to the value of the prize ($6,000).
Accordingly, we start by figuring out the contribution margin on each table.
Using the data provided, we have:
Contribution margin per table = $187,500/1,500 = $125. Thus, salespersons

would need to sell an additional $6,000/$125 = 48 tables each quarter to justify
running the sales contest.
Companies frequently offer a bonus or prize only after a certain goal is met; this
goal may be based on sales in units, sales in dollars, net income, return on
investment, or residual income. In this example, Pippin may stipulate that the
prize will only be awarded if at least 1,550 tables are sold, which is 50 more than
the current level of table sales. This effectively ensures that Pippin will not lose
money on the contest, thereby minimizing the downside risk of offering the prize.

6-24
b. Using the information from part [a], the incremental contribution margin
associated with selling 288 more tables at $125 per table is $36,000. Thus,
profit on the tables product line is expected to increase by $36,000 – $6,000 =
$30,000.
c. Merry’s concerns probably are well founded. Indeed, the contest will stir most
salespersons’ competitive juices and, as a result, shift much of their attention
to the sales of tables. People have limited attention and effort (there are only
so many hours in the day) – thus, while the contest may increase salespersons’
overall effort somewhat, it is bound to re-allocate effort from the chairs
product line to the tables product line. In turn, sales of chairs likely will suffer.
We calculated in part [b] that the sales contest is expected to increase profit on
tables by $30,000. Thus, profit on chairs could decrease by $30,000 before overall
company profit decreases. Since the contribution margin on each chair =
$320,000/8,000 = $40, this translates to $30,000/$40 = 750 chairs.
Pippin would need to assess whether the sales contest will actually decrease sales
on chairs by this amount. Pippin may wish to consider offering trips to Hawaii for
the salesperson selling the most tables and the salesperson selling the most chairs.
Moreover, with two product lines, Pippin needs to ensure that any incentive he
provides encourages salespersons to allocate their effort in a manner that
maximizes overall company profits, not just the profit on one product line.
d. In addition to concerns about whether the contest will adversely affect chair
sales, there are several other considerations, including:
 The contest is based on units. Pippin would need to put controls in place to
ensure that salespersons do not offer price discounts to increase their sales
numbers. That is, sales persons could actually sell more units without
increasing overall profit (i.e., there is a price, quantity tradeoff). This is
perhaps why companies frequently set fixed prices on their products and
do not allow salespersons much leeway in altering prices.
 Pippin would need to consider the effect on employee morale. Such

contests pit salesperson against salesperson and could adversely affect
cooperation.
6.47
a. Based on the information provided, Cottage Bakery’s opportunity set consists
of three options – the first option is the status quo and, indeed, this option is
viable:
1. Do nothing with the remaining counter space. That is, continue to donate the
excess muffins and do not sell raspberry-filled croissants.

6-25
2. Use the remaining counter space to sell day-old muffins. That is, do not
donate the excess muffins to the homeless shelter and do not sell raspberry-
filled croissants.
3. Use the remaining counter space to sell raspberry-filled croissants. That is,
continue to donate the excess muffins to the homeless shelter and donate any
excess raspberry-filled croissants to the homeless shelter.
b. Option 2: Use the remaining counter space to sell day-old muffins. That is, do
not donate the excess muffins to the homeless shelter and do not sell
raspberry-filled croissants.
Revenue from “day old” muffins 15  $1.50  50% $11.25 per day
Net increase in profit $11.25 per day
Notice that the cost of making the muffins is not relevant – it is a sunk
cost. Cottage incurs this cost regardless of whether the excess muffins are
sold as “day old” or donated to the homeless shelter.
Option 3: Use the remaining counter space to sell raspberry-filled croissants. That
is, continue to donate the excess muffins to the homeless shelter and donate any
excess raspberry-filled croissants to the homeless shelter.
Revenue from raspberry croissants 20  $2.00 $40.00 per day

Costs of making raspberry croissants 22  $1.20 ($26.40) per day
Net increase in profit $13.60 per day
Notice that the cost of making the croissants is relevant because this cost will
only be incurred if management decides to make the raspberry-filled
croissants.
c. The Cottage Bakery should choose option 3 and use the remaining counter
space to sell raspberry-filled croissants, continuing to donate the excess
muffins to the homeless shelter, in addition to donating any excess raspberry-
filled croissants to the homeless shelter. This option leads to the largest
increase in Cottage Bakery’s daily profit, or $13.60. This option also seems to
be preferred from a social standpoint – the homeless shelter will now receive
an average of 2 croissants per day, in addition to the 20 muffins they currently
receive.
Note: While the problem examines profit before tax, we note that tax
considerations also arise. For example, the donation to the charity might be tax
deductible.

6-26
6.48
a. Let us begin by calculating relative revenue.
JAV-100 : $80,000
YAZ-200 $40,000
Total $120,000
Thus, 2/3rd of the joint cost (= ($80,000/$120,000) × $100,000 = $66,667) would

be allocated to JAV-100 and the remainder to YAZ-200.
We then have:
Item JAV-100 YAZ-200 Total

Revenue $80,000 $40,000 $120,000
Allocated cost $66,667 $33,333 $100,000
Profit $13,333 $6,667 $20,000
b. Let us begin by calculating relative revenue.
JAV-100 $80,000
YAZ-400 $80,000
Total $160,000
Thus, half the joint cost is allocated to either product.
Item JAV-100 YAZ-400 Total

Revenue $80,000 $80,000 $160,000
Allocated cost 50,000 $50,000 $100,000
Traceable cost 25,000 25,000
Profit $30,000 $5,000 $35,000
c. Comparing the product-level profits alone, it would appear that Chemco

should not process YAZ-200 further. Doing so reduces profit from $6,667 to
$5,000. However, we know that such a conclusion is erroneous because only
incremental revenues and costs are important for this decision. Let us
therefore calculate the net gain from processing YAZ-200 further.
Value of YAZ-400 $80,000

Lost of YAZ-200 lost ($40,000)
Net gain in revenue $40,000
Cost of additional processing ($25,000)
Net value $15,000
Thus, Chemco gains $15,000 by processing YAZ-200 further. The amount of

the joint cost, or how it is allocated, is not relevant for this decision.

6-27
6.49
a. The following table classifies each of the aforementioned items as being
relevant or not relevant and provides a succinct explanation for each
classification.
Relevant?
Item (Y or N) Reason
Regular selling price No The regular sales price is not relevant
($175) because Award Plus will not receive
this amount from the little-league
organization. Additionally, even with
the special order, Award Plus will be
operating below 100% of their
production capacity (i.e., 7,500 +
1,800 < 10,000); thus, Award Plus
will not sacrifice any regular business
by accepting the special order.
Special order selling price Yes The additional revenue associated
($100) with the special order clearly depends
on this value.
Direct materials cost Yes Presumably, the special order medals
will require the same amount of
materials as other medals. Thus, the
cost is relevant.
Direct labor cost Yes Presumably, the special order medals
will require the same amount of labor
as other medals. Thus, the cost is
relevant.
Fixed manufacturing cost No Fixed manufacturing costs will be the
same in total regardless of whether
the special order is accepted. (Since
Award Plus will still be operating in
the relevant range if they accept the
special order).
Fixed marketing & No Fixed marketing and administrative
administrative cost costs will be the same in total
regardless of whether the special
order is accepted. (Since Award Plus
will still be operating in the relevant
range if they accept the special
order).
b. Using the classifications in the above table, the following table summarizes
the amounts by which each relevant cost or revenue will change if the special
order is accepted. The net of the increased revenues less the increased costs

6-28
provides us with the incremental profit (or loss) associated with accepting the
special order. That is, we are using the incremental approach with status quo
as the benchmark option. (In the text, we also called this method “Controllable
Cost Analysis.”)
Item Detail Total

Additional revenue $100 × 1,800 medals $180,000
Direct materials cost $50 × 1,800 medals $90,000
Direct labor cost $40 × 1,800 medals $72,000
Incremental profit $18,000
Thus, Award Plus’s profit is expected to increase by $18,000 if they accept the
special order.
c. Referring to part [a] of the problem, the regular sales price is now relevant
since, by accepting the special order, Award Plus will sacrifice sales of 300
medals to their regular customers. Moreover, Award Plus will lose ($175 –
$50 – $40)  300 = $25,500 in contribution margin on regular business if they
accept the special order. Thus, the net benefit from accepting the special order
= $18,000 – $25,500 = ($7,500). In other words, Award Plus’s profit will
decrease by $7,500 if they accept the special order.
We can also see this effect by comparing the contribution margins from accepting
or not accepting the special order (since fixed costs will be the same across
decisions). Here, we employ the gross method to compute the contribution from
the two options.
Contribution Margin (accept special order) = [7,200  ($175 – $50 – $40)] +

[1,800  ($100 – $50 – $40)] = $630,000.
Contribution Margin (reject special order) = 7,500  ($175 – $50 – $40) =

$637,500.
Again, we see that Award Plus’ profit is $7,500 higher if they reject the special
order.
This problem reinforces that, in the short-term, capacity is fixed and, accordingly,
short-term decisions center on the best use of available capacity. Oftentimes, it is
profitable to find uses for excess capacity, as shown in part [b]. However, there
also are situations where it is best to let some capacity remain idle, as shown in
part [c]. In short, the optimal use of available capacity does not necessarily mean
that all available capacity should be used.

6-29
6.50
Hōgyoku has two options: (1) run the special promotion or (2) do not run the
special promotion. Calculating the incremental revenues and costs associated with
running the promotion is more difficult than it first appears. First, we need to keep
in mind that, while the price charge on winter items will decrease to $6, the
variable cost per item will not decrease. That is, the variable cost per winter item
will equal $9  .40 = $3.60. This implies that the incremental contribution margin
due to the increased sales volume = ($6.00 – $3.60)  1,500 = $3,600. Second, we
need to consider the lost contribution margin on regular business related to winter
items – that is, the $4,500 in regular business means that Hōgyoku typically
cleans $4,500/9 = 500 winter items each month. Presumably, these customers (in
the coming month) also will be charged $6 for each winter item cleaned, implying
that the contribution margin on “regular” winter item business will go down by
500  ($9 – $6) = $1,500. These two numbers, coupled with the increased
advertising expenditure, allow us to calculate the change in profit from running
the special promotion:
Incremental contribution margin (6.00 – 3.60)  1,500 $3,600

from increased sales
Lost contribution margin on 500  ($9 – $6) ($1,500)

regular winter item business
Incremental advertising Given ($1,000)
Net change in monthly profit $1,100
Hōgyoku should run the promotion as her profit in the coming month is expected
to increase by $1,100.
6.51
a. In this problem, it is important to recognize that all of the common fixed costs
allocated to the dry cleaning operations would not disappear if the dry
cleaning business were to be closed. Specifically, the dry cleaning business
currently generates a segment margin of $300,000 ($800,000 – $500,000).
This margin would not be available if the dry cleaning business were to close.
However, the common fixed costs would decrease by $200,000; thus, the net
reduction in profit is $300,000 – $200,000 = $100,000. That is, SpringFresh’s
profit will decrease by $100,000 to $200,000 if it eliminates the dry cleaning
department.

6-30
This effect is perhaps most easily seen (and verified) by constructing an income
statement without the dry cleaning business. We present such an income statement
below:
Laundry Only
Revenue $3,000,000
Variable costs $1,000,000
Contribution margin $2,000,000
Direct fixed costs $1,000,000
Common fixed costs* $800,000
Profit $200,000
* = $1,000,000 – $200,000.
Again, we see that SpringFresh’s overall profit decreases by $100,000 to

$200,000. Assuming the accuracy of the estimate of the reduction in common
fixed costs, SpringFresh should not eliminate its dry cleaning operations.
This particular problem underscores that income statements can be misleading in

terms of what a particular department or product actually contributes to overall
profitability. The key in making this assessment is determining what revenues and
costs actually disappear if the department is eliminated.
b. Increasing the volume of laundry will increase the contribution margin

available to cover fixed costs. Based on the data provided, we find that each
$1.00 of revenue in laundry provides $0.67 in contribution margin
($2,000,000 in contribution margin divided by $3,000,000 in revenue). Thus,
an increase of 10% in laundry sales will increase the laundry contribution
margin by 10% as well. This implies that the laundry contribution margin will
increase to $2,200,000. Our revised income statement with laundry only looks
as follows:
Laundry Only
Revenue $3,300,000 $3,000,000  1.1
Variable costs $1,100,000 $1,000,000  1.1
Contribution margin $2,200,000 $2,000,000  1.1
Direct fixed costs $1,000,000
Common fixed costs* $800,000 $1,000,000 – $200,000
Profit $400,000
Here, we see that SpringFresh’s overall profit increases by $100,000 to $400,000.

Assuming the accuracy of the estimates, SpringFresh should eliminate its dry
cleaning operations as profit increases.

6-31
In constructing this income statement, however, notice the assumption that neither
the traceable fixed costs nor the common fixed costs would increase if the volume
of laundry were to increase by 10%. This is a questionable assumption.
Management judgment is key in determining whether the increase in the fixed
costs, if any, would exceed $100,000, or the expected net increase in the firm’s
profit.
6.52
a. GoGo Juice’s decision deals with excess supply. The competition has moved
in, soaking up some of GoGo Juice’s monthly gasoline and merchandise sales.
Consequently, GoGo Juice finds itself in a position with “excess” gasoline and
merchandise (i.e., GoGo Juice has the supply to accommodate more
customers). A short-term promotion is one way to spur additional demand.
b. Because the question asks for the change in profit, we employ the incremental
approach with the status quo as the benchmark option. That is, we employ
controllable cost analysis. The following table calculates the expected change
in monthly profit if GoGo Juice runs the special promotion:
Item Detail Total

Additional sales of gasoline .08 × $150,000 $12,000
Additional sales of merchandise .12 × $75,000 9,000
- Cost of additional gasoline sales 0.75 × $12,000 (9,000)
- Cost of additional merchandise sales 0.50 × $9,000 (4,500)
- Free merchandise sales 0.01 × [($150,000 (8,100)
+ $12,000)/$0.20]
Incremental profit ($600)
GoGo Juice’s monthly fixed costs are not relevant to running the special
promotion because they will be incurred regardless of whether GoGo Juice runs
the special promotion. In short, running the special promotion does not appear to
be a good idea because GoGo Juice’s monthly profit is expected to decrease by
$600.
c. By using a threshold, GoGo Juice is trying to give customers the impression
that they are receiving $0.01 in free merchandise for every $0.20 spent on
gasoline (after all, $0.50/$10.00 = $0.05 per $1.00, or $0.01 per $0.20). In
reality, this is not the case since customers only receive $0.01 per $0.20 spent
on gasoline if their purchase equals $10, $20, $30, etc. (i.e., some whole
number multiple of $10). Otherwise, customers receive strictly less than $0.01
per $0.20 spent. For example, a customer spending $9.99 on gasoline receives
$0.00 per $0.20 spent on gasoline in free merchandise and a customer
spending $12.50 on gasoline receives $0.50/$12.50 = $0.04 per $1.00, or
$0.01 per $0.25 in free merchandise. Conceptually, the scheme converts a
variable discount to a step-discount, with $10 as the step-size. This change
ensures that the actual discount provided will always be lower than $0.01 per
$0.20 of gasoline sales.

6-32
Management of GoGo Juice may believe that such a threshold will stimulate the
same increase in gas sales as before, thereby increasing monthly gas profit by
$3,000 (= $12,000 - $9,000; as shown in part [b]). Additionally, because of the
threshold the scheme would reduce the “loss” on free merchandise sales (since
customers effectively receive less than $0.01 per $0.20 spent on gasoline, there
will be less than $8,100 in free sales). The cost (or risk) is that some savvy
customers may not respond to GoGo Juice’s promotion and, as a result, demand
for both gasoline and merchandise will not increase as expected.
Note: Organizations devote much time and resources to structuring coupons and
promotions that look more attractive to customers than actually is the case. For
example, businesses frequently offer rebates, but require customers to fill out
detailed paperwork to receive the rebate. The rebate then comes 6-8 weeks later in
a package that looks like “junk mail” (the company is hoping that the consumer
throws the letter away along with the other junk mail). In a similar fashion,
companies often issue coupons that can only be used later – here, the company is
hoping the person will lose the coupon, thus lowering the redemption rate.
Similarly, lottery organizations advertise the total payout in the jackpot without
taking into the present value for money or taxes – such accounting would reduce
the prize from say, $100 million, to $25 million! The lesson is that organizations
frequently do what they can to increase sales, but minimize the cost of increasing
sales. Special promotions and coupons are one way of providing consumers with
the “illusion of value.” The amount the firm saves is “breakage,” and could be in
the millions of dollars for firms such as Best Buy and Home Depot.

6-33
6.53
a. Timmy’s overall profit equals all revenues less all costs. One could quickly
calculate profit for battery testers as ($35 – $28)  20,000 = $140,000 and
profit for solenoid testers as ($20 – $22)  10,000 = ($20,000). Thus, overall
profit = $140,000 + ($20,000) = $120,000.
More formally, one might depict overall profit and the profit for each product as
follows:
Battery Solenoid
Testers Testers Total
Revenue $35  20,000; $700,000
$20  10,000 $200,000 $900,000
Fixed costs:
Manufacturing $10  20,000; (200,000)
$10  10,000 (100,000) (300,000)
Marketing & $4  20,000; (80,000)
administrative $4  10,000 (40,000) (120,000)
Variable costs:
Manufacturing $12  20,000; (240,000)
$6  10,000 (60,000) (300,000)
Marketing & $2  20,000; (40,000)
administrative $2  10,000 (20,000) (60,000)
Profit $140,000 ($20,000) $120,000
b. Timmy’s contribution margin equals revenues less all variable costs. Thus,
Timmy’s contribution margin on battery testers equals [$35.00 – ($12 + $2)]
 20,000 = $420,000 and Timmy’s contribution margin on solenoid testers
equals [$20.00 – ($6 + $2)]  10,000 = $120,000. Thus, the total
contribution margin = $420,000 + $120,000 = $540,000. More formally, one
might show overall contribution margin and contribution margin for each
product as (by re-arranging the income statement calculated in part [a]):

6-34
Battery Solenoid
Testers Testers Total
Revenue $35  20,000; $700,000
$20  10,000 $200,000 $900,000
Variable costs:
Manufacturing $12  20,000; (240,000)
$6  10,000 (60,000) (300,000)
Marketing & $2  20,000; (40,000)
Administrative $2  10,000 (20,000) (60,000)
Contribution Margin $420,000 $120,000 $540,000
Fixed costs:
Manufacturing $10  20,000; ($200,000)
$10  10,000 ($100,000) ($300,000)
Marketing & $4  20,000; (80,000)
Administrative $4  10,000 (40,000) (120,000)
Profit $140,000 ($20,000) $120,000
c. The key here is to realize that, as stipulated in the problem, the overall fixed
costs of $420,000 will not decrease if Timmy drops the solenoid testers. Thus,
if Timmy stops producing the solenoid testers his profit will decrease by
$120,000, which is the contribution margin from the solenoid testers
calculated in part [b]. In essence, this question illustrates the value associated
with restating income statements using a contribution margin format. The
profit effect of dropping solenoid testers also can be verified by constructing
an income statement with battery testers. Such an income statement is
presented below:
Battery Testers
Revenue $700,000
Variable costs* (280,000)
Contribution margin $420,000
Fixed costs (420,000)
Profit $0
* = $240,000 + $40,000
Again, we see that Timmy’s overall profit is expected to decrease by $120,000 to

$0.

6-35
d. We see that unitizing fixed costs (expressing them on a per-unit basis) can
allow us to quickly calculate overall profitability or the reported profitability
of any particular product. That is, we can simply take the price per unit less
the cost per unit multiplied by the number of units sold. Unfortunately,
unitizing fixed costs could lead to disastrous effects in terms of decision-
making. This outcome occurs because decision makers can be tempted to
multiply the unitized fixed cost by some new level of volume to arrive at total
fixed costs. Over many ranges of activity, however, fixed costs in total will not
change – thus, it is important to remember that total fixed costs equal the fixed
cost per unit multiplied by the level of volume used to arrive at the fixed cost
per unit. By using one volume to calculate the fixed cost per unit and
multiplying it by another volume, the decision maker is treating the fixed cost
as if it were variable, which it is not. This feature [again] underscores that
fixed costs often are not relevant to short-term decisions.
6.54
a. The incremental cost associated with the show appears to be $250, or the
variable cost of running the show. The [allocated] fixed cost per show is not
relevant because the total amount of fixed costs for the year will not change as
a result of the special screening. Further, the stated ticket prices are not
relevant because the show will take place in the mid-morning hours when the
IMAX is not traditionally open – thus, the students will not be displacing any
regular customers. Based on the financial data provided, the minimum price
quote appears to be $250.
b. At a minimum, Randy should consider the following:
 Does the Science Station have a gift shop and/or cafeteria? If so, many students
are likely to buy food and/or gift items, thereby increasing the Science Station’s
contribution margin. In turn, this would reduce the minimum price quote in part
[a].
 What is the impact on future revenue? What proportion of the students and
teachers would have seen the show at the regular price? (That is, what is the
opportunity cost in the form of lost revenue?). Alternatively, after seeing the show,
many students may return with their parents, thereby increasing future revenue.
 Are there costs associated with the special showing that are not captured by the
$250 variable cost number? For example, will the Science Station have to pay an
overtime premium for a projectionist and/or usher?

6-36
c. Randy probably should consider the educational mission of the Science

Station. Such screenings directly contribute to this mission, the station, and,
hopefully, the betterment of the students. The special screening may be an
excellent way to expose some students to science – these students may have
never gone through the Science Station if it were not for the school outing.
Overall, the “best” price to charge is unclear and requires some managerial
judgment as Randy needs to balance an array of financial and non-financial
factors.
6.55
We can address this problem from both quantitative and qualitative perspectives.
From a quantitative perspective, the incremental costs and revenues associated
with reducing the length of stay from 1.8 days to 1.5 days are as follows:
Increment due to
reducing LOS
Number of patients 10,000
Reduction in average LOS 0.30
Decrease in number of days (10,000  .30) 3,000
Variable cost per day $125
Cost savings from reducing LOS (3,000  125) $375,000
Revenue from increased re-admissions (200  100,000
500)
Cost of increased re-admissions (50,000)
Total additional savings/change in profit $425,000
From a financial perspective, Quincy’s plan makes sense – the analysis suggests
that the hospital’s annual profit would increase by $425,000. One might also
sympathize with Quincy’s logic – the quest for survival in an era where hospital
revenues are fixed and medical costs are increasing have pushed many healthcare
administrators into making similar decisions (for example, maternity stays have
been reduced dramatically in recent years).
There are, however, other important considerations. One has to consider the effect
on patients being discharged “early.” At a minimum, numerous patients will
experience added discomfort and disruption in their lives. Further, approximately
200 patients will have to be re-admitted and undergo additional treatment – there
are both monetary and non-monetary costs that will be borne by these individuals.
Finally, some patients may even die as a consequence of being discharged early.
Here, the hospital’s and the management’s value systems play a key role in
determining these intangible, but very real and relevant, costs. Finally, one might
reasonably argue that by discharging patients early the hospital will incur negative
reputation costs or come under the scrutiny of the press/media and/or medical
review boards.

6-37
There is no “correct” answer to this problem – the problem shows that for many
decisions in life it is important to balance quantitative and qualitative
considerations. Decision models invariably incorporate both types of factors, and
students [rightfully] may place different weights or values on the various factors.
Moreover, it is important to recognize and think about such tradeoffs – hopefully,
the lively discussion the problem generates helps demonstrate the value of
viewing decision making as an exercise in model building and measurement, and
also see that decision models are unique, somewhat like an individual’s
fingerprints.
6.56
a. We first calculate the incremental cost associated with offering the free web-
based tax-filing product, which is:
Cost of developing product sunk

Cost of maintaining product given $420,000
Value of names obtained 250,000  0.80  $0.09 (18,000)
Incremental cost $402,000
Next, since the unit contribution margin from the personal-finance software is
$25.00 – $1.00 = $24.00, the increased volume required can be calculated as
$402,000/$24.00 = 16,750 software packages. Because 250,000 individuals are
expected to use the free web-based product, the required proportion is
16,750/250,000 = 6.7%. This seems eminently reasonable.
b. There are many other factors to consider. Perhaps the most prominent relates
to the cannibalization of the stand-alone tax product. That is, offering the free-
web-based tax product is likely to eat into the sales of the stand-alone tax
product. The lost contribution margin on these sales needs to be factored in as
an incremental cost – the problem does not, however, provide us with enough
information to calculate this opportunity cost.
There also are likely to be legal liability issues – in offering the free web-based
product, TaxPlan needs to be concerned about system breakdown, loss of data,
incorrect transmission, and so on. Should the system fail for any reason, TaxPlan
likely exposes itself to legal action as well as negative publicity. Other factors
may relate to issues of how long returns need to be stored and how many names
will be “new” to the system.

6-38
c. The IRS has a financial interest because the costs (to the IRS) associated with
receiving paper returns are substantially higher than the costs of receiving
electronic returns. Some of the incremental costs include having staff to
receive and open the paper returns, keying (inputting) the data from the paper
returns into the computer, correcting any errors in keying, storing the paper
returns, handling any checks, and so on. Thus, the IRS vastly prefers
electronic filing! This aspect of the problem reminds students of the
importance in considering externalities in their decision making – invariably,
the decisions we make affect others.
6.57
a. Compared to the status quo of keeping the recently acquired machines, the
table below presents the change in profit associated with acquiring the better
video poker machines:
Proceeds from sale of

recently purchased $1,000  250 $250,000
machines
Profit from increased $30,000  250  .10 1,500,000
wagering on better  2 years
machines
Cost of better machines $5,500  250 (1,375,000)
Increased Profit $375,000
The casino would gain $375,000 over the two years by replacing the recently
acquired video poker machines with the better model. Notice that the cost of the
recently acquired video poker machines, or $1,250,000, is sunk and not relevant
to the analysis.
b. As shown above, the casino gains $375,000 by replacing the recently acquired
video poker machines. The original acquisition cost is sunk and is not relevant
for this decision. However, if Lucy goes forward with the purchase of the
better machines, she risks damage to her reputation. After all, it is her job to
foresee industry trends and she might appear to be careless or sloppy in her
duties. Moreover, management of the Diamond Jubilee might attribute a
$1,000,000 “error” to Lucy ($1,000,000 = ($5,000 – $1,000)  250, or the
difference between the purchase and disposal price of the recently purchased
video poker machines multiplied by 250 machines). The magnitude of this
error may be difficult to forget or live down. All in all, Lucy probably would
think long and hard before she recommends acquiring the better machines.

6-39
c. From the standpoint of the Diamond Jubilee, the change has no effect – the
cost is still sunk and the casino would still favor acquiring the better machines
as 2-year profit increases by $375,000.
One could argue, however, that the potential damage to Lucy’s reputation
increases as the magnitude of the price paid for the recently acquired machines
increases. The “error” attributed to Lucy would no longer be $1,000,000 but,
rather, $375,000 ($375,000 = ($2,500 – $1,000)  250). That is, from Lucy’s
perspective, the cost to acquire the old machines is not sunk because it affects the
magnitude of the damage to her reputation. Compared to our earlier analysis,
Lucy likely will be more inclined to recommend purchasing the better machines.
The classification of a cost as sunk is only valid within a decision context and for
the specified decision maker (please also see the continuation problem). This is
because a sunk cost can influence the value for relevant items such as reputation.
Because different parties may care differently about factors such as personal
reputation, a cost that is sunk for one decision maker may be a relevant item for
another decision maker.
6.58
a. As shown in part [a] to previous problem, the $1,250,000 cost of the recently
acquired video poker machines does not affect the decision to purchase the
better video poker machines. This cost is sunk and it does not lead to
differential cash flows across options. Moreover, in a world without taxes it
does not matter whether the acquisition cost was $1,250,000 or, for that
matter, $10,000,000.
b. In this case, the acquisition cost, while sunk, does lead to differential cash
flows across options. Suppose the new machines are not purchased. Then, the
existing machines will be depreciated over the next two years. The
depreciation expense will reduce taxable income, thereby reducing taxes paid.
(Spend a few minutes reviewing the difference between a cash outflow and an
expense.)
Given the data for the Diamond Jubilee, keeping the existing machines produces
an overall tax benefit of 0.25 × $1,250,000 = $312,500.
Now, consider the option of buying the new machines. The acquisition cost of the
old machines affects taxes paid in this case as well. If the better video machines
are purchased, the Diamond Jubilee will reap a tax benefit from the loss on selling
the “old” machines. This loss and concomitant tax benefit are shown below:
Purchase price $1,250,000

Proceeds from sale of recently purchased
machines ($1,000  250) 250,000
Loss $1,000,000

6-40
Tax Rate .25

Tax Savings $250,000
The important points to notice are that the tax in either case depends on the
purchase price of the old machine and that the tax benefit is different across
options. That is, the tax effect is not a wash. Keeping the old machines yields an
additional tax savings of $62,500 = $312,500 - $250,000.
The acquisition cost, while sunk, clearly “matters” in a world with taxes because
it leads to differential cash flows between the options.
c. Above and beyond our calculations in part [b], there are two other tax effects
we need to consider when we compute the profit impact of replacing the old
machines: (1) The taxes on profit from wagering, and (2) the tax shield due to
the depreciation on the new machine.
Proceeds from sale of $1,000  250 $250,000

recently purchased
machines
Profit from increased
wagering on better $30,000  250  .10  2 1,500,000
machines
Tax on profit from
increased wagering Previous row × 0.25 (375,000)
Cost of better machines $5,500  250 (1,375,000)
Tax benefit due to
depreciation on new $5,500 × 250 × 25% 343,750
machine
Net tax benefit lost if old
machines are sold Computed in part b (62,500)
Increased Profit (Value of machine) $281,250
The casino would gain $281,250 over the two years by replacing the recently
acquired video poker machines with the better model.
The above table presented the incremental approach for buying the new machines,
with status quo as the benchmark (i.e., performed controllable cost analysis). For
completeness, we present the gross approach. First, we compute the profit if we
keep the old machines. (Note: Because we do not know the wagers over the two
years associated with the recently acquired “old” machines, let us call it W. This
term “washes” out because it is common to both options.)

6-41
Wagers on old machine Not known W
Tax on profit from wagers

in old machine W × 25% (0.25W)
Tax shield because of
depreciation of old $1,250,000× 0.25 312,500
machines
Profit if we keep old $312,500+ 0.75 W
machines
Next, we compute the profit if the casino purchases the new machines.
Proceeds from sale of recently

purchased machines $1,000  250 $250,000
Tax shield because of loss due ($5,000-$1,000) ×
to sale 250 × 0.25 250,000
Profit from wagering on better W + ($30,000  250
machines  .10  2) W + $1,500,000
Tax on profit from wagering Previous row × (0.25W + $375,000)
25%
Tax shield because of $5,500 × 250 × $343,750
depreciation of new machines 25%
Cost of better machines
$5,500  250 ($1,375,000)
Profit if we buy the new 0.75W + $593,750
machines
The difference in profit is $281,250, as calculated before. The incremental method

has fewer steps and is less tedious. However, the gross method has fewer chances
for omitting items, and often is preferred by decision makers when the number of
options becomes large and/or the cash flow pattern is complex.
d. Similar to the previous problem, this problem reinforces the notion that the
classification of a cost as sunk and irrelevant is only valid within a decision
context and for a specified decision maker. While the earlier problem focused
on a multi-person, or strategic, setting the current problem illustrates that the
relevance can change in a single-person setting. This is because a sunk cost
can influence the value for relevant items such as taxes. Moreover, a cost that
is sunk and irrelevant for one decision context may be relevant for another
decision context.

6-42
6.59
a. The key aspect of this problem is to recognize that the original cost of the
existing case ($20,000) is a sunk cost and, therefore, is not relevant for the
decision to repair the existing case or buy a new case. Additionally, the book
value of the existing case also is not relevant. The controllable costs
associated with each option follow (Note: rather than deducting the utility
costs from the purchase price of the new case, these savings could be added to
the costs of repairing and keeping the existing case – the net difference is still
$4,500 in favor of repairing the existing case):
Cost of the New Case

Purchase price $21,000
Utility savings 100  12  10* (12,000)
Net Cost $9,000
Cost to Repair Existing Case:

New motor and wiring $4,500
* $100 per month for 10 years
We see that it is cheaper for Gina to fix the existing case than buy the new case.
Gina saves $4,500 by repairing the existing case.
b. This information does not change the analysis in any way. The purchase price
of the existing machine and its current book value are simply not relevant for
the analysis (given the current setup).
Note: The current book value could become relevant for the analysis if Gina could
claim a tax deduction for the loss incurred on the sale of the existing case. Thus, a
seemingly sunk cost (the book value of the old case) can become relevant because
it influences the value of a relevant cost (the tax loss). This issue is more fully
explored in requirement [d] below.
c. Absolutely. The ability to sell the existing case for $5,000 reduces the cost of
buying the new case from $9,000 to $4,000 (alternatively, one could view this
as an opportunity cost associated with keeping the existing case; here, we
would add the $5,000 to the cost of the existing case). The cost of repairing
the existing case remains unchanged at $4,500. Consequently, Gina now
favors buying the new case by $500.

6-43
d. Gina’s tax status can affect her decision because taxes will alter Gina’s out-of-
pocket costs associated with repairing the existing case versus buying the new
case. For example, if Gina sells the existing case then she can claim the loss
on the sale as a tax deduction. Additionally, Gina’s expenses associated with
operating the cases will be deductible for tax purposes. That is, each dollar of
expense will reduce taxable income by $1, thereby saving $0.30 in taxes. The
net after-tax cost of a dollar is thus only $0.70. Such savings frequently are
referred to as a “tax shield.”
The controllable after-tax costs associated with each option follow. (Again, please
note that costs such as expenditures on utilities can be framed as either reducing
the cost of buying the new case or increasing the cost of repairing the existing
case); the net difference between the options is what we are after:
Cost of the New Case

Purchase price $21,000
Proceeds – sale of old case not taxed (5,000)
Utility savings $100  12  10 (12,000)
Tax savings from purchase of new .30  $21,000** (6,300)
case
Taxes on utility savings .30  $12,000 3,600
Tax savings – loss on sale of old case .30  $11,000* (3,300)
Net Cost ($2,000)
Cost to Repair Existing Case:

Before tax cost for motor and wiring $4,500
Tax savings of 30%** .30  $4,500 (1,500)
Tax savings from depreciating .30 × $16,000 (4,800)
current
Case
Net Cost ($1,800)
*
Loss = $16,000 (book value) – $5,000 (proceeds) =
$11,000
**
Both the original book value and the cost of
improvements will be depreciated over time, yielding a tax
shield.
Gina is better off (to the tune of $200) if she buys the new case. Indeed, the
negative cost of getting the new case suggests that Gina should have purchased
the new case even if the motor had not burned out – perhaps Gina should thank
her assistant for leaving the case’s door open!

6-44
Note: The conclusion about a mistake increasing profit is, of course, tongue in
cheek...if the assistant had not made the mistake, no repairs would be necessary.
Gina would have had a net cost of ($4,800) from retaining the old case. We do not
have enough data to say if the new case is preferred in this event. Presumably, the
resale price for the old case also would increase from $5,000 if it were not broken.
Note: This problem features a non-standard treatment of the tax shield on the
purchase of the new case. Typically, the new case would be depreciated over time,
and the depreciation provides a tax shield. Absent a time value for money,
however, the net effect is a tax shield on the purchase price.
e. These types of “open-ended” questions are important to address because there

are numerous factors that are relevant to any decision but may be difficult to
quantify. Such measurement difficulties, however, do not relieve us from our
obligation to consider certain variables in the decision model. In this particular
example, Gina likely should consider whether the new case would have better
climate control and extend the shelf life of her flowers (this could increase
sales and/or reduce costs). The new case also may be more or less attractive,
have a larger or smaller storage capacity, and so on. In turn, these factors
likely affect sales and, as such, can tilt the analysis in favor of buying the new
case or repairing the existing case.
6.60
a. First, we should determine Bob’s capacity to ensure that the professor’s order
will not impose any constraints on Bob’s business. At $675,000 in sales, Bob
expects to operate at 90% of capacity; thus, we can calculate Bob’s capacity as
$675,000/.90 = $750,000. Since the order is for $50,000 (with pre-discount
price), Bob has enough idle capacity to fulfill the order without eating into his
regular business.
The next key is to realize that fixed costs would not change whether Bob provides
the professor with a discount. Further, Bob will incur $0.45 in variable costs for
each pre-discount sales dollar.
We are now in a position to calculate, relative to the status quo of not accepting
the order, the incremental costs and benefits of accepting the order as:
Incremental revenue $50,000  .75 $37,500

Incremental costs $50,000  .45 ($22,500)
Net Increase in Profit $15,000
Thus, Bob’s profit increases by $15,000 as a result of providing the professor with
the 25% discount. This assumes, of course, that some of Bob’s other customers
also will not demand a similar discount, in which case, Bob needs to factor in the
lost contribution margin on these orders.

6-45
b. If Bob is operating at 96% of capacity at a sales level of $675,000 we can

calculate Bob’s capacity in sales dollars as $675,000/.96 = $703,125. Since
the order is for $50,000, this implies that Bob will have to sacrifice $725,000
($625,000+$50,000) – $703,125 = $21,875 in regular business.
If Bob sacrifices $21,875 in regular business he will lose $21,875  .55 =

$12,031.25 in contribution margin. This amount reduces the increase in profit we
arrived at in part [a], resulting in a net increase in profit of $15,000 – $12,031.25
= $2,968.75 by providing the professor with the discount.
c. In this case, Bob will lose $50,000 in regular business, which amounts to
$50,000  .55 = $27,500 in lost contribution margin. In turn, by providing the
professor with the discount Bob’s profit will decrease by $15,000 – $27,500 =
$12,500. Notice that this corresponds perfectly to the amount of the discount,
or $50,000  .25 = $12,500. Barring some unusual circumstances, Bob should
not provide the professor with the discount.
This problem helps illustrate the opportunity cost of capacity. In part [a] capacity
was not binding and, as a result, the opportunity cost of capacity was $0. In part
[b], acceptance of the special order meant that capacity did bind, resulting in a
loss of some regular business. However, the opportunity cost of capacity was such
that it did not exceed the increased contribution margin associated with giving the
professor the 25% discount. In part [c], acceptance of the special accepting again
meant that capacity did bind, in this case resulting in a 1-for-1 loss of regular
business. Here, the opportunity cost of capacity does exceed the increased
contribution margin associated with giving the professor the 25% discount.
Moreover, the opportunity cost exactly equals the discount itself, as all other costs
are unaffected.
6.61
The incremental revenue to Edmund from accepting the project = 20 hours  0.50
 $100 per hour = $1,000. Based on the information provided, the incremental
financial cost appears to be $0 as Edmund’s costs are mostly fixed. Additionally,
because this is the slow season, Edmund likely has enough free time (idle
capacity) to do the project. That is, Edmund probably will not be foregoing
another job by taking on this project. Thus, from a purely quantitative standpoint,
Edmund increases his profit by $1,000 from accepting the project.
From a qualitative standpoint, accepting the project may curtail Edmund’s

recreational activities. Thus, Edmund needs to consider the value he attaches to
his “free” time – it is quite possible that Edmund values 20 hours of free time
during the off-peak months at an amount greater than $1,000.
From a qualitative standpoint, Edmund also needs to consider whether accepting

the project will lead other clients to demand similar loyalty discounts during the

6-46
slow season – surely, this is a position Edmund does not wish to be in. Finally,
Edmund needs to assess whether rejecting the project will lead to a loss of all
future business with this client.
Because the increase in profit from accepting the project is rather small, it is
likely that Edmund’s decision will hinge on the qualitative factors.
6.62
a. The first step is to rank-order the products per their contribution margin of the
scarce resource (binding constraint). For Sylvester’s, the cold rolling mill
(CRM) is the scarce resource. Thus, we need to calculate each product’s
contribution margin per minute of CRM usage. Doing so yields:
Steel
Alloy Coils Bars Wire
Contribution margin per pound
$1.40 $0.45 $0.98 $0.75
Minutes per pound in CRM 0.10 0.03 0.35 0.30
Contribution per minute* $14.00 $15.00 $2.80 $2.50
* = (contribution margin per pound)/(minutes per pound in CRM)

Our analysis reveals that coils are the most profitable product, followed by alloy,
steel bars, and then wire. Coils are most profitable because they make the most
efficient (in the sense of contribution to profit) use of the resource that limits
Sylvester’s profit – the Cold Rolling Mill. Barring other constraints (see part [b]),
we would recommend that Sylvester’s use all of its available CRM capacity to
produce coils.
Since the Cold Rolling Mill can be operated for 24,000 minutes per month and
coils yield $15.00 per minute, Sylvester’s total contribution margin for the month
= 24,000 × $15.00 = $360,000. From this, we subtract Sylvester’s monthly fixed
costs of $200,000 (= $2,400,000/12) to arrive at a monthly profit of $160,000.
b. Based on our calculations in part [a], Sylvester’s should devote all available
capacity to coils. However, this assumes a perfectly competitive market, or a
fixed output price and unbounded demand at this price. Of course, there may
be market constraints that prohibit Sylvester’s from producing coils only. (In
operations, this is called a corner solution.) For example, our solution calls for
Sylvester to produce 24,000/.03 = 800,000 lbs. of coils per month, or
9,600,000 lbs. of coils per year. Given Sylvester’s overall size, it is not clear
that the demand for their coils (used in appliances) is this high, requiring
Sylvester’s to use CRM time to produce other products, as it currently does.

6-47
More generally, Sylvester’s would devote as much time as possible to coils until
the contribution per minute in the CRM (due to market constraints) was lower
than alloys. It would then turn its attention to alloys and devote the maximum
attention to this product until its contribution margin per minute in the CRM was
just lower than steel bars. This process would be repeated until Sylvester’s “runs
out” of CRM time. Implementing this strategy, though, requires that we know the
market demand constraints for each of the products. This information is not
available in the problem, but clearly is necessary for optimal decision-making.
In addition to confirming price, we also would want to check the reliability of the
variable cost number in the computation of the contribution margin. For example,
Sylvester’s may classify direct labor cost as being variable. However, if, as is
typical for steel mills, the company is a union shop where employees have a
guaranteed contract, then Sylvester’s essentially is committed to paying its
employees regardless of output or product mix. Thus, the labor cost may be more
like a fixed cost than a variable cost.
Each product’s contribution margin might change if the amount of direct labor
cost that previously was included in the contribution margin differed across the
four products. In turn, this could change our rank ordering of products vis-à-vis
product profitability.
Note: This problem to the “Theory of Constraints” (TOC). The TOC essentially
argues that even variable selling and variable overhead costs are fixed in the short
run. Consequently, the contribution under TOC equals: sales – materials cost.
Again, if “variable” overhead and selling costs differ across products, the ranking
of products could change. Moreover, this problem encourages students to think
critically about what is “fixed” and what is “variable.”
6.63
a. Crash faces a problem of excess demand. He only has 300 square feet of space
available.
To install the maximum desired number of each game, he would need:
Video games 5 × 50 square feet/game 250 square feet

Dance games 2 × 75 square feet/game 150 square feet
Simple games 6 × 10 square feet/game 60 square feet
Total space needed 460 square feet
Thus, Crash has to ration available space among the games. As detailed in the
text, he could determine the profit-maximizing mix by considering the
contribution margin per unit of the scarce resource. In our case, the scarce
resource is space. The following table shows the contribution margin for each
game per square foot.

6-48
Video Dance Simple

Game Game Game
Revenue per hour $20 $40 $15
(fully occupied)
Occupancy rate 40% 30% 10%
Total hours available 100 100 100
per week
Revenue per week (= $800 $1,200 $150
revenue per hour ×
occupancy rate ×
hours available)
Maintenance costs $100 $300 $0
per week
Contribution margin $700 $900 $150
per week
Square feet 50 75 10
occupied/machine
Contribution per $14 $12 $15
square foot
Thus, a simple ranking would show Crash’s optimal allocation of space to be:
6 simple games 60 square feet

4 video games 200 square feet.
Unused space 40 square feet.
With this solution, we could compute Crash’s profit as:
6 simple games × $150/week $900 per week

4 video games × $700/week $2,800 per week
Total $3,700 per week.
b. Our solution from part [a] does not use all available capacity because our
three choices involve a minimum amount of space: that is, they are “lumpy.”
We need 10 square feet for a simple game, 50 square feet for a video game,
and 75 square feet for a dance game. The left over space of 40 square feet is
too small to accommodate a video game or a dance game, and we do not need
more space for the simple games.
c. Two features of the solution to part [a] are problematic. First, the solution
does not include any “dance” games and having at least one dance game
seems very important from a marketing perspective. Second, more than 10%
of the space is wasted. Let us therefore modify the solution a bit to see if we
could do better.

6-49
First, let us consider putting in one dance game and then optimally allocate the
remaining space.
1 dance game 75 square feet
With this allocation, we could compute Crash’s profit as:
1 dance game × $900/week $900 per week

Total profit $3,900 per week.
Another possible modification is to only install five simple games (saving 10

square feet) and installing five video games. With this, we have:

With this solution, we could compute Crash’s profit as:

Total profit $4,250 per week.
d. This problem highlights a hidden assumption in the above-cited rule. In

particular, the rule implicitly assumes no constraints in how we use capacity
for available uses. In the context of Crash’s problem, this means that we could
install, for example, 2.54 video machines or 1.26 dance machines. In other
words, each of the games must be “smooth” in its use of the scarce resource,
space. This assumption is clearly not tenable in some situations.
How can we modify the rule for such situations? In classes on operations
management, we can formulate problems with constraints on use (e.g.,
“lumpy” uses) as integer programming problems and obtain optimal solutions.
The intuition for the solution methodology is to use the rule cited in the
question to identify an initial solution and then to improve on it via various
algorithms.
The overarching point is that the simple rule gives us an excellent starting
point to find the optimal solution even if it ignores some real world
constraints. The rule guarantees the optimal solution only when each resource
is “smooth” in its use of the scarce resource.

6-50
6.64
a. Space is the binding constraint in this problem and, accordingly, Vidya needs
to allocate products according to their contribution per unit of space (e.g.,
cubic foot). Referring to newspaper sales per unit of space as x, we can make
this calculation as follows:
CM Sales per CM per unit of

($1 of sales) unit of space space
Newspapers 0.10 x $0.10x
Magazines 0.25 5x $1.25x
Snack foods 0.20 10x $2.00x
Thus, the maximum possible space should be devoted to snack food items and the
least amount of space should be devoted to newspapers. Subject to the other
constraints identified in the problem, this leaves Vidya with the following
allocation of her available space:
CM
per unit of space Space Allocated
Snack foods $2.00x 10% (limit)
Magazines $1.25x 40% (plug)
Newspapers $0.10x 50% (minimum)
Thus, Vidya would allocate:

300  .50 = 150 cubic feet to newspapers
300  .40 = 120 cubic feet to magazines, and
300  .10 = 30 cubic feet to snack foods
b. A prudent place to start is with the multi-product CVP model with a weighted
contribution margin ratio (WCMR) formulation. Recall from Chapter 4:
Profit = (WCMR  Revenue) – Fixed costs.
Unfortunately, we do not know the sales prices of each item. As in part [a], we
assume that each cubic foot generates $x of sales in newspapers. Then, a cubic
foot devoted to magazines and candy will generate $5x and $10x of revenue
respectively. The following table uses these numbers to calculate the total
contribution margin ratio per average sales $

6-51
Total Sales = cubic feet CM =CMR per sales $

Item Space × sales $ per cubic foot × total sales
Newspapers 150 cubic foot $150x (= 150 × $x) $15x
Magazines 120 cubic feet $600x (= 120 × $5x) $150x
Snacks 30 cubic feet $300x (= 30 × $10x) $60x
Total $1,050x $225x
Thus, Vidya expects to make a total contribution of $225x on sales of $1,050x,

where x is the sales in $ per cubic foot devoted to newspapers. Dividing, we
have:
WCMR = $225x/$1,050x = 21.4286%
Thus, the breakeven revenue = $2,700/0.214285 = $12,600.
We can divide the required sales volume ($12,600) by the amount of cubic feet
available (300 cubic feet) to get the sales as $42 per cubic foot.
Note: This problem assumes a continuous stocking model – that is, Vidya never
runs out of any product.
MINI CASES
6.65
a. Cody faces excess demand for his services; accordingly, Cody needs to
determine which group he is best off booking. To make this assessment, we
compute the incremental revenues and costs associated with booking each
group.
We begin by calculating the increase in Cody’s business income:
Trip
Item Detail Upper Keys Lower Keys
Fare Given $300 $500
Fuel and oil costsa 160miles  $.30; $48
400miles  $.30 $120
Maintenance costsa 160miles  $.15; $24
400miles  $.15 $60
Contribution margin $228 $320
a
: Although the trip is only one way, Cody will incur round-trip costs for fuel, oil,
and maintenance. Thus, the round-trip costs are relevant.

6-52
Notice that the cost of the bus, office operating expenses, and advertising costs are
all fixed. These costs do not vary with respect to Cody’s decision and, thus, are
not relevant. For a similar reason, the fixed cost associated with insurance also is
excluded.
Based on our calculations, Cody’s business income will increase by $320 if he

books the trip to the Lower Keys and by $228 if he books the trip to the Upper
Keys.
Cody’s expected tip also is relevant to this decision. The expected tip for a trip to
the Lower Keys = $500  .15 = $75, while his expected tip for a trip to the Upper
Keys = $300  .15 = $45.
Thus, Cody’s overall (business + personal) income will increase by:
$320 + $75 = $395 if he books the trip to the Lower Keys, and
$228 + $45 = $273 if he books the trip to the Upper Keys.
In short, Cody’s overall income increases by $395 – $273 = $122 more by

booking the trip to the Lower Keys versus booking the trip to the Upper Keys.
Above and beyond the financial benefits, Cody would need to consider the
additional hours it will take to the complete the trip to the Lower Keys. By
booking the group going to the Lower Keys, it is likely that Cody will not return
home until late at night. If Cody has plans for the evening (e.g., a family event,
playing poker with his buddies, watching the big game with friends), this could
tip the scales in favor of booking the trip to the Upper Keys. Cody also likely will
consider whether each group has used his services in the past and is likely to do so
in the future (i.e., is the relationship ongoing or one time).
b. This piece of information changes the problem in a relatively straightforward

way – Cody will now earn a fare on the return trip from the Upper Keys but
(as assumed in part [a]) not on the return trip from the Lower Keys.
Additionally, Cody will earn a tip on the return trip from the Upper Keys.
Thus, Cody will be able to put the excess supply on the return trip from the
Upper Keys to profitable use.

6-53
The revised calculations are presented below:
Trip
Item Detail Upper Keys Lower Keys
$300  2; $600
Fare $500
$500  1
$600  .15; $90
Tip $75
$500  .15
160miles  $.30; ($48)
Fuel & oil costs ($120)
400miles  $.30
160miles  $.15; ($24)
Maintenance costs ($60)
400miles  $.15
Increase in business +
$618 $395
personal income
We now see that Cody prefers the trip to the Upper Keys as his overall (business +
personal) income increases by $618, or $618 – $395 = $223 relative to booking
the group traveling to the Lower Keys. The switch in Cody’s preference relative
to part [a] relates to the additional $300 fee + the $45 tip (= $300 × 0.15); in other
words, $300 + $45 – $122 = $223.
Here, we see the importance of the effective utilization of available capacity to

maximize income. In this particular setting, the benefit of Cody to making a trip
to the Upper Keys or Lower Keys depends crucially on whether he has a paid
return trip.

6-54
c. The following table re-classifies Cadillac Cody’s business and personal

income data by when the trip was made: peak season or off-peak season.
Peak Trips Off-Peak Trips Total
Revenuea $152,500 $67,500 $220,000

Tipsb $22,875 $10,125 $33,000
Fuel & oil costsc ($18,750) ($11,250) ($30,000)
Maintenance costsd ($9,375) ($5,625) ($15,000)
Contribution Margin $147,250 $60,750 $208,000
Cost of buse ($60,000)
Insurance costse ($10,000)
Office operating expensese ($45,000)
Brochures & advertisinge ($5,000)
Overall Income $88,000
a
: $152,500 = (275  $300) + (140  $500); $67,500 = (125  $300) + (60  $500).
b
: $22,875 = $152,500  .15; $10,125 = $67,500  .15.
c
: $18,750 = 62,500  .30; $11,250 = 37,500  .30.
d
: $9,375 = 62,500  .15; $5,625 = 37,500  .15.
e
: all of these costs are fixed and cannot be traced to the timing of the trip.
Since both the peak and the off-peak seasons last for 6 months (or roughly 26
weeks), Cody will lose $147,250/26 = $5,663 in overall income if he schedules the
trip for March and $60,750/26 = $2,337 in overall income if he schedules the trip for
July.
This information is likely to be very useful to Cody and his wife in planning their
vacation! Rightfully, this is part of the opportunity cost of going on vacation and
should be added to the other vacation costs. In essence, we see that it costs Cody
substantially less to vacation during July (Cody’s off-peak business season) than
during March (Cody’s peak business season) – Cody loses less income by
scheduling his vacation in a period of excess supply.
This part of the problem also shows us the importance of taking aggregate data and
breaking it into smaller pieces. If Cody were to use his overall income to guide his
vacation decision, he might erroneously conclude that he would lose only $88,000/52
weeks = $1,692 by going on vacation. This calculation, however, ignores both fixed
costs and the timing of the trip. Cody might do a little better with the overall business
contribution margin data, calculating that he would lose $208,000/52 = $4,000 by
taking the trip. This number, however, still ignores the seasonal nature of Cody’s
business. Cody would underestimate the cost of taking a vacation in March and

6-55
overestimate the cost of taking a vacation in July. Moreover, Cody sacrifices the least
amount of income by taking the trip during the non-peak season.
d. Assuming the friend’s calculations are accurate, we calculate Cody’s

incremental income as follows:
Off-Peak Trips Off-Peak Trips
(normal fare) (25% discount)
Revenuea $67,500 $81,000

Tipsb $10,125 $12,150
Fuel & oil costsc ($11,250) ($15,750)
Maintenance costsd ($5,625) ($7,875)
Contribution Margin
(business and personal income) $60,750 $69,525
a
: $67,500 = (125  $300) + (60  $500); $81,000 = [(125  1.60)  ($300  .75)]
+ [(60  1.60)  ($500  .75)].
b
: $10,125 = $67,500  .15; $12,150 = $81,000  .15.
c
: $11,250 = 37,500  .30; $15,750 = 37,500  1.40  .30.
d
: $5,625 = 37,500  .15; $7,875 = 37,500  1.40  .15.
Notice that the cost of the bus, office operating expenses, and advertising costs are
all fixed. Since these costs do not vary across Cody’s decision, they are not
relevant. For a similar reason, the fixed cost associated with insurance also is not
relevant. (Absent information to the contrary, we are assuming that the additional
mileage will not decrease the bus’s salvage value. Any such decrease would
diminish the attractiveness of slashing off-peak fares.)
Assuming the friend’s numbers are accurate, we see that Cody’s overall business
and personal income will increase to $69,525, which represents a $69,525 –
$60,750 = $8,775 increase in overall income compared to his current pricing
strategy.
In terms of evaluating the advice, we would first need to consider whether Cody
actually would want to be this much busier during the off-peak season – perhaps
Cody enjoys the free time and having a more relaxed schedule for half of the year.
At another level, we see that such differential pricing strategies (also known as
peak-load pricing) are widely followed. Ready examples are utility firms that
offer different rates based on time-of-use, airlines offering summer specials,
hotels offering “deals” for weekend getaways, and golf courses offering reduced
rates for winter or mid-week play. The pricing strategy makes sense when fixed

6-56
costs are relatively high, implying that capacity utilization is key for maximizing
profit.

6-57
While this strategy may work well for airlines and hotels, it probably will not
work well for Cadillac Cody. Stated simply, the strategy works well for airlines,
hotels, and golf courses because the size of the overall market changes (it
increases) when these organizations cut prices. In other words, spurred by a low
airfare or a low green fee, more people will travel or play golf. The increase in the
market size is the source for the incremental revenue. For Cadillac Cody,
however, his actions are likely to have minimal impact on market size. After all,
people do not plan a vacation, costing thousands of dollars, based on the prices of
local transportation! The number of people traveling to the Keys will be the same
regardless of whether Cody keeps his prices the same or slashes them (similarly, a
relatively small change in shuttle-bus fees are unlikely to affect the number of car
rentals).
If Cody were to cut his prices, it also is likely that other shuttle-bus operators will
cut their prices. Since market size and market share are likely to stay the same,
everyone will make a lower profit! In other words, the friend’s calculation
assumes that all other persons would stay put, which is not a good assumption in
the real world. Given this insight and the fact that lowering prices will not affect
the overall size of the market, Cody would be well advised not to lower his off-
peak prices.
One may well ask what prevents Cody (and the other bus operators) from raising
prices to exorbitant amounts. Some amount of price-gouging no doubt takes
place. We must remember, however, that this is a market with relatively low entry
barriers. If shuttle-bus operators start making too much money, competition is
likely to intensify and exert downward pressure on prices. Price gouging is mostly
likely to occur in settings where the customer is not very price sensitive and non-
market forces prevent competitive entry (e.g., as for a professional or college
sports team).

6-58
6.66
a. For all practical purposes, Hannah really has only two decision options:
 Option 1: Accept Piedmont’s business and reject Capelli’s offer. Thus, in

total, 192 suites (= 320 × 0.60; 75 to Piedmont and 117 to individuals) will
be booked for each of the three days at the end of February, with a daily
occupancy rate of 60%, which is close to the usual level.
 Option 2: Accept Capelli’s business and reject Piedmont’s offer. Thus, all
available suites or 320 suites (225 to Capelli and 95 to individuals) will be
booked for each of the three days.
Technically, Hannah has a third decision option. She could reject both Piedmont
and Capelli – this is the status quo. However, Hannah does not view this option to
be part of her opportunity set. As discussed in Chapter 2, Hannah has pruned her
opportunity set to focus on her two most viable choices.
b. The table below presents the total costs and total revenues associated with
each of Hannah’s decision options. In employing the gross approach, we only
included revenues and costs related to the three days in question. Thus, we did
not include Elegant Suite’s normal revenues or variable costs for the other
days in the month. We also did not include Elegant Suites’ overall fixed costs.
We could include any or all of these amounts under the gross approach as they
are the same across Hannah’s two options. Moreover, it is the difference in
profit that we ultimately are interested in.
The total revenues for each option comprise monies received from both corporate
and individual suite rentals. Corporate suite revenues equal the number of
corporate suites for the 3-day period  $120; individual suite revenues equal
number of individual suites for the 3-day period  $150; convention center
revenues are $5,000 per day, and food, telephone, and movie revenues equal the
total number of suites occupied  $25.
Variable costs comprise food, laundry, supplies, telephones, and movies (cost =
total number of suites  $30; $30 = $180,000/6,000), and labor related to cleaning
and cooking (for Piedmont, this is the total number of suites  $35; $35 =
$210,000/6,000; for Capelli, this cost is the total number of suites  $52.50 $35 ×
1.50), since Hannah will have to pay an overtime premium if she accepts the
Capelli offer). Finally, Elegant Suites will spend $3,000 to build the runway for
Capelli. (Note: as discussed earlier, the other remaining labor fixed costs for hotel
management and building and grounds are not controllable for this decision and,
thus, we did not include them as part of the total cost of each option).

6-59
Accept Accept
Piedmont Capelli
Data:
Total suites – corporate 225 675
Total suites – individual 3511 2852
Price per suite – corporate $120.00 $120.00
Price per suite – individual $150.00 $150.00
Revenues:
Suites – corporate $27,000 $81,000
Suites – individual 52,650 42,750
Convention center 15,000 15,000
Food, telephone, & movies 14,4003 24,000
Total revenues $109,050 $162,750
Variable Costs:
Food, laundry, supplies, etc. $17,280 $28,800
Labor (kitchen help, maids) 20,1604 50,400
Contribution margin $71,610 $83,550
Additional Fixed Costs:

Build runway $3,000
“Profit” $71,610 $80,550
1
351 = [(320 × 3 days) × 0.60] – 225.
2
285 = [(320 × 3 days) - 675].
3
14,400 = ($25 × 960) × 0.60.
4
20,160 = ($30 × 960) × 0.60.
From a profit-maximizing perspective, we find the Cappelli Option to be the most
attractive. We also could verify this using the incremental approach, using either
controllable cost analysis or relevant cost analysis.
c. The new information would have a substantive effect on Hannah’s decision.

Let us begin by re-calculating the value of each decision option assuming
minimum possible demand.

6-60
Accept Accept
Piedmont Capelli
Data:
Total suites – corporate 180 450
Total suites – individual 351 285
Price per suite – corporate $120.00 $120.00
Price per suite – individual $150.00 $150.00
Revenues:
Suites – corporate $21,600 $54,000
Suites – individual 52,650 42,750
Convention center 15,000 15,000
Food, telephone, & movies 13,275 18,375
Total revenues $102,525 $130,125
Variable Costs:
Food, laundry, supplies, etc. $15,930 $22,050
Labor (kitchen help, maids) 18,585 38,588
Contribution margin $68,010 $69,488
Additional Fixed Costs:

Build runway $3,000
“Profit” $68,010 $66,488
From a profit-maximizing perspective, we find the Cappelli option is no longer as

attractive. If Hannah were sure that demand would be at the low end, it is prudent
to go with the Piedmont option. However, as we learned earlier, the Capelli option
maximizes profit if demand were at the high end.
From a purely financial perspective, Hannah’s beliefs about possible demand

influence her decision. Many firms construct a “best case, most likely, worst case”
scenario to include uncertainty in their estimates. Sophisticated analyses could
include a demand distribution and simulations.
Hotels routinely buffer themselves against demand fluctuations such as these by

requiring a minimum number of occupied suite-days. Moreover, they might
release the “blocked” rooms 2-3 weeks prior to the conference to increase the
chance of filling any unused rooms.
d. If Hannah accepts the Capelli deal, she will not be able to host Piedmont’s
meeting this year. By turning down Piedmont, a long-time client, Hannah may
indeed lose all future business with the company. Moreover, including the

6-61
possibility of uncertain demand reduces the financial attractiveness of Capelli,

although it is likely the better financial option. Thus, even though the
profitable short-term decision is to accept Capelli’s business, Hannah probably
will feel uncomfortable making this decision because it could mean losing the
Piedmont contract forever. Is the immediate incremental benefit of $8,940 (=
$80,550 – $71,610; see part b. above) worth losing a valued client? It may be
advisable for Hannah to go with decision option 1 and forgo this short-term
benefit.
6.67
a. Brenda’s decision deals with excess demand. There are competing demands
for Brenda’s time this coming Sunday, as she could either hold the open house
or show homes to some of her clients who are looking to buy a house. Brenda
cannot perform both activities on Sunday, giving rise to her dilemma.
b. Brenda’s expected profit is a function of the expected probability of sale, the

expected selling price, her commission rate, and the costs she incurs on the
open house. Formally, we have:
Expected probability of sale 10% given

Expected selling price $237,500 .95  asking price of 250,000
Expected commission $712.50 10%  3%  $237,500
Variable costs of open house $250
Expected profit (net commission) $462.50
c. Brenda’s expected profit is a function of the expected probability of sale, the

expected selling price, and her commission rate (the costs she incurs to show
homes are negligible). Formally, we have:
Expected selling price $209,000 0.95  $220,000
Expected commission (other’s listing) $250.80 4%  3%  $209,000

Expected commission (own listing) $125.40 1%  6%  $209,000
Expected profit (total commission) $376.20
d. Based on her expected profit (commission), Brenda should hold the open
house.
e. We know from part [c] that Brenda’s expected profit from showing homes to
potential buyers is $376.20. Additionally, we can model her profit from the
second open house as a function of the likelihood (chance) of selling the
home, or:
Expected profit from second open house = (chance of selling  $237,500  .03) –
$250.

6-62
We find the probability that makes Brenda’s indifferent between the two options
by setting her expected profit from the second open house equal to $376.20. Thus,
we have:
$376.20 = (chance of selling  $237,500  .03) – $250, or chance of selling = .

0878. Thus, if the chance of selling the house on the second open house is less
than approximately 8.78% then Brenda should not hold the second open house.
Alternatively, if the chance of selling the house on the second open showing is
greater than approximately 8.79% then Brenda should hold the second open
house.
6.68
a. In solving this problem, it probably is best to set-up a profit model for each
option. Based on the information provided, we have:
Profit (outsource) = 0.20  whitewater rafting revenue.

Profit (operate internally) = (.60  whitewater rafting revenue) – $40,000.
These models allow us to calculate the profits under each option at the two
different revenue levels. Thus, we have:
Expected Revenue
Option $75,000 $125,000
Outsource $15,000 $25,000
Operate internally $5,000 $35,000
If revenues = $75,000 then Jackrabbit Trails should outsource as this

increases profit by $10,000; on the other hand, if revenues = $125,000 then
Jackrabbit Trails should operate the whitewater rafting tours internally as
this option leads to $10,000 higher profit than outsourcing.
b. Setting the two profit models equal to each other we have:
.20  gross whitewater rafting revenue = (.60  gross whitewater rafting revenue)
– $40,000.
Solving, we find gross whitewater rafting revenue = $100,000. Furthermore, for

revenue < $100,000, outsourcing is preferred. For revenue > $100,000, it is more
profitable to provide the service in house. More generally, the following graph
depicts whitewater rafting profit as a function of whitewater rafting revenue.

6-63
Rafting Profit ($)

$80,000
$60,000 in-house
$40,000
outsource
$20,000
$0
0
20,00040,00060,00080,000100,000
120,000
140,000
160,000 200,000
180,000
-$20,000
-$40,000
Gross Whitewater Rafting Revenue
c. There are numerous other factors that Jackrabbit Trails might take into
consideration.
 Jackrabbit Trails should consider the quality of the service being offered –
will patrons’ whitewater rafting experience be more/less enjoyable and
safe with Tributary Tours or the in-house service? To this end, the
reliability and trustworthiness of Tributary Tours needs to be established.
 Jackrabbit Trails should consider the uncertainty in their estimate of gross

whitewater rafting revenues. They should also consider other sources of
risk such as the liability. By outsourcing, Jackrabbit trails shifts most, if
not all of the risk from themselves to Tributary Tours. Thus, increased
uncertainty would make contracting out the preferred option if
management were averse to risk. (Note: naturally, one could conceive of
this risk being priced out in the adventure tour market. That is, the price
charged would include a premium for the estimated value of risk in the
venture.)
 Jackrabbit Trails needs to consider how offering whitewater rafting will

affect their other activities – it is quite likely that the revenues on, for
example, sailing or canoeing will decrease – this opportunity cost would
need to be considered before any decision is made.
6.69
From a purely monetary (quantitative) standpoint, the corporate donor is the better
deal. Robin and the museum net $2,000 + 10% of $15,000 less the $500 from the
charity by renting the atrium to the corporate donor. This is before counting any

6-64
“surprise” donation received from the corporate donor and any future events that
the corporate donor might hold.
Weighed against this, however, are the qualitative factors. First, there is the loss of
goodwill associated with moving the charitable event. It appears that a lot of
effort has been vested in the event, and canceling it is likely to trigger much
adverse publicity, perhaps with implications for future donations. One could
imagine the local newspaper writing an article titled something like “Museum
Stiffs Kids for Dough.” Second, there is the clear ethical obligation to the charity
– after all, they reserved the atrium first! There also is a legal obligation to the
extent Robin has a contract with the charity. There is an implicit long-term value
that arises from these factors. The problem is that the effects are hard to quantify.
Most managers in this setting probably would call the charity to see if it is
possible to move the date and/or the location (with the museum or the corporate
donor picking up the cost). Some might even have the corporation call the
charity! If such a change is not feasible, then the right thing to do is honor the
commitment to the children’s charity. In addition to the ethical obligation, the
potential dilution of the Museum’s mission as well as the possibility of substantial
negative publicity are significant. (There also might be a legally binding
obligation, even if no written contract exists.)
Robin’s quandary reminds us that both quantitative and qualitative considerations

factor into most decisions. The quantitative analysis often is only a start, and it is
important to remember that better measurement does not necessarily make the
quantitative aspects more relevant than the qualitative aspects (i.e., issues with
greater measurement error). Ultimately, managerial talent lies in the ability to
estimate well the qualitative aspects and to reach a reasoned conclusion. In this
particular instance, the qualitative considerations are likely to receive the most
weight and guide Robin’s decision.

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CHAPTER 6

DECISION MAKING IN THE SHORT TERM

6.11 When demand is high and a resource is in short supply.

6.13 Typically on a qualitative basis – by considering how customers, suppliers, and

Airline companies usually face no long-term adverse implications from increasing

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

6.25 Products requiring minimum production quantities involve committing requisite

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

6.28 Employee morale is an important factor in outsourcing decisions, especially if

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

Without Helper With Helper

Incremental revenue 50 packages per day  $3 $150

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

Note: A precise definition of capacity is at the level of individual resources. Thus,

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

Item Detail Amount

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

per day is not relevant for computing this amount.

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

Item Price for valet

b. There are several qualitative considerations. First, we need to consider the

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

inconvenienced, leading to some lost memberships. Second, we have to

Incremental fee due to evening class $100 $700-$600

Based on the above, adding the evening class is an unwise move.

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

Note: This problem links to a common business practice. Specifically, we often

Expected Profit = ($0.50 × 1,500) + ($0.20 × 2,500) = $1,250.

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

The following table summarizes the per-person, round-trip cost of flying:

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

 From an enjoyment perspective, the trip is potentially a great deal more

d. We characterize this problem as one of excess demand. Money is the resource

Gravel: 9,000 tons × 0.8 × $30 $216,000

Thus, 75% of the joint cost (=$216,000/$288,000) would be allocated to gravel

Value of sandbox quality 900 tons × $160 $144,000

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Decreased ticket sales (200 tickets @ $3.95 per ticket) ($790)

Value of promotion $485

Increase in contribution margin from customers attracted by after-school special =

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Incremental fixed costs = $150

= (200 × .75) × (6.00 – .60) = $810 increase per week.

Note: Greg’s compensation arrangement appears to be misaligned with the

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Item Detail Total

b. Oftentimes, decision makers need to consider the implicit assumptions

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Contribution from Valves 500 valves × $30 per valve $15,000

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* = (# of customers)  (Time per visit).

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Item Detail Amount

From a purely financial perspective, Christine should accept the assignment. In

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 Will accepting the assignment unduly disrupt Christine’s MBA studies?

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Dogs Cats Total

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Contribution margin per table = $187,500/1,500 = $125. Thus, salespersons

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