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Chapter 25: 26PGA (page 1418)

Oak Petroleum has spent \(202,000 to refine 63,000 gallons of petroleum distillate, which can be sold for \)6.00 per gallon. Alternatively, Oak can process the distillate further and produce 58,000 gallons of cleaner fluid. The additional processing will cost \(1.80 per gallon of distillate. The cleaner fluid can be sold for \)9.10 per gallon. To sell the cleaner fluid, Oak must pay a sales commission of \(0.12 per gallon and a transportation charge of \)0.19 per gallon.

Requirements

1. Diagram Oak鈥檚 decision alternatives, using Exhibit 25-18 as a guide.

2. Identify the sunk cost. Is the sunk cost relevant to Oak鈥檚 decision?

3. Should Oak sell the petroleum distillate or process it into cleaner fluid? Show the expected net revenue difference between the two alternatives.

Short Answer

Expert verified

The company should focus onprocessing the product further.

Step by step solution

01

Meaning of Sunk Cost

The term sunk cost refers to the cost that has already been incurred by a business concern and is irrecoverable.Such costs are considered irrelevant when making decisions regarding outsourcing, making, buying, and processing a product further.

02

Diagram for decision alternatives

03

Identification of sunk cost

According to the given scenario, Oak Petroleum has to bear the sunk cost in both situations. Hence, thejoint cost is irrelevant in making a decision to choose an alternative.

04

Preparation of analysis

Differential analysis of revenue:

Particulars

Sell ($)

Processed further ($)

Difference ($)

Revenue

378,000

527,800

149,800

Incremental analysis of whether Oak should sell or process further:

Particulars

Amounts ($)

Expected increase in revenue

149,800

Less: Expected increase in cost (63000*1.80)

(113,400)

Expected increase in profit

$36,400

According to the analysis, it is concluded that the company should process the petroleum distillatebecause it will increase the profits by $36,400.

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Most popular questions from this chapter

What questions should managers answer when considering special pricing orders?

When should special pricing orders be accepted?

What makes information irrelevant to decision making?

Grimm Company makes decorative wedding cakes. The company is considering buying the cakes rather than baking them, which will allow it to concentrate on decorating. The company averages 100 wedding cakes per year and incurs the following costs from baking wedding cakes:

Direct materials \(500

Direct labor 1,000

Variable manufacturing overhead 200

Fixed manufacturing overhead 1,200

Total manufacturing cost \)2,900

Number of cakes 梅 100

Cost per cake \(29

Fixed costs are primarily the depreciation on kitchen equipment such as ovens and mixers. Grimm expects to retain the equipment. Grimm can buy the cakes for \)25.

  1. Should Grimm make the cakes or buy them? Why?
  2. If Grimm decides to buy the cakes, what are some qualitative factors that Grimm should also consider?

Snow Ride manufactures snowboards. Its cost of making 1,900 bindings is as follows:

Direct materials \(17,590

Direct labor 3,200

Variable overhead 2,080

Fixed overhead 6,300

Total manufacturing costs for 1,900 bindings \)29,170

Suppose Livingston will sell bindings to Snow Ride for \(13 each. Snow Ride would pay \)3 per unit to transport the bindings to its manufacturing plant, where it would add its own logo at a cost of \(0.50 per binding.

Requirements

1. Snow Ride鈥檚 accountants predict that purchasing the bindings from Livingston will enable the company to avoid \)2,100 of fixed overhead. Prepare an analysis to show whether Snow Ride should make or buy the bindings.

2. The facilities freed by purchasing bindings from Livingston can be used to manufacture another product that will contribute $3,100 to profit. Total fixed costs will be the same as if Snow Ride had produced the bindings. Show which alternative makes the best use of Snow Ride鈥檚 facilities: (a) make bindings, (b) buy bindings and leave facilities idle, or (c) buy bindings and make another product.
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