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Chapter 25: Q32PGB (page 1422)

Elm Petroleum has spent \(204,000 to refine 61,000 gallons of petroleum distillate, which can be sold for \)6.30 per gallon. Alternatively, Elm 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, Elm must pay a sales commission of \(0.10 per gallon and a transportation charge of \)0.16 per gallon.

Requirements

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

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

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

Short Answer

Expert verified

Answer

The company should focus on processing its 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

As per the given scenario, Elm Petroleum has to bear the sunk cost in both situations. Hence, thejoint cost is irrelevant in making the decision to choose an alternative.

04

Preparation of analysis

Differential analysis of revenue:

Particulars

Sell ($)

Processed further ($)

Difference ($)

Revenue

384,300

527,800

143,500

Incremental analysis of whether Elm Petroleum should sell or process further:

Particulars

Amounts ($)

Expected increase in revenue

143,500

Less: Expected increase in cost (61000*1.80)

(109,800)

Less: Selling expense [(58000*0.1)+(58000*0.16)]

(15,080)

Expected increase in profit

$18,620

As per the above analysis, it is concluded that the company should process the petroleum distillate further because it will increase the profits by $18,620.

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Most popular questions from this chapter

Members of the board of directors of Security Check have received the following operating income data for the year ended May 31, 2018:

SECURITY CHECK

Income Statement

For the Year Ended May 31, 2018

Product Line

Industrial Systems

Household Systems

Total

Net Sales Revenue

\( 360,000

\) 380,000

\( 740,000

Cost of Goods Sold:

Variable

37,000

47,000

84,000

Fixed

260,000

63,000

323,000

Total Cost of Goods Sold

297,000

110,000

407,000

Gross Pro铿乼

63,000

270,000

333,000

Selling and Administrative Expenses:

Variable

64,000

73,000

137,000

Fixed

44,000

26,000

70,000

Total Selling and Administrative Expenses

108,000

99,000

207,000

Operating Income (Loss)

\) (45,000)

\( 171,000

\) 126,000

Members of the board are surprised that the industrial systems product line is not profitable. They commission a study to determine whether the company should drop the line. Company accountants estimate that dropping industrial systems will decrease fixed cost of goods sold by \(80,000 and decrease fixed selling and administrative expenses by \)12,000.

Requirements

1. Prepare a differential analysis to show whether Security Check should drop the industrial systems product line.

2. Prepare contribution margin income statements to show Security Check鈥檚 total operating income under the two alternatives: (a) with the industrial systems line and (b) without the line. Compare the difference between the two alternatives鈥� income numbers to your answer to Requirement 1.

3. What have you learned from the comparison in Requirement 2?

Skiable Acres operates a Rocky Mountain ski resort. The company is planning its lift ticket pricing for the coming ski season. Investors would like to earn a 10% return on investment on the company鈥檚 \(270,000,000 of assets. The company primarily incurs fixed costs to groom the runs and operate the lifts. Skiable Acres projects fixed costs to be \)31,000,000 for the ski season. The resort serves about 725,000 skiers and snowboarders each season. Variable costs are about \(8 per guest. Currently, the resort has such a favorable reputation among skiers and snowboarders that it has some control over the lift ticket prices.

Requirements

1. Would Skiable Acres emphasize target pricing or cost-plus pricing? Why?

2. If other resorts in the area charge \)85 per day, what price should Skiable Acres charge?

Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Collector-Cardz with a special order. The Hall of Fame wishes to purchase 56,000 baseball card packs for a special promotional campaign and offers \(0.38 per pack, a total of \)21,280. Collector-Cardz鈥檚 total production cost is \(0.58 per pack, as follows:

Variable costs:

Direct materials \)0.11

Direct labor 0.09

Variable overhead 0.08

Fixed overhead 0.30

Total cost \(0.58

Collector-Cardz has enough excess capacity to handle the special order.

Requirements

1. Prepare a differential analysis to determine whether Collector-Cardz should accept the special sales order.

2. Now assume that the Hall of Fame wants special hologram baseball cards. Collector-Cardz will spend \)5,700 to develop this hologram, which will be useless after the special order is completed. Should Collector-Cardz accept the special order under these circumstances, assuming no change in the special pricing of $0.38 per pack?

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.

Johnson Builders builds 1,500-square-foot starter tract homes in the fast-growing suburbs of Atlanta. Land and labor are cheap, and competition among developers is fierce. The homes are a standard model, with any upgrades added by the buyer after the sale. Johnson Builders鈥檚 costs per developed sublot are as follows:

Land \(50,000

Construction 123,000

Landscaping 9,000

Variable selling costs 8,000

Johnson Builders would like to earn a profit of 14% of the variable cost of each home sold. Similar homes offered by competing builders sell for \)207,000 each. Assume the company has no fixed costs.

Requirements

1. Which approach to pricing should Johnson Builders emphasize? Why?

2. Will Johnson Builders be able to achieve its target profit levels?

3. Bathrooms and kitchens are typically the most important selling features of a home. Johnson Builders could differentiate the homes by upgrading the bathrooms and kitchens. The upgrades would cost \(16,000 per home but would enable Johnson Builders to increase the sales prices by \)28,000 per home.

(Kitchen and bathroom upgrades typically add about 175% of their cost to the value of any home.) If Johnson Builders makes the upgrades, what will the new cost-plus price per home be? Should the company differentiate its product in this manner?
See all solutions

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