“Sunk costs are easy to spot—they’re the fixed costs associated with a decision.” Do you agree? Explain.

Troy Engines, Ltd., manufactures a variety of engines for use in heavy equipment. The company has always produced all of the necessary parts for its engines, including all of the carburetors. An outside supplier has offered to sell one type of carburetor to Troy Engines, Ltd., for a cost of $\$35$ per unit. To evaluate this offer, Troy Engines, Ltd., has gathered the following information relating to its own cost of producing the carburetor internally:

*One-third supervisory salaries; two-thirds depreciation of special equipment (no resale value).

Required:

1. Assuming that the company has no alternative use for the facilities that are now being used to produce the carburetors, should the outside supplier’s offer be accepted? Show all computations.
2. Suppose that if the carburetors were purchased, Troy Engines, Ltd., could use the freed capacity to launch a new product. The segment margin of the new product would be $\$150,000$ per year. Should Troy Engines, Ltd., accept the offer to buy the carburetors for $\$35$ per unit? Show all computations.

“In my opinion, we ought to stop making our own drums and accept that outside supplier’s offer,” said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. “At a price of $18 per drum, we would be paying$5 less than it costs us to manufacture the drums in our own plant. Since we use 60,000 drums a year, that would be an annual cost savings of $300,000.” Antilles Refining’s current cost to manufacture one drum is given below (based on 60,000 drums per year):

$$\begin{array}{lr} \text{Direct materials}&\text{\$10.35}\\ \text{Direct labor}&\text{6.00}\\ \text{Variable overhead}&\text{1.50}\\ \text{Fixed overhead (\$2.80 general company }&\text{}\\ \qquad\text{overhead, \$1.60 depreciation, and \$0.75 supervision)}&\underline{\text{\hspace{10pt}5.15}}\\ \text{Total cost per drum}&\underline{\underline{\text{\$23.00}}}\\ \end{array}$$

A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are:

Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $135,000 per year.

Alternative 2: Purchase the drums from an outside supplier at$18 per drum.

The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by 30%. The old equipment has no resale value. Supervision cost ($45,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 90,000 drums per year.The company’s total general company overhead would be unaffected by this decision.

Required:

1. Assuming that 60,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 75,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 90,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

4. What other factors would you recommend that the company consider before making a decision?

Come-Clean Corporation produces a variety of cleaning compounds and solutions for both industrial and household use. While most of its products are processed independently, a few are related, such as the company’s Grit 337 and its Sparkle silver polish.Grit 337 is a coarse cleaning powder with many industrial uses. It costs $1.60 a pound to make, and it has a selling price of$2.00 a pound. A small portion of the annual production of Grit 337 is retained in the factory for further processing. It is combined with several other ingredients to form a paste that is marketed as Sparkle silver polish. The silver polish sells for $4.00 per jar.

$$\begin{array}{lr} \text{Other ingredients}&&\text{\$0.65}\\ \text{Direct labor}&&\underline{\text{\hspace{5pt}1.48}}\\ \text{Total direct cost}&&\underline{\underline{\text{\$2.13}}}\\ \end{array}$$

Overhead costs associated with processing the silver polish are:

Variable manufacturing overhead cost                     25% of direct labor cost
Fixed manufacturing overhead cost (per month):
    Production supervisor                                $3,000
    Depreciation of mixing equipment$1,400

The production supervisor has no duties other than to oversee production of the silver polish. The mixing equipment is special-purpose equipment acquired specifically to produce the silver polish. It can produce up to 15,000 jars of polish per month. Its resale value is negligible and it does not wear out through use.Advertising costs for the silver polish total $4,000 per month. Variable selling costs associated with the silver polish are 7.5% of sales.Due to a recent decline in the demand for silver polish, the company is wondering whether its continued production is advisable. The sales manager feels that it would be more profitable to sell all of the Grit 337 as a cleaning powder.

Required:

1. How much incremental revenue does the company earn per jar of polish by further processing Grit 337 rather than selling it as a cleaning powder?

2. How much incremental contribution margin does the company earn per jar of polish by further processing Grit 337 rather than selling it as a cleaning powder?

3. How many jars of silver polish must be sold each month to exactly offset the avoidable fixed costs incurred to produce and sell the polish? Explain.

4. If the company sells 9,000 jars of polish, what is the financial advantage (disadvantage) of choosing to further process Grit 337 rather than selling is as a cleaning powder?

5. If the company sells 11,500 jars of polish, what is the financial advantage (disadvantage) of choosing to further process Grit 337 rather than selling is as a cleaning powder?

The Walton Toy Company manufactures a line of dolls and a doll dress sewing kit. Demand for the dolls is increasing, and management requests assistance from you in determining an economical sales and production mix for the coming year. The company has provided the following data:

$$\begin{array}{|l|r|r|r|r|} \hline {\text { Product }} & \begin{array}{c} \text { Demand } \\ \text { Next Year } \\ \text { (units) } \end{array} & \begin{array}{c} \text { Selling } \\ \text { Price per } \\ \text { Unit } \end{array} & \begin{array}{c} \text { Direct } \\ \text { Materials } \end{array} & \begin{array}{c} \text { Direct } \\ \text { Labor } \end{array} \\ \hline \text { Debbie } & 50,000 & \$ 13.50 & \$ 4.30 & \$ 3.20 \\ \hline \text { Trish } & 42,000 & \$ 5.50 & \$ 1.10 & \$ 2.00 \\ \hline \text { Sarah } & 35,000 & \$ 21.00 & \$ 6.44 & \$ 5.60 \\ \hline \text { Mike } & 40,000 & \$ 10.00 & \$ 2.00 & \$ 4.00 \\ \hline \text { Sewing kit } & 325,000 & \$ 8.00 & \$ 3.20 & \$ 1.60 \\ \hline \end{array}$$

The following additional information is available:
a. The company's plant has a capacity of $130,000$ direct labor-hours per year on a single-shift basis. The company's present employees and equipment can produce all five products.
b. The direct labor rate of $\$ 8$ per hour is expected to remain unchanged during the coming year.
c. Fixed costs total $\$ 520,000$ per year. Variable overhead costs are $\$ 2$ per direct labor-hour.
d. All of the company's nonmanufacturing costs are fixed.
e. The company's finished goods inventory is negligible and can be ignored.
Required:

1. Determine the contribution margin per direct labor-hour expended on each product.
2. Prepare a schedule showing the total direct labor-hours that will be required to produce the units estimated to be sold during the coming year.
3. Examine the data you have computed in (1) and (2) above. How would you allocate the $130,000$ direct labor hours of capacity to Walton Toy Company's various products?
4. What is the highest price, in terms of a rate per hour, that Walton Toy Company would be willing to pay for additional capacity (that is, for added direct labor time)?
5. Assume again that the company does not want to reduce sales of any product. Identify ways in which the company could obtain the additional output. (CMA, adapted)

Polaski Company manufactures and sells a single product called a Ret. Operating at capacity, the company can produce and sell 30,000 Rets per year. Costs associated with this level of production and sales are given below:

The Rets normally sell for $\$ 50$ each. Fixed manufacturing overhead is constant at $\$ 270,000$ per year within the range of $25,000$ through $30,000$ Rets per year.
Required:

1. Assume that due to a recession, Polaski Company expects to sell only $25,000$ Rets through regular channels next year. A large retail chain has offered to purchase $5,000$ Rets if Polaski is willing to accept a $16 \%$ discount off the regular price. There would be no sales commissions on this order; thus, variable selling expenses would be slashed by $75 \%$. However, Polaski Company would have to purchase a special machine to engrave the retail chain's name on the $5,000$ units. This machine would cost $\$ 10,000$. Polaski Company has no assurance that the retail chain will purchase additional units in the future. Determine the impact on profits next year if this special order is accepted.
2. Refer to the original data. Assume again that Polaski Company expects to sell only 25,000 Rets through regular channels next year. The U.S. Army would like to make a one-time-only purchase of 5,000 Rets. The Army would pay a fixed fee of $\$ 1.80$ per Ret, and it would reimburse Polaski Company for all costs of production (variable and fixed) associated with the units. Because the army would pick up the Rets with its own trucks, there would be no variable selling expenses associated with this order. If Polaski Company accepts the order, by how much will profits increase or decrease for the year?
3. Assume the same situation as that described in (2) above, except that the company expects to sell $30,000$ Rets through regular channels next year. Thus, accepting the U.S. Army's order would require giving up regular sales of $5,000$ Rets. If the Army's order is accepted, by how much will profits increase or decrease from what they would be if the $5,000$ Rets were sold through regular channels?

Superior Markets, Inc., operates three stores in a large metropolitan area. A segmented absorption costing income statement for the company for the last quarter is given below:

Please refer to the image from textbook.

The North Store has consistently shown losses over the past two years. For this reason, management is giving consideration to closing the store. The company has asked you to make a recommendation as to whether the store should be closed or kept open. The following additional information is available for your use:

a. The breakdown of the selling and administrative expenses that are shown above is as follows:

b. The lease on the building housing the North Store can be broken with no penalty.

c. The fixtures being used in the North Store would be transferred to the other two stores if the North Store were closed.

d. The general manager of the North Store would be retained and transferred to another position in the company if the North Store were closed. She would be filling a position that would otherwise be filled by hiring a new employee at a salary of $\$ 11,000$ per quarter. The general manager of the North Store would continue to earn her normal salary of $\$ 12,000$ per quarter. All other managers and employees in the North store would be discharged.

e. The company has one delivery crew that serves all three stores. One delivery person could be discharged if the North Store were closed. This person's salary is $\$ 4,000$ per quarter. The delivery equipment would be distributed to the other stores. The equipment does not wear out through use, but does eventually become obsolete.

f. The company pays employment taxes equal to $15 \%$ of their employees' salaries.

g. One-third of the insurance in the North Store is on the store's fixtures.

h. The "General office salaries" and "General office-other" relate to the overall management of Superior Markets, Inc. If the North Store were closed, one person in the general office could be discharged because of the decrease in overall workload. This person's compensation is $\$ 6,000$ per quarter.

1. How much employee salaries will the company avoid if it closes the North Store?

2. How much employment taxes will the company avoid if it closes the North Store?

3. What is the financial advantage (disadvantage) of closing the North Store?

4. Assuming that the North Store's floor space can't be subleased, would you recommend closing the North Store?

5. Assume that the North Store's floor space can't be subleased. However, let's introduce three more assumptions. First, assume that if the North Store were closed, one-fourth of its sales would transfer to the East Store, due to strong customer loyalty to Superior Markets. Second, assume that the East Store has enough capacity to handle the increased sales that would arise from closing the North Store. Third, assume that the increased sales in the East Store would yield the same gross margin as a percentage of sales as present sales in the East store. Given these new assumptions, what is the financial advantage (disadvantage) of closing the North Store?

Bill has just returned from a duck hunting trip. He has brought home eight ducks. Bill’s friend, John, disapproves of duck hunting, and to discourage Bill from further hunting, John has presented him with the following cost estimate per duck:

$$\begin{array}{lrrrr} \text{Camper and equipment:}\\ \quad\text{Cost, \$12,000; usable for eight seasons; 10 hunting trips per season}&\text{\$\hspace{1pt}150}\\ \text{Travel expense (pickup truck):}\\ \quad\text{100 miles at \$0.31 per mile (gas, oil, and tires—\$0.21 per mile; depreciation and insurance—\$0.10 per mile)}&\text{31}\\ \text{Shotgun shells (two boxes per hunting trip) }&\text{20}\\ \text{Boat:}\\ \quad\text{Cost, \$2,320, usable for eight seasons; 10 hunting trips per season}&\text{29}\\ \text{Hunting license:}\\ \quad\text{Cost, \$30 for the season; 10 hunting trips per season}&\text{3}\\ \text{Money lost playing poker:}\\ \quad\text{ Loss, \$24 (Bill plays poker every weekend whether he goes hunting or stays at home)}&\text{24}\\ \text{Bottle of whiskey:}\\ \quad\text{Cost, \$15 per hunting trip (used to ward off the cold)}&\underline{\text{\hspace{11pt}15}}\\ \text{Total cost}&\underline{\text{\$\hspace{1pt}272}}\\ \text{Cost per duck (\$272 $\div$ 8 ducks)}&\underline{\underline{\text{\$\hspace{6pt}34}}}\\ \end{array}$$

Required:

1. Assuming the duck hunting trip Bill has just completed is typical, what costs are relevant to a decision as to whether Bill should go duck hunting again this season?
2. Suppose Bill gets lucky on his next hunting trip and shoots 10 ducks using the same amount of shotgun shells he used on his previous hunting trip to bag 8 ducks. How much would it have cost him to shoot the last two ducks? Explain.
3. Which costs are relevant in a decision of whether Bill should give up hunting? Explain.

Polaski Company manufactures and sells a single product called a Ret. Operating at capacity, the company can produce and sell 30,000 Rets per year. Costs associated with this level of production and sales are given below:

$$\begin{array}{|c|c|c|c|} \hline & \text { Unit } & & \text { Total } \\ \hline \text { Direct materials } \ldots \ldots \ldots \ldots \ldots \ldots & \$ 15 & \$ & 450,000 \\ \hline \text { Direct labor.................. } & 8 & \text {. } & 240,000 \\ \hline \text { Variable manufacturing overhead ... } & 3 & & 90,000 \\ \hline \text { Fixed manufacturing overhead..... } & 9 & & 270,000 \\ \hline \text { Variable selling expense } \ldots . \ldots \ldots & 4 & & 120,000 \\ \hline \text { Fixed selling expense } \ldots \ldots \ldots \ldots \ldots & 6 & & 180,000 \\ \hline \text { Total cost. .......... } & \$ 45 & \$ 1 & 1,350,000 \\ \hline \end{array}$$

The Rets normally sell for $\$ 50$ each. Fixed manufacturing overhead is $\$ 270,000$ per year within the range of 25,000 through 30,000 Rets per year.

1. Assume that due to a recession, Polaski Company expects to sell only 25,000 Rets through regular channels next year. A large retail chain has offered to purchase 5,000 Rets if Polaski is willing to accept a $16 \%$ discount off the regular price. There would be no sales commissions on this order; thus, variable selling expenses would be slashed by $75 \%$. However, Polaski Company would have to purchase a special machine to engrave the retail chain's name on the 5,000 units. This machine would cost $\$ 10,000$. Polaski Company has no assurance that the retail chain will purchase additional units in the future. What is the financial advantage (disadvantage) of accepting the special order?

2. Refer to the original data. Assume again that Polaski Company expects to sell only 25,000 Rets through regular channels next year. The U.S. Army would like to make a one-time-only purchase of 5,000 Rets. The Army would pay a fixed fee of $\$ 1.80$ per Ret, and it would reimburse Polaski Company for all costs of production (variable and fixed) associated with the units. Because the army would pick up the Rets with its own trucks, there would be no variable selling expenses associated with this order. What is the financial advantage (disadvantage) of accepting the U.S. Army's special order?

3. Assume the same situation as described in (2) above, except that the company expects to sell 30,000 Rets through regular channels next year. Thus, accepting the U.S. Army's order would require giving up regular sales of 5,000 Rets. Given this new information, what is the financial advantage (disadvantage) of accepting the U.S. Army's special order?

The Walton Toy Company manufactures a line of dolls and a sewing kit. Demand for the company’s products is increasing, and management requests assistance from you in determining an economical sales and production mix for the coming year. The company has provided the following data:

The following additional information is available:

a. The company’s plant has a capacity of 130,000 direct labor-hours per year on a single-shift basis. The company’s present employees and equipment can produce all five products.

b. The direct labor rate of$16 per hour is expected to remain unchanged during the coming year.

c. Fixed manufacturing costs total $520,000 per year. Variable overhead costs are$2 per direct labor-hour.

d. All of the company’s nonmanufacturing costs are fixed.

e. The company’s finished goods inventory is negligible and can be ignored.

Required:

1. How many direct labor hours are used to manufacture one unit of each of the company’s five products?

2. How much variable overhead cost is incurred to manufacture one unit of each of the company’s five products?

3. What is the contribution margin per direct labor-hour for each of the company’s five products?

4. Assuming that direct labor-hours is the company’s constraining resource, what is the highest total contribution margin that the company can earn if it makes optimal use of its constrained resource?

5. Assuming that the company has made optimal use of its 130,000 direct labor-hours, what is the highest direct labor rate per hour that Walton Toy Company would be willing to pay for additional capacity (that is, for added direct labor time)?

6. Identify changes that the company could make to enable it to satisfy the customers’ demand for all of its products.

"In my opinion, we ought to stop making our own drums and accept that outside supplier's offer," said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. "At a price of $18$ florins per drum, we would be paying 5 florins less than it costs us to manufacture the drums in our own plant. (The currency in Aruba is the florin, denoted below by fl.) Because we use $60,000$ drums a year, that would be an annual cost savings of 300,000 florins." Antilles Refining's present cost to manufacture one drum is given below (based on 60,000 drums per year):

A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are:

Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for fl135,000 per year. Alternative 2: Purchase the drums from an outside supplier at fl18 per drum. The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by $30 \%$. The old equipment has no resale value. Supervision cost ($\mathrm{fl45,000}$ per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment's capacity would be $90,000$ drums per year. The company's total general company overhead would be unaffected by this decision. Required:

1. To assist the managing director in making a decision, prepare an analysis showing the total cost and the cost per drum for each of the two alternatives given above. Assume that $60,000$ drums are needed each year. Which course of action would you recommend to the managing director?
2. Would your recommendation in (1) above be the same if the company's needs were: (a) $75,000$ drums per year or (b) $90,000$ drums per year? Show computations to support your answer, with costs presented on both a total and a per unit basis.
3. What other factors would you recommend that the company consider before making a decision?

Define the following terms: incremental cost, opportunity cost, and sunk cost.

Andretti Company has a single product called a Dak. The company normally produces and sells 60,000 Daks each year at a selling price of $\$ 32$ per unit. The company's unit costs at this level of activity are given below:

$$\begin{array}{|c|c|c|} \hline \text { Direct materials......................... } & \$ 10.00 & \\ \hline \text { Direct labor............................ } & 4.50 & \\ \hline \text { Variable manufacturing overhead....... } & 2.30 & \\ \hline \text { Fixed manufacturing overhead ........... } & 5.00 & (\$ 300,000 \text { total) } \\ \hline \text { Variable selling expenses ................. } & 1.20 & 4 \\ \hline \text { Fixed selling expenses...................... } & 3.50 & \text { ( } \$ 210,000 \text { total) } \\ \hline \text { Total cost per unit ... } & & \\ \hline \end{array}$$

A number of questions relating to the production and sale of Daks follow. Each question is independent.
Required:

1. Assume that Andretti Company has sufficient capacity to produce 90,000 Daks each year without any increase in fixed manufacturing overhead costs. The company could increase its sales by $25 \%$ above the present 60,000 units each year if it were willing to increase the fixed selling expenses by $\$ 80,000$. Would the increased fixed selling expenses be justified?
2. Assume again that Andretti Company has sufficient capacity to produce $90,000$ Daks each year. A customer in a foreign market wants to purchase $20,000$ Daks. Import duties on the Daks would be $\$ 1.70$ per unit, and costs for permits and licenses would be $\$ 9,000$. The only selling costs that would be associated with the order would be $\$ 3.20$ per unit shipping cost. Compute the per unit break-even price on this order.
3. The company has $1,000$ Daks on hand that have some irregularities and are therefore considered to be "seconds." Due to the irregularities, it will be impossible to sell these units at the normal price through regular distribution channels. What unit cost figure is relevant for setting a minimum selling price? Explain.
4. Due to a strike in its supplier's plant, Andretti Company is unable to purchase more material for the production of Daks. The strike is expected to last for two months. Andretti Company has enough material on hand to operate at $30 \%$ of normal levels for the two-month period. As an alternative, Andretti could close its plant down entirely for the two months. If the plant were closed, fixed manufacturing overhead costs would continue at $60 \%$ of their normal level during the two-month period and the fixed selling expenses would be reduced by $20 \%$. What would be the impact on profits of closing the plant for the two-month period?
5. An outside manufacturer has offered to produce Daks and ship them directly to Andretti's customers. If Andretti Company accepts this offer, the facilities that it uses to produce Daks would be idle; however, fixed manufacturing overhead costs would be reduced by $75 \%$. Because the outside manufacturer would pay for all shipping costs, the variable selling expenses would be only two-thirds of their present amount. Compute the unit cost that is relevant for comparison to the price quoted by the outside manufacturer.

Birch Company normally produces and sells 30,000 units of RG-6 each month. The selling price is $22 per unit, variable costs are$14 per unit, fixed manufacturing overhead costs total $150,000 per month, and fixed selling costs total$30,000 per month.Employment-contract strikes in the companies that purchase the bulk of the RG-6 units have caused Birch Company’s sales to temporarily drop to only 8,000 units per month. Birch Company estimates that the strikes will last for two months, after which time sales of RG-6 should return to normal. Due to the current low level of sales, Birch Company is thinking about closing down its own plant during the strike, which would reduce its fixed manufacturing overhead costs by $45,000 per month and its fixed selling costs by 10%. Start-up costs at the end of the shutdown period would total$8,000. Because Birch Company uses Lean Production methods, no inventories are on hand.

Required:

1. What is the financial advantage (disadvantage) if Birch closes its own plant for two months?

2. Should Birch close the plant for two months? Explain.

3. At what level of unit sales for the two-month period would Birch Company be indifferent between closing the plant or keeping it open? (Hint: This is a type of break-even analysis, except that the fixed cost portion of your break-even computation should include only those fixed costs that are relevant [i.e., avoidable] over the two-month period.)