EXERCISE OF CHAPTER 6

I. MULTIPLE CHOICE TESTS

1. Differential costs are sometimes referred to as ________________ costs.
2. Which of the following costs should not be taken into consideration when making a decision?
a. Opportunity costs.
b. Sunk costs.
c. Relevant costs.
d. Differential costs.
3. Which of the following is often not a differential cost?
a. Material.
b. Labor.
c. Variable overhead.
d. Fixed overhead.
4. True or false? Fixed costs are never incremental costs.
5. Which of the following is not relevant when considering whether or not to drop a product?
a. The contribution margin.
b. Qualitative factors.
c. The potential impact on demand for other products.
d. Allocated common costs.
6. Opportunity costs are:
a. Never incremental costs.
b. Always incremental costs.
c. Sometimes sunk costs.
d. None of these answer choices is correct.
II. ESSAY TESTS
1. What are differential costs and revenues?
2. Why are sunk costs irrelevant in decision making?
3. What are avoidable costs?
4. Why are opportunity costs relevant when making decisions?
5. What is the proper approach to analyzing whether a product line should be dropped?

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6. Give an example of a fixed cost that is not sunk but is still irrelevant.
7. What is a qualitative advantage of making rather than buying a component?
8. Incremental analysis. Bainbridge Harbor Service currently operates a walk-on ferry service
between Bainbridge Island and downtown Seattle. Five days per week, the schedule is as follows:
Morning
7 a.m.
Ferry departs Bainbridge, arrives in Seattle at 7:30 a.m.
Returns empty to Bainbridge.
8:15 a.m. Ferry departs Bainbridge, arrives in Seattle at 8:45 a.m.

Evening
Ferry departs Seattle, arrives in Bainbridge at 5:45 p.m.
5:15 p.m.
Returns empty to Seattle.
6:30 p.m.
Ferry departs Seattle, arrives in Bainbridge at 7:00 p.m.
The cost of a round-trip ticket is $30, and only round-trip tickets are sold. Profit last year was as
follows:
Revenue (40 round-trip fares per day × $30 × 52 weeks × 5 days) $312,000
Depreciation 20,000
Dock rental 12,000
Fuel 62,400
Captain 90,000
Mate 55,000
Bookkeeping 15,000
Miscellaneous 10,400 264,800
Profit $ 47,200
The distance between Bainbridge and Seattle is 5 miles, the boat’s fuel efficiency is 1 mile
per gallon, and the cost of a gallon of fuel is estimated at $4. Bookkeeping costs are fixed, as is
the annual rental of dock space on both sides. Miscellaneous costs vary with miles.
The company is now considering offering a 10a.m. trip to Seattle on Saturday morning with
a return trip at 3p.m., on Saturday afternoon. The round-trip fare will remain at $30, and the
company estimates 15 fares per day. A captain will be paid $300 per day, and a mate will be paid
$150 per day.

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Required:
What is the annual incremental profit (loss) associated with the Saturday trips?
9. Incremental analysis. Mayfield Software has a 2,000-square-foot cafeteria located on the lower
level of Building 3, the company’s largest building. The vice president of operations for Mayfield
insists that meal prices be reasonable so workers will stay on campus and avoid wasting time
driving to restaurants with slow service. Employees at Mayfield are generally happy with the
quality of food and the level of service in the cafeteria. Still, Mayfield is considering outsourcing
to Regal Food Service. Mayfield is expanding and realizes that the future success of the company
will require increased focus on its core competencies (and food service is not a core competency!).
A cafeteria profit report for 2017 follows. In the report, the cafeteria is charged $20 per year per
square foot for space and 3 percent of sales for general overhead (to cover the centrally
administered costs of Mayfield Software, such as legal, brand advertising, salary of the CFO, etc.).
All business units receive the same 3 percent charge.

The terms of the agreement with Regal (which has not yet been signed) call for Regal to provide
similar-quality meals and service at the same prices that were charged in 2017. Regal will use the
current cafeteria space and existing equipment without cost. Regal will keep 96 percent of sales
revenue and remit 4 percent of sales revenue back to Mayfield. Regal will pay for all food and
supplies and hire and pay the salaries of all staff including the cafeteria manager, cooks, and
servers.
Required:
Evaluate the annual financial impact of the outsourcing decision assuming sales in the coming
year, under Regal, will be the same as in 2017.

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 10. Drop a product line. Jordan Walken owns and operates an electronics store in Seattle,
Washington. Her accountant has prepared a product line income statement that is reproduced
below. (Jordan’s two lines are music devices and accessories.). In preparing the income statement,
the accountant allocated all common costs, including rent, Jordan’s salary and the salary of her
two assistants, utilities, and other common costs based on relative sales (rounded to thousands).
Her reason: “Each product line needs to cover its share of common costs.” In light of this report,
Jordan is considering eliminating accessories and concentrating solely on the sale of music devices
(although, she does not expect an increase in music device sales).

Incremental Revenue
-150000 Incremental
savings: 120000
Incremental decrease in
profit if the 'accessories'
product line is dropped
-30000 New profit =
Original operating income
+/- Change in operating
income = New prof

Required:
Analyze the effect on profit of dropping accessories. Then write a paragraph explaining the role of
common costs in your analysis and how allocation of common costs can lead to the cost allocation
death spiral.
11. Incremental analysis. Rustic Interiors, an interior design company, has experienced a drop in
business due to an increase in interest rates and a corresponding slowdown in remodeling projects.
To stimulate business, the company is considering exhibiting at the Middleton Home and Garden
Expo. The exhibit will cost the company $15,000 for space. At the show, Rustic Interiors will
present a slide show on a laptop, pass out brochures that were printed previously (the company
printed more than needed), and show its portfolio of previous jobs. The company estimates that
revenue will increase by $40,000 over the next year as a result of the exhibit. For the previous
year, profit was as follows:

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Required: Calculate the impact of the exhibit on company profit. Should the company exhibit at
the home show?
12. Make-or-buy Decision. The Howell Corporation produces an executive jet for which it
currently manufactures a fuel valve; the cost of the valve is indicated below:

The company has an offer from Duvall Valves to produce the part for $2,100 per unit and supply
1,000 valves (the number needed in the coming year). If the company accepts this offer and shuts
down production of valves, production workers and supervisors will be reassigned to other areas
where, unfortunately, they really are not needed. The equipment cannot be used elsewhere in
the company, and it has no market value. However, the space occupied by the production of the
valve can be used by another production group that is currently leasing space for $55,000 per
year.
Required: Should the company make or buy the valve?