CHAPTER 21

INCREMENTAL ANALYSIS

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 SOLUTIONS TO EXERCISES

Ex. 21–1 a. Incremental analysis

b. Sunk cost
c. Relevant information
d. Opportunity cost
e. Joint products
f. Out-of-pocket cost
g. None (This statement does not describe any accounting term.)

Ex. 21–2 Costs that would be considered incremental to the decision to reengineer the Tootsie Roll
production lines includes the additional labor costs and materials costs associated with the
reengineering effort. Employing individuals to undertake the reengineering design and
implementation, purchasing the needed equipment and installation materials and testing
the new line are all incremental to the decision to reengineer.

Some sunk costs of the decision include the cost of the current facility and equipment,
insurance and taxes on the existing facility, and any other cost that has already been
incurred or will not be affected by the reengineering decision.

Opportunity costs related to the reengineering decision include lost profits from lost
production as the reengineering is being undertaken. If the production lines have to be
shut down during the reengineering process, they will not be contributing to profits during
that time. Also, employee productivity might decrease during reengineering and/or until
the employees learn the newly reengineered production processes.

Ex. 21–3 a. Average per-unit manufacturing cost at 110,000 units per month:
Variable cost per unit ($45 + $25 + $5) .......................................................... $75
Fixed manufacturing cost per unit ($1,430,000  110,000 units) ................. 13
Average per-unit manufacturing cost ........................................................ $88

b. Incremental cost per paper feed drive is the product’s unit variable cost
($45 + $25 + $5) .................................................................................................. $75

c. Unit sales price for a $500,000 pretax profit on 20,000 units:

Incremental cost per unit (from part b) ......................................................... $ 75
Required profit per unit ($500,000  20,000 units) ....................................... 25
Unit sales price ............................................................................................. $100

166 © The McGraw-Hill Companies, Inc., 2005

Ex. 21–4 The contribution margin per machine hour for a bolt of each type of cloth is as follows:
Denim: contribution margin per hour = $14 per bolt ÷ .5 hours per bolt = $28 per hour
Chenille: contribution margin per hour = $22 per bolt ÷ 1 hour per bolt = $22 per hour
Gauze: contribution margin per hour = $ 9 per bolt ÷ .3 hours per bolt = $30 per hour

Machine hours should first be used to make the product with the highest contribution
margin per machine hour. Textile should make as much gauze as they can sell = 1,200
bolts × .3 hours per bolt = 360 machine hours; next make as much denim as they can sell =
6,000 bolts × .5 hours / bolt = 3,000 hours; finally, use the remaining hours (3,600 – 3,360 =
240 hours) to make chenille. The 240 remaining machine hours can be used to make
chenille at 1 hour per bolt resulting in 240 bolts of chenille.

The total contribution from this combination is:

1200 bolts of gauze × $ 9 = $ 10,800
6000 bolts of denim × $14 = 84,000
240 bolts of chenille × $22 = 5,280
total contribution = $100,080

Ex. 21–5 a. Normal crates: incremental costs are all variable costs including direct labor, direct
materials and variable overhead. = $4.50 + $10.50 + $3.50 = $18.50.
Special order crates: incremental costs include all variable costs for the normal crate
plus an additional cost for the special labels and minus $.50 in distribution costs. =
$18.50 + $1.00 - $.50 = $19.00.

b. Monthly operating profit when distributing the normal 30,000 crates can be found by
multiplying the contribution margin by the number of crates sold and deducting fixed
expenses as follows: CM = $24 - $18.50 = $5.50. Monthly operating profit = $5.50 ×
30,000 = $165,000 - $122,000 = $43,000.

If Poppycrock accepts the special order, they will add the contribution margin for the
5,000 crates for the Boys and Girls of Canada order to their monthly profit: ($20 -
$19.00) × 5,000 = $5,000. Monthly operating profit with the special order is $43,000 +
$5,000 = $48,000. The opportunity cost of not accepting the special order is $5,000.

c. In this case, Poppycrock is operating at full capacity. They have a production

constraint that will require them to forego some of their normal sales in order to
accept the special order. Without the special order, their monthly profits at full
capacity would be:
($24 - $18.50) × 35,000 crates - $122,000 = $70,500

With the special order their monthly profits would be:

($24 - $18.50) × 30,000 crates + ($20.00 - $19.00) × 5,000 - $122,000 = $48,000.

The difference between these monthly operating profit numbers ($70,500 - $48,000 =
$22,500) is the opportunity cost of accepting the special order when Poppycrock is
operating at full capacity. It is also equal to the difference in the normal and special
order contribution margins ($5.50 - $1.00 = $4.50) for the 5,000 crates being
considered:
$4.50 × 5,000 crates = $22,500.

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Ex. 21–6 The company should continue to manufacture the part rather than buying it from the out-
side supplier. The supporting schedule follows:
Make the Buy the Incremental
Part Part Analysis
Manufacturing costs:
Variable .............................................................. $155,000 $155,000
Fixed manufacturing overhead ........................ 100,000 $100,000
Purchase price of part (20,000  $8) .................... 160,000 (160,000)
Totals ...................................................................... $255,000 $260,000 $ (5,000)

Note to instructor: This exercise makes no mention of an alternative use for the plant facilities involved
in the manufacture of the part. If we were to assume that these facilities could be utilized to generate
more than $5,000 in contribution margin, the company should then consider buying the part from the
outside source and converting the facilities to the more profitable use.

Ex. 21–7 Compare the incremental cost to make with the incremental cost to buy. Remember the
incremental cost to make includes the opportunity cost of the foregone rent revenue.

Incremental cost to make: $2.50  60,000 + $5,000 = $155,000

Incremental cost to buy: $2.65  60,000 = $159,000

It is less costly for Bacrometer to continue to make part no. 566.

Ex. 21–8 The company should sell the defective units as scrap at $4.18 per unit, rather than spend-
ing $119,200 to correct the defects and realize a unit sales price of $10 per unit, as sum-
marized below:
Scrap value of units (20,000  $4.18) ........................................................................ $83,600
Proceeds from sale of reworked units ($10  20,000) .......................... $200,000
Less: Cost of corrective work ................................................................ 119,200
Net proceeds from sale of reworked units ............................................................ 80,800
Net benefit of selling the defective units as scrap .................................................... $ 2,800
In addition to contributing $2,800 to profitability, scrapping the defective units leaves the
production facilities that would be utilized in the rework free for other purposes.

Note to instructor: The $123,500 already incurred in the manufacture of these units is a sunk cost and
is not relevant.

168 © The McGraw-Hill Companies, Inc., 2005

Ex. 21–9 To maximize its total contribution margin, the company should produce and sell the
product with the highest contribution margin per direct labor hour. As shown below, this
product is Bio-Mutant.
Android Bio-Mutant Cyclops
Selling price ............................................................ $100 $60 $125
Direct labor ............................................................ 48 24 60
Direct materials ..................................................... 9 8 16
Variable overhead ................................................. 7 4 9
Contribution margin per unit............................... $ 36 $24 $ 40

Direct labor hours per unit (direct labor cost

per unit  $12 per hour) .................................... 4 2 5
Contribution margin per direct labor hour ........ $ 9 $12 $ 8

With 1,000 direct labor hours available, the company can produce a total of 500 Bio-Mutant
games (1,000 hours  2 hours per unit). Thus, its total contribution margin will be:
500 games  $24 contribution margin per game = $12,000

Ex. 21–10 a. It is $100 more profitable to sell Amoxiphore at the split-off point than it is to process
it further ($2,700 versus $2,600). It is also $100 more profitable to sell Benidrate at the
split-off point ($2,400 versus $2,300). Supporting calculations are as follows:
Amoxiphore Benidrate
Proceeds if sold at the split-off point ..................................... $2,700 $2,400

Proceeds if processed further ................................................. $4,200 $6,000

Incremental cost of further processing ................................. 1,600 3,700
Net proceeds if processed further .......................................... $2,600 $2,300

b. The primary nonfinancial issue in this problem is an ethical consideration. If

Amoxiphore is sold at the split-off point, users of the drug suffer from nausea and
headaches. Even with these side effects, demand for the drug is extremely high. If the
company processed the product past the split-off point, the side effects would diminish.
However, the company’s profit would be reduced by $100 for each batch produced.
Does the company have an ethical responsibility to forego $100 per batch in order to
relieve suffering in those who must take the drug? Some would argue that the
company does have this responsibility. However, others may argue that the company’s
primary responsibility is to maximize stockholder wealth.

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Ex. 21–11 a. The profitability of the entire joint process can be determined as follows:
Revenues:
Molecue: $25  3,000 = $ 75,000
Borphue: $15  10,000 = 150,000
Polygard: $5.50  1,000 = 5,500
Total Revenue $230,500
Less Costs:
Joint Cost ($50,000)
Molecue additional ($10,000)
Polygard additional (1,000  $1.50) ($ 1,500)
Total Cost ($ 61,500)
Total Profit $169,000

b. Incremental revenue to process further = $25 - $5 = $20 per gallon  3,000 gallons =
$60,000. Compare to incremental cost to process further = $10,000. Incremental profit
to process further is $50,000.

c. Incremental revenue to process Polygard further = $5.50  1,000 - $3,500 = $2,000.

Compare to incremental cost to process further = $1.50  1,000 = $1,500. Incremental
loss if BioMorphs accepts the offer to sell at split off is ($500).

d. Sunk costs related to the decision to process Polygard further are the costs of the joint
process.

170 © The McGraw-Hill Companies, Inc., 2005

Ex. 21–12 a. At a current operating level of 100,000 units, the company will not have to turn away
any of its regular customers in order to fill the special order. If it wishes to increase
operating income by $2 per unit included in the special order, it only needs to generate
a contribution margin per unit of $2. Thus, the selling price per unit included in the
special order is $20, as shown below:
Special
Sale
Selling price .......................................................................................................... $20
Less: Direct materials ..................................................................... 6
Direct labor ............................................................................ 4
Variable overhead (2/3  $9) ................................................ 6
Additional shipping costs...................................................... 2 18
Contribution margin per unit ............................................................................. $ 2

b. In order for the company to increase its operating income $60,000 above what it would
be without the order, the contribution margin per unit included with the special order
must be $2 per unit more ($2  30,000 units = $60,000) than the normal contribution
margin. The normal contribution margin is the sales price, $28, less all variable costs
($6 + $4 + 2/3 × $9), or $12. Thus, the selling price of the special order must cover the
additional shipping costs, and still result in a contribution margin of $14 ($12 normal +
$2 additional requirement). Therefore, a selling price of $32 is required, as shown
below:
Special
Sale
Selling price .......................................................................................................... $32
Less: Direct materials ..................................................................... 6
Direct labor ............................................................................ 4
Variable overhead (2/3  $9) ................................................ 6
Additional shipping costs...................................................... 2 18
Contribution margin per unit ............................................................................. $14

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 SOLUTIONS TO PROBLEMS
25 Minutes, Easy PROBLEM 21–1
D. LAWRANCE

a. Effect of accepting the special order:

Incremental revenue ($80  10,000 units).............................................................................. $800,000
Less: Incremental costs:
Variable manufacturing costs ($50  10,000 units) ...................................... $500,000
Variable selling expenses ($5  10,000 units) ................................................ 50,000 550,000
Expected increase in operating income ................................................................................. $250,000

b. Relevant considerations other than expected effect on operating income may include:
(1) Discount Apparel may sell the jackets to customers who otherwise would buy regular D. Law-
rance jackets. Thus, the special-order jackets may create difficulties for D. Lawrance in meet-
ing its original sales forecasts.
(2) A low-priced jacket that is identical to D. Lawrance jackets but that is sold through discount
stores may lessen D. Lawrance’s reputation for quality goods.
(3) The sales price to Discount Apparel ($80) is so low that Discount Apparel could retail the
jackets at less than the wholesale cost of the regular jackets ($150). This may create ill feelings
between D. Lawrance and its regular retail outlets.
(4) Accepting the special order will place D. Lawrance’s scheduled production (50,000) very close
to capacity (55,000). Therefore, if the regular jackets sell better than anticipated, D. Lawrance
may not have the ability to meet the additional demand.
(5) This may be the beginning of a long-term relationship with Discount Apparel, in which D.
Lawrance can use its excess capacity to produce a variety of “private label” merchandise.
(6) The special-order jackets have a relatively low contribution margin percentage [($80  $55) 
$80 = 31.25%] as compared with the regular jackets [($150  $70)  $150 = 53.33%]. This may
suggest that D. Lawrance might be able to use its excess capacity to produce a product with a
higher contribution margin percentage.
(7) Accepting the special order may allow D. Lawrance to maintain a consistent size labor force
by avoiding layoffs.

Note to instructor: Part b is intended to be open-ended with no “correct” solution. Its objective is to get
students to think about the various factors other than incremental revenue and expenses that are
relevant to business decisions.

172 © The McGraw-Hill Companies, Inc., 2005

15 Minutes, Easy PROBLEM 21–2
VISIONARY GAME COMPANY

Estimated increase in operating income:

Incremental revenue (10,000 units  12 mo.  $8.00).................................................................. $960,000
Incremental costs:
Direct materials (10,000 units  12 mo.  $3.00) ................................................. $360,000
Direct labor (10,000 units  12 mo.  $1.00) ........................................................ 120,000
Variable overhead (10,000 units  12 mo.  $3.50) ............................................. 420,000
Cost of rented space per year ................................................................................ 12,000 912,000
Estimated increase in operating income ...................................................................................... $ 48,000

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30 Minutes, Medium PROBLEM 21–3
CRAFTY TOOLS
a.
Make the Buy the Incremental
Motors Motors Analysis
Manufacturing costs for 10,000 motors:
Direct materials $ 9 6 0 0 0 $ 9 6 0 0 0
Direct labor 1 2 0 0 0 0 1 2 0 0 0 0
Factory overhead:
Variable [$90,000  ($90,000  75%)] 9 0 0 0 0 $ 2 2 5 0 0 6 7 5 0 0
Fixed [$114,000  $4,000] 1 1 4 0 0 0 1 1 0 0 0 0 4 0 0 0
Cost to purchase 10,000 motors at $20 each 0 2 0 0 0 0 0 (2 0 0 0 0 0 )
Totals $4 2 0 0 0 0 $3 3 2 5 0 0 $ 8 7 5 0 0

Based upon the above analysis, management will save $87,500 if it buys the motors from an
outside source.

b. Effect of alternative use of factory space:

Incremental benefit of buying motors from an outside source (see part a ) $ 8 7 5 0 0

Add: Contribution margin of alternative use of factory space (7,000 units $10 each) 7 0 0 0 0
Incremental benefit of buying motors from an outside source and using space to
produce additional power trimmers $ 1 5 7 5 0 0

174 © The McGraw-Hill Companies, Inc., 2005

30 Minutes, Medium PROBLEM 21–4
PARSONS PLUMBING & HEATING
a.
Make the Buy the Incremental
Thermostats Thermostats Analysis
Manufacturing costs for 80,000 thermostats:
Direct materials $1 5 6 0 0 0 $ 1 5 6 0 0 0
Direct labor 1 3 2 0 0 0 1 3 2 0 0 0
Manufacturing overhead:
Variable 1 6 8 0 0 0 $ 6 7 2 0 0 (1) 1 0 0 8 0 0
Fixed 1 4 4 0 0 0 1 3 4 8 0 0 (2) 9 2 0 0
Cost to purchase 80,000 thermostats at
$6 per unit: 4 8 0 0 0 0 (4 8 0 0 0 0 )
Totals $6 0 0 0 0 0 $6 8 2 0 0 0 $ (8 2 0 0 0 )

(1) $168,000  ($168,000  60%)  $67,200

(2) $144,000  $9,200  $134,800

Based upon the above analysis, management will save $82,000 by continuing to manufacture
thermostats rather than buying them from an outside source.

b. Effect of alternative use of factory space:

Incremental benefit (cost) of buying thermostats from outside source (see part a ) $ ( 8 2 0 0 0)
Add: Contribution margin from alternative use of factory space (6,000 units $18) 1 0 8 0 0 0
Incremental benefit of buying thermostats from outside source and using factory
space to produce additional heat-flow regulators $ 2 6 0 0 0

Introducing the alternative use of factory space changes the initial conclusion reached in part a. If
management can use the factory space to generate an additional $108,000 of contribution margin
by producing additional heat-flow regulators, a net benefit of $26,000 per year will result from
buying thermostats from the outside source and using the factory space to produce heat-flow
regulators.

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30 Minutes, Medium PROBLEM 21–5
OPTICAL INSTRUMENTS
a. Schedule showing contribution margin per machine-hour for each product:

Model 100 Model 101

Sales price per unit $ 2 0 0 $ 1 3 5
Less variable costs and
expenses:
Direct materials $ 5 1 $ 3 8
Direct labor 3 3 3 0
Variable manufacturing
overhead (2/3 of total) 2 4 1 2
Variable selling expense 3 0 1 5
Total costs and expenses 1 3 8 9 5
Contribution margin per unit $ 6 2 $ 4 0
Machine-hours required to
produce one unit 2 1
Contribution margin per
machine-hour $ 3 1 $ 4 0

b. Recommendation as to which product should be discontinued:

Model 100 should be discontinued because the contribution margin per machine-hour (the scarce
resource in this case) is higher on Model 101 ($40) than it is on Model 100 ($31). The profitability
of this enterprise will be aided by continuing production with the model that offers the higher con-
tribution margin per machine-hour.

176 © The McGraw-Hill Companies, Inc., 2005

20 Minutes, Medium PROBLEM 21–6
GULF BREEZE CORPORATION
a.

Life Vests Tow Ropes Water Skis

Selling price $ 5 8 $ 2 5 $ 1 7 5
Direct labor 2 0 1 0 8 0
Direct materials 1 2 3 7 5
Variable overhead 6 2 4
Contribution margin per unit $ 2 0 $ 1 0 $ 1 6

Direct labor hours per unit (direct labor cost

per unit  $10 per hour) 2 1 8

Contribution margin per direct labor hour $ 1 0 $ 1 0 $ 2

Total hours required to meet demand of

25,000 units, 15,000 units, and 5,000
units for vests, ropes, and skis, respectively 5 0 0 0 0 1 5 0 0 0 4 0 0 0 0

To maximize operating income, the company should produce those products that provide the
greatest contribution margin per unit of scarce resource (direct labor hours). Thus, as shown
above, it would have to produce life vests and tow ropes, each of which have a contribution margin
per direct labor hour of $10. However, to do so would use the entire 65,000 hours of direct labor
available (50,000 + 15,000), leaving no labor hours for the production of skis.

b. The least profitable product (skis) may, to a limited extent, create a demand for life vests and
ropes. However, due to the large number of vests and ropes the company anticipates selling
(25,000 units and 15,000 units, respectively) relative to the small number of skis the company an-
ticipates selling (5,000 units), it would appear that the demand for vests and ropes depends very
little on the sale of skis.

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25 Minutes, Medium PROBLEM 21–7
BESTVIEW
a. Sell to
Mail-Order Convert Incremental
Firm to new model Analysis
Expected sales revenue $ 1 5 0 0 0 0 $12 0 0 0 0 0 $10 5 0 0 0 0
Original cost to manufacture (4 5 0 0 0 0 ) (4 5 0 0 0 0 ) 0
Additional manufacturing costs 0 (7 0 0 0 0 0 ) (7 0 0 0 0 0 )
Gross profit on sales $(3 0 0 0 0 0 ) $ 5 0 0 0 0 $ 3 5 0 0 0 0

b. Sunk costs: The $450,000 incurred in manufacturing the old models.

Out-of-pocket costs: The $700,000 that may be spent to convert the old models to new ones.

Opportunity costs: The profit foregone on the production and sale of new products if
remanufacturing the old models forces the company to reduce production of other salable
products.

c. (1) Assuming excess capacity, BestView should convert the old models and realize $350,000 in
incremental gross profit computed in part a.
(2) If BestView is already operating at full capacity, it probably should sell the old models to the
mail-order firm. If we assume that rebuilding the old models reduces by 1,000 units the
production of new models, this option involves an opportunity cost of approximately $400,000
[$1,200 sales price of new models, less $800 unit cost, times 1,000 units). This opportunity cost
exceeds by $50,000 the incremental benefit of rebuilding the cameras rather than selling them
“as is.”

178 © The McGraw-Hill Companies, Inc., 2005

25 Minutes, Medium PROBLEM 21–8
SILENT SENTRY
a. Incremental benefit of each option, in total and on a per-unit basis:
Repair Repackage Sell to
and Sell and Sell Foreign Buyer
Incremental revenue per unit $ 2 5 $ 2 4 $ 2 2
Incremental cost per unit 8 3 0
Net incremental benefit per unit $ 1 7 $ 2 1 $ 2 2
Multiplied by total number of units 5 0 0 0 0 5 0 0 0 0 5 0 0 0 0
Net incremental benefit for 50,000 units $8 5 0 0 0 0 $10 5 0 0 0 0 $11 0 0 0 0 0

Based solely on this analysis, Silent Sentry should sell the detectors to the foreign buyer.
Note: The unit costs given in the problem are not relevant because they are sunk costs.

b. There are several nonfinancial issues that management should consider:

(1) If the packaging of each unit was changed to inform buyers that the sensory cells have a life of
18 months, this may cause confusion for those familiar with the 2-year life of a normal sensory
cell.
(2) There are legal and ethical issues regarding the option to sell the inferior units to the foreign
buyer. If the packaging of these units clearly states that the life of the sensory cell is 2 years,
when in fact the life is only 18 months, human lives could be in jeopardy, and the company
may be liable for its negligence.
(3) There may be opportunity costs to consider such as alternative uses of production capacity
other than its use to repair or repackage the defective units.

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25 Minutes, Medium PROBLEM 21–9
KELP COMPANY
a.

Sea Tea Sea Paste Sea Powder

Sales value if sold at the split-off point $ 6 0 0 0 0 $ 8 0 0 0 0 $ 7 0 0 0 0

Sales value if processed further $ 9 0 0 0 0 $1 6 0 0 0 0 $ 8 5 0 0 0

Incremental cost of further processing 3 5 0 0 0 5 0 0 0 0 1 4 0 0 0
Incremental proceeds if processed further $ 5 5 0 0 0 $1 1 0 0 0 0 $ 7 1 0 0 0

Incremental benefit (cost) of further processing $ (5 0 0 0 ) $ 3 0 0 0 0 $ 1 0 0 0

There is an incremental benefit associated with the further processing of Sea Paste and Sea Powder,
as shown above.

b. Minimum price per pound needed to sell Sea Paste at the split-off point:

Incremental proceeds if processed further ($160,000 - $50,000) $ 1 1 0 0 0 0

Sales value at split-off point 8 0 0 0 0
Additional benefit needed to sell at split-off point $ 3 0 0 0 0
Number of pounds 4 0 0 0
Incremental benefit per pound needed to sell at split-off point $ 7 50
Add: Current price per pound at split-off point ($80,000  4,000 pounds) 2 0 00
Minimum price per pound needed to sell at split-off point $ 2 7 50

180 © The McGraw-Hill Companies, Inc., 2005

 SOLUTIONS TO CASES
35 Minutes, Medium CASE 21–1
I KNEW THAT

1. The doctor’s or dentist’s time (direct labor) is the limiting factor. (This is why most doctors no
longer make “house calls.”)
To increase contribution margin per hour, the practitioner tries to see as many patients as
possible. This involves scheduling appointments well in advance to ensure that each day is “fully
booked.” (Many physicians tend to “overbook,” which explains why they may be running late and
the “waiting room” is crowded.)
By having multiple examining rooms (or dental chairs), the professional can schedule several
appointments for the same time slot, allowing nurses (or dental hygienists) to perform many of the
routine procedures. Perhaps the doctor will actually be in each room for only a few minutes out of
a 15- or 20-minute appointment.
High-technology equipment also may assist the professional in performing procedures more
quickly.

2. Seating capacity is the factor that limits restaurants’ potential output. One means of increasing
contribution margin per seat (or table) is to promote sales of the highest-margin products, such as
beverages and desserts. Another is to speed up the “turnover” at each station through faster
service and rapid food preparation techniques.
Many restaurants use “peak pricing” strategies. This means charging higher prices when the
restaurant is most crowded (such as the dinner hour), and lower prices to bring in customers
during the slower parts of the day (such as “happy hour” and “early-bird” specials).
Restaurants operating near full capacity often do not accept reservations, because this often
results in the reserved tables standing vacant for more time than necessary.
Another strategy is to promote “take-out” orders, which allows the restaurant to serve more
people than it can seat.

3. With today’s computerized checkout stands, there is almost no limit to the number of customers a
supermarket can service. Thus, the factor that limits its output is its ability to deliver products,
which—in turn—is limited by shelf space. (This explains why modern supermarkets are so large.)
For a market of any given size, there are several strategies for increasing contribution margin per
square foot of shelf space. An obvious strategy is to sell more of those products with the highest
profit margins. These products might be placed at the front of each aisle, near the checkout stands,
or near the “basic” products, such as milk and bread. In this way, the high margin products will
be seen by more shoppers.
But of even greater importance than the contribution margin per unit is turnover. Some items can
“turnover” their shelf space several times each day.
The key to rapid turnover is twofold—first, attract more customers. This is done largely through
advertising, low-price specials, “double-coupons,” and other sales promotions. Second, never run
out of product. This involves scheduling merchandise purchases to ensure adequate supplies, and
constantly restocking the shelves to keep merchandise available to shoppers.

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 CASE 21–1
I KNEW THAT (concluded)

4. The output of many residential builders is limited by available land. Contribution margin per acre
is increased by building higher density projects, meaning more housing units per acre. This is
accomplished by smaller lot sizes, attached units, and—where land is extremely scarce—high-rise
construction.
Also, the contribution margin per acre is increased by building “upscale” projects, which provide
higher contribution margins. (This explains why “affordable housing” developments tend to be
built only in areas in which land is readily available.)

5. In the service department of an auto dealership, skilled labor hours (mechanics’ time) usually is
the factor limiting potential. Output per hour can be increased by providing mechanics with
highly automated equipment, such as impact tools and computer diagnostic equipment. In
addition, time can be saved by simply replacing nonfunctional parts rather than attempting to
repair them. Piecework compensation—that is, paying mechanics by the job, rather than by the
hour, also may increase the number of jobs mechanics complete during a day.

Note to instructor: Many garages charge customers for “standard” labor hours, published in an
industry guidebook, rather than for actual labor hours. The published standard hours do not assume
that the mechanic is a specialist with respect to the make of car or specific type of repair, nor that the
mechanic has access to anything other than standard types of tools. Thus, mechanics in auto
dealerships can effect repairs in substantially less than standard times. (This is why you can bring in
your car at 8:00 A.M., pick it up at noon, and still be charged for seven hours’ labor.)
In effect, standard times enable dealers to bill customers for more labor hours than the mechanics
actually work and to benefit substantially from special tools and other strategies that increase the
mechanics’ actual output.
One might question the ethics of this practice. Actually, we see nothing wrong with charging the
customer a standard price for repair. In fact, we encourage it—providing the customer is given a fair
estimate in advance. However, we consider it unethical to mislead the customer to believe a repair
took much longer than it really did.

182 © The McGraw-Hill Companies, Inc., 2005

15 Minutes, Medium CASE 21–2
McFRIENDLY SOFTWARE

a. Yes, the $10 million is “relevant” because it represents revenue that varies between alternative
courses of action. If the software rights are sold, this $10 million will be received; if they are not
sold, it will not be forthcoming.

b. (1) If McFriendly accepts Jupiter’s offer, its opportunity cost will be the profit that it might have
made by producing and marketing the software itself.
(2) If McFriendly turns down the offer, its opportunity cost is the $10 million that it could have
received by selling the rights to the software.
Opportunity costs relate to the action not taken, rather than the action that is taken. Thus,
opportunity costs are not recorded in the accounting records.

c. The $10 million opportunity cost of not accepting Jupiter’s offer is known to McFriendly’s manage-
ment at the time of making the decision. However, the opportunity cost of accepting the offer—that
is, the profits foregone by not producing and marketing the software—can only be estimated.

d. There are unlimited opportunity costs, just as there are unlimited alternative possible courses of
action. For example, McFriendly’s management might consider such alternatives as developing
and marketing the software in a joint venture with Jupiter, licensing the software to Jupiter for a
percentage of Jupiter’s sales of the product, selling the software rights to someone other than
Jupiter, or marketing the software through channels other than mail order. Every possible
alternative course of action has its own opportunity costs. Thus, management wants to be sure
that it is aware of the most profitable alternatives.

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35 Minutes, Strong CASE 21–3
NOT IN MY BACKYARD

a. The incremental analysis is deficient in numerous respects.

 The first option is not a viable alternative. It is illegal and unethical, and bribing this reporter
would not eliminate the costs shown in the second option. At best, it would only defer the con-
sequences of public disclosure, and probably would increase the ultimate cost.
 Some figures in the analysis are annual costs, such as the bribe (consulting fee) and additional
waste disposal costs, while some are “one-time” costs.
 The second option, public disclosure, is a “worst case scenario,” showing the worst possible
outcome. The first option, on the other hand, is overly optimistic from any realistic cost
perspective.

b. Ladies and gentlemen of the Board, I am addressing you today on a most important matter. It has
come to my attention that for over two decades, our company has been illegally dumping toxic
waste in a manner hazardous to public health.
This practice is unacceptable, and it has already been stopped. As of this morning, I have ordered
implementation of new, legal, and safe waste disposal procedures. These procedures are expected
to cost us approximately $10 million per year. We can and we will absorb these costs.
Related to this issue, an investigative reporter has threatened to expose our past waste-disposal
procedures, which could result in very large fines and, perhaps, a widespread boycott of our
products. She has offered to keep silent on this issue for a consulting fee of $1 million per year.
This “consulting fee” is nothing more than a bribe, and I have already told this reporter to go to
_ _ _ _. Not only do I find paying a bribe to this corrupt individual morally repugnant, but it
would be entirely ineffective. Our past actions are known to many and soon will be made public—
if not by this reporter, by another; or by a disgruntled employee; or a townsperson rightly
alarmed by our dangerous practices.
But no one is going to have an opportunity to blow the whistle on us, because we are going to blow
it ourselves. I have contacted the Nightline television show and will be appearing on that program
tomorrow night. I will announce the changes in our disposal procedures and our intention to
immediately sanitize the previous disposal site. In addition, I will call upon the Environmental
Protection Agency to initiate a national effort to ensure safe disposal of hazardous waste
throughout our industry.
The course that I am proposing is not only the right thing to do, it is the only thing to do. Yes, it
will be expensive; but it will minimize the damage to our public image and also any fines and
penalties that we may incur. It brings upon us no costs that we will not soon incur anyway.
Let me add, however, that if we cannot operate profitably without illegally jeopardizing public
safety, then we should close our doors. I ask the Board to support me in this matter. If you choose
not to do so, I will submit my resignation. But I will still be appearing on Nightline.

184 © The McGraw-Hill Companies, Inc., 2005

30 Minutes, Medium CASE 21–4
BUSINESS WEEK ASSIGNMENT:
AN APPLE A DAY AT BLUE CROSS

a. The disease management strategy of getting chronically ill employees to do a better job managing
their disease may or may not pay off in the long run. For example, General Motors believes the
incremental costs of the asthma classes ($140) will be offset by later reductions in emergency room
visits, hospitalization and absenteeism. The sunk costs are high because these programs require
large up front spending including the costs associated with creating and developing the program,
paying instructors, incentive plans for participants, program brochures, etc. All of the up-front
sunk costs must occur before any of the savings materialize. Opportunity costs are created when
employees are diverted from their jobs to take the classes.

b. Disease management programs need to be designed for employees who are equipped to undertake
the requirements of the program. Additional training may be necessary. Also, companies may
want to consider the long-run implications of “locking” employees to these programs. In
particular, if employees are unhappy with these new services, reputation effects may affect long-
run hiring and retention. Finally, regulations about the privacy of employee health care
information may create significant unforeseen barriers to making these programs effective.

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 SOLUTION TO INTERNET ASSIGNMENT
20 Minutes, Easy INTERNET 21–1
THE DOW CORPORATION

a. Specific incremental decisions may vary by product line, but would likely include special order,
make or buy, and joint product decisions.

b. A likely limiting resource would be the production capacity of existing machinery.

c. One important qualitative factor that should be considered is the impact of a particular product
or process on the environment.

186 © The McGraw-Hill Companies, Inc., 2005