Practice Problems:

Make or Buy

The airline is serving meals to all passengers as part of their package service. The following costs
of one complete meal they are presently serving are as follows:

Variable costs:
Ingredients P6.00
Direct labor 4.00
Variable overhead 4.00
Fixed costs (allocated to products):
Supervisory salaries and other fixed costs 4.00
Depreciation of flight kitchen equipment 7.00
Total cost per meal P25.00

A catering service has offered to supply the meals for P20.00 each. Assume further that
P1.00 of the total fixed costs could be eliminated. Fixed cost per unit was computed using the
normal operations of 2,000 meals per month.

It seems that the airline will accept the offer since it is cheaper than to prepare the meals.
However, the accountant must consider only relevant costs because some costs included in the
P25.00 cannot be eliminated or avoided even if they buy from the catering company.

Should the airline make or buy?

Activity:

ABC Motors manufactured 4,000 gears are used in its motors and incurred the following costs:

Direct materials P40,000

Direct labor 16,000
Variable manufacturing overhead 20,000
Fixed manufacturing overhead 12,000
P88,000

A supplier has offered to sell the gears to ABC for P20.00 each. The fixed manufacturing
overhead consists mainly of depreciation on the equipment used to manufacture the part and
would not be reduced if the gears were purchased from the outside firm. If the gears are
purchased from the supplier, ABC has the opportunity to use the factory equipment to produce
another product which is estimated to have a contribution margin of P5,000.

Should ABC make or buy?

 Accept or Reject a Special Order

Assume that a Japanese Tourist Agency approached the president of the airline about flying
chartered tourist flights from Manila to Japan. The tourist agency has offered the airline P150,000
per round-trip flight on a jumbo jet. Given the airline’s usual occupancy rate and airfares, a round
trip jumbo jet flight brings in revenue of P250,000. This requires careful analysis because the
price is a special price which is lower than its regular revenue.

In analyzing this particular decision, the following general situations are considered to be present:

➢ The offer is on a one time deal that is why it could be priced lower than the regular price,
otherwise, it should be treated as part of the regular services in the long-run.
➢ The airline has an excess capacity. If the company has no excess capacity, and to accept
the offer requires taking some services from regular routes, then, the lost contribution
margin on such routes must be included in the analysis as a cost of accepting the offer.
➢ The acceptance of the special offer will not affect the present market of the company.

Assume the following data as a typical flight between Manila to Japan:

Revenues:
Passenger P250,000
Cargo 30,000 P280,000

Expenses:
Variable expenses of flight P90,000
Fixed expenses allocated to each flight 100,000 190,000
Profit P90,000

If the offer is accepted the company will not incur reservations and ticketing costs estimated to be
P5,000.

Should the airline accept or reject the offer?

a. Assume there is excess capacity enough to produce additional units of the special offer
b. Assume there is no excess capacity.

Activity:

ABC company produced and sold 8,000 units of product and is operating at 80% of plant
capacity. Unit information about its product is as follows:

Sales price P35

Variable manufacturing cost P16
Fixed manufacturing cost (P48,000/8,000) 6 22
Profit per unit P13

The company received a proposal from a foreign company to buy 1,000 units of ABC’s product for P20
per unit. This is a one-time only order and acceptance of this proposal will not affect the company’s
regular sales. The president of ABC company is reluctant to accept the proposal because he is concerned
that the company will lose money on the special order. All fixed costs are allocated to individual projects.

Should ABC accept or reject the offer?

 Drop/Eliminate/Retain/Add a service, product or department decision

The airline is presently offering its passengers to join in a club that entitles them to use the club facilities.
The controller ascertained that all variable costs can be avoided if the club operation will be discontinued
including some fixed costs:

1. Supervisor’s salaries P20,000

2. Airport fees 5,000
3. Depreciation on some equipment 10,000

Responsibility accounting report showed a net loss from this department as shown:

Sales Revenue P200,000

Less, Variable costs:
Food and beverages P70,000
Labor costs 40,000
Variable overhead 25,000 135,000
Contribution Margin P65,000
Less, Fixed Expenses:
Depreciation on furniture & equipment P30,000
Supervisor’s salaries 20,000
Insurance 10,000
Airport fees 5,000
General overhead, allocated 10,000 75,000
Net Loss (P10,000)

Should the airline continue or discontinue?

Activity:

A recent accounting graduate from ABC University evaluated the operating performance of XYZ
Company’s three divisions. The following presentation was made to XYZ’s Board of Directors. During
the presentation, the accountant made the recommendation to eliminate the Apple Division stating that the
total net income would increase by P20,000, as shown in the analysis below.

Other Two Division Apple Division Total

Sales P1,000,000 P300,000 P1,300,000
Cost of Goods Sold 650,000 200,000 850,000
Gross Profit 350,000 100,000 450,000
Operating Expenses 100,000 120,000 220,000
Net Income P250,000 P(20,000) P230,000

Cost of goods sold is 80% variable and operating expenses are 70% variable. If the division is eliminated,
40% of the fixed costs will be eliminated.

Do you concur with the new accountant’s recommendation?

 Sell or process further

Assume the following:

1 ton of fish is put into processing at P500,000 per ton
Joint conversion costs incurred is P600 per ton
Units produced at split off:
1,500 pounds of fish meat at P750 per 1,500 pounds
500 pounds of fish oil at P500 per 500 pounds

If processed further:
Total selling price after processing further:
Fish meat, as canned good (for 1,500 lbs) P2,000
Fish oil, as premium fish sauce (for 500 lbs) 1,000
Total further processing costs:
Fish meat 800
Fish oil 600

Sell or process further?

Activity:

ABC petrochemical factory produces two produces, L and M, as a result of a particular joint process.
Both products are sold to manufacturers as ingredients for assorted chemical products. Product L sells at
split-off for P0.25 per gallon; M, for P0.30 per gallon. Data for April follow:

Joint processing cost P1,500,000

Gallons produced and sold
L 4,000,000
M 2,500,000

Suppose that in April the 2,500,000 gallons of M could have been processed further into Super M at an
additional cost of P235,000. The super M output could have been sold for P0.38 per gallon. Product L
would have been sold at split-off in any event.

Should M have been processed further in April and sold as Super M?

 Product mix

Assume the following products and its related selling price and production data:

A B
Selling price per unit P10.00 P14.00
Less, variable costs:
Prime costs P 5.00 P 6.25
Factory overhead 3.00 3.75
Selling and administrative expenses 1.00 2.00
Machine hours required per unit .02 hours .05 hours

Assume that the firm has a maximum hours of 100

Assume, further the following situations in relation to market:
1. Without market limit
2. With market limit of 4,000 for A
3. With market limit of 4,000 for A and 300 for B

How many units should they produce?

Activity:

ABC company manufactures and sells two products. Relevant per unit data concerning each product are
given below:

Standard Deluxe
Selling price P50 P75
Variable costs P30 P30
Machine hours 1.6 3

If 1,200 additional machine hours are available, which product should be manufactured?
 Replace or retain

The airline has a three-year old loader truck used to load in-flight meals onto airplanes. The box on the
truck can be lifted hydraulically to the level of a jumbo jet’s side doors. The management is considering
replacing it with a new type of loader that is much cheaper than the old hydraulic loader and costs less to
operate. However, the new loader would be operable for only one year before it would need to be
replaced. Pertinent data for the decision are as follows:

Acquisition cost of the old loader P100,000

Depreciation on straight line basis from the time of acquisition 4 years
No salvage value considered for computing depreciation
Disposal value now (year 3) 5,000
Annual variable operating costs for the loader
(gasoline, cost of operator & maintenance costs) 80,000
Acquisition cost of new loader 15,000
Useful life one year
Annual operating costs P45,000

Should the airline replace the loader?

Activity:

ABC Corporation uses a machine that winds twine onto spools. The machine is unreliable and results in a
significant amount of downtime and excessive labor costs. The management is considering replacing the
machine with a more efficient one which will minimize downtime and excessive labor costs. Data are
presented below for the two machines:

Old machine New machine

Original purchase cost P160,000 P240,000
Accumulated depreciation 120,000 -
Estimated life 4 years 4 years

It is estimated that the new machine will produce annual cost savings of P55,000. The old machine can
be sold to a scrap dealer for P24,000. Both machines will have a salvage value of zero if operated for the
remainder of their useful lives.

Determine whether the company should purchase the new machine.