PLEASE COMPLETE NO LATER THAN 10/28 @3:30PM

Each question(1,2,& 3) must be a minimum of 200 words. Please EXPLAIN answers in FULL detail and make answers knowledgeable based off the attached reading, also using outside scholarly sources.

ARE YOU ABLE TO COMPLETE THIS FOR ME? 20.00

ATC 6-1 (Pg. 298-299)

1. (Analyzing inventory reductions at Supervalu) In a narrative format, answer all question presented in the case. Mention some ways other than cost cutting that will improve company operations.

2. How do managers go about making segment product line elimination decisions?

This discussion must be a minimum of 100 words:

What is a job order cost system? Describe a situation in which you would use job order cost information. What type of information is useful in making your decision? In your initial response, please do not use citations to convey your understanding. Based on your reading, please communicate your own understanding of the requirements.

edm10890_ch06_252-303.indd Page 252 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd CHAPTER 6 Relevant Information for Special Decisions LEARNING OBJECTIVES W I L S O N , After you have mastered the material in this chapter, you will be able to: 1 Identify the characteristics of relevant information.Q U 2 Distinguish between unit-level, batch-level, product-level, and facility-level costs and understand how these costs affect decision making. 3 4 5 6 7 8 Make appropriate special order decisions. Make appropriate outsourcing decisions. Make appropriate segment elimination decisions. A S H E Make appropriate asset replacement decisions. 1 Explain the conflict between short-term and long-term profitability (Appendix). Make decisions about allocating scarce resources9 (Appendix). 9 7 B CHAPTER OPENING U Mary Daniels paid $25,000 to purchase a car that was used in her rental business. After one year the car had a book value of $21,000. Ms. Daniels needs cash and is considering selling the car. After advertising the vehicle for sale, the best offer she received was $19,000. Ms. Daniels really needed the money, but ultimately decided not to sell because she did not want to incur a $2,000 loss ($21,000 market value 2 $19,000 book value). Did Ms. Daniels make the right decision? Whether Ms. Daniels will be better off selling the car or keeping it is unknown. However, it is certain that she based her decision on irrelevant data. Ms. Daniels incurred a loss when the market value of the car dropped. She cannot avoid a loss that already exists. Past mistakes should not affect current decisions. The current value of the car is $19,000. Ms. Daniels's decision is whether to take the money or keep the car. The book value of the car is not relevant. This chapter explains how to isolate and focus on the variables that are relevant in the decision-making process. 252 edm10890_ch06_252-303.indd Page 253 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd The Curious Accountant In July 2009, the authors compared the prices of 10 of the top selling prescription drugs at two large online pharmacies, one in the United States and one in Canada. The analysis showed the Canadian prices for W I Zocor, were only 51 percent of prices charged in the L United States. S Major pharmaceutical companies have earnings before tax that average around 25 percent of sales, indicating O that their costs average around 75 percent of the prices they charge. In other words, it costs approximately $75 to N generate $100 of revenue. Given that drugs are sold in Canada for 51 percent of the U.S. sales price, a drug that is , these 10 popular prescription drugs, such as Lipitor and sold in the U.S. for $100 would be sold in Canada for only $51. How can drugs be sold in Canada for less ($51) than cost ($75)? (Answer on page 259.) Q U A S H E 1 9 9 7 B U 253 edm10890_ch06_252-303.indd Page 254 254 7/24/10 2:44 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 RELEVANT INFORMATION LO 1 Identify the characteristics of relevant information. How can you avoid irrelevant information when making decisions? Two primary characteristics distinguish relevant from useless information. Specifically, relevant information (1) differs among the alternatives and (2) is future oriented. The first characteristic recognizes that relevant information differs for one or more of the alternatives being considered. Suppose the car Ms. Daniels is considering selling is due for a state required safety inspection. Further assume that the inspection must be completed before the car can be sold or driven. Since the inspection fee must be paid regardless of whether Ms. Daniels keeps or sells the car, it does not differ among the alternatives and therefore is not relevant to her decision. In contrast, assume the car is due for an oil change that can be delayed until after the car is sold. Since Ms. Daniels can avoid the cost of the oil change if she sells the car but must pay for the oil change if she keeps the car, the cost of the oil change differs between the alternatives and is relevant to her decision. The second characteristic of relevant information is that it impacts the future. \"Don't cry over spilt milk.\" \"It's water over the dam.\" These aphorisms remind people they cannot W change the past. With regard to business decisions, the principle means you cannot avoid a cost that has already been incurred. In the Daniels example, the historical cost ($25,000) of I the car is not relevant to a decision regarding whether to sell the car today. The current L market value of $19,000 is relevant to the decision regarding whether to sell the car today. It is interesting to note thatS two characteristics are merely different views of the the same concept because historical information does not differ between the alternatives. O In other words, we could say that historical costs are not relevant because they do not differ between alternatives associated with current decisions. N Sunk Cost , Historical costs are frequently called sunk costs. Since sunk costs have been incurred in past transactions, they cannot be changed and are not relevant for making current deciQ sions. The $25,000 original cost of the car in the Daniels example is a sunk cost. U Why even bother to collect historical information if it is not relevant? Historical information may be useful in predicting the future. A company that earned $5 million A last year is more likely to earn $5 million this year than a company that earned $5,000 S last year. The predictive capacity is relevant because it provides insight into the future. H E An opportunity cost is the sacrifice that is incurred in order to obtain an alternative Opportunity Costs opportunity. For example, in the above case, Ms. Daniels must give up the opportunity to obtain $19,000 in order to keep the car. So, the opportunity cost of owning the car is 1 $19,000. Since this cost differs between the alternatives of owning the car versus selling it and since it affects the present or future, it is relevant to the decision regarding 9 whether to keep or sell the car. 9 The best offer that Ms. Daniels received for the car was $19,000. Suppose 7 Ms. Daniels also received the less favorable offer of $18,000. Does this mean that the opportunity cost of keeping the car is $37,000 ($18,000 1 $19,000)? No. Opportunity B costs are not cumulative. Ms. Daniels really has only one opportunity. If she accepts the U $19,000 offer, she must reject the $18,000 offer or vice versa. Accountants normally measure opportunity cost as the highest value of the available alternatives. In this case, the opportunity cost of keeping the car is $19,000. CHECK YOURSELF 6.1 Aqua, Inc., makes statues for use in fountains. On January 1, 2011, the company paid $13,500 for a mold to make a particular type of statue. The mold had an expected useful life of four years and a salvage value of $1,500. On January 1, 2013, the mold had a market value of $3,000 and a salvage value of $1,200. The expected useful life did not change. What is the relevant cost of using the mold during 2013? edm10890_ch06_252-303.indd Page 255 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions 255 The relevant cost of using the mold in 2013 is the opportunity cost [(market value 2 salvage value) 4 remaining useful life], in this case, ($3,000 2 $1,200) 4 2 5 $900. The book value of the asset and associated depreciation is based on a sunk cost that cannot be avoided because it has already been incurred and therefore is not relevant to current decisions. In contrast, Aqua could avoid the opportunity cost (market value) by selling the mold. Answer Relevance Is an Independent Concept The concept of relevance is independent from the concept of cost behavior. In a given circumstance, relevant costs could be either fixed or variable. Consider the following illustration. Executives of Better Bakery Products are debating whether to add a new product, either cakes or pies, to the company's line. Projected costs for the two options follow. W Cost of Pies I Materials (per unit) $ 1.50 Materials (per unit) $ 2.00 Direct labor (per unit) 1.00 Direct laborL unit) (per 1.00 Supervisor's salary* 25,000.00 Supervisor's salary* 25,000.00 S Franchise fee 50,000.00 Advertising 40,000.00 *It will be necessary to hire a new production supervisor at a cost of $25,000 per year. O Cakes will be distributed under a nationally advertised label. Better Bakery pays an annual franchise fee for N the right to use the product label. Because of the established brand name, Better Bakery will not be required to advertise the product. , Better Bakery will market the pies under its own name and will advertise the product in the local market in which Cost of Cakes the product sells. Q U Which costs are relevant? Fifty cents per unit of the materials can be avoided by choosing cakes instead of pies. A portion of the materials cost is therefore relevant. A Labor costs will be one dollar per unit whether Better Bakery makes cakes or pies. S H E REALITY BYTES Determining what price to charge for their company's goods or services is one of the most 1 difficult decisions that business managers make. Charge too much and customers will go elsewhere. Charge less than customers are willing to pay and lose the opportunity to earn 9 profits. This problem is especially difficult when managers are deciding if they should re9 duce (mark down) the price of aging inventoryfor example, flowers that are beginning to wilt, fruit that is beginning to overripen, or clothing that is going out of season. 7 At first managers may be reluctant to mark down the inventory below its cost beB cause this would cause the company to take a loss on the aging inventory. However, the concept of sunk cost applies here. Since the existing inventory has already been paid U for, its cost is sunk. Since the cost is sunk it is not relevant to the decision. Does this mean the merchandise should be sold for any price? Not necessarily. The concept of opportunity cost must also be considered. If the goods are marked down too far, too quickly, they may be sold for less than is possible. The lost potential revenue is an opportunity cost. To minimize the opportunity cost, the amount of a markdown must be the smallest amount necessary to sell the merchandise. The decision is further complicated by qualitative considerations. If a business develops a reputation for repeated markdowns, customers may hesitate to buy goods, thinking that the price will fall further if they only wait a while. The result is a dilemma as to when and how much to mark down aging inventories. How do managers address this dilemma? Part of the answer has been the use of technology. For years airlines have used computerized mathematical models to help them decide how many seats on a particular flight should be sold at a discount. More recently, retailers began using this same type of modeling software. Such software allows retailers to take fewer markdowns at more appropriate times, thereby resulting in higher overall gross profit margins. edm10890_ch06_252-303.indd Page 256 256 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 Labor cost is therefore not relevant. Although both materials and direct labor are variable costs, one is relevant but the other is not. Since Better Bakery must hire a supervisor under either alternative, the supervisor's salary is not relevant. The franchise fee can be avoided if Better Bakery makes pies and advertising costs can be avoided if it makes cakes. All three of these costs are fixed, but only two are relevant. Finally, all the costs (whether fixed or variable) could be avoided if Better Bakery rejects both products. Whether a cost is fixed or variable has no bearing on its relevance. Relevance Is Context Sensitive A particular cost that is relevant in one context may be irrelevant in another. Consider a store that carries men's, women's, and children's clothing. The store manager's salary could not be avoided by eliminating the children's department, but it could be avoided if the entire store were closed. The salary is not relevant to deciding whether to eliminate the children's department but is relevant with respect to deciding to close the store. In one context, the salary is notW relevant. In the other context, it is relevant. I Relationship between Relevance and Accuracy L Information need not be exactS be relevant. You may decide to delay purchasing a to laptop computer you want if you know its price is going to drop even if you don't know O exactly how much the price decrease will be. You know part of the cost can be avoided by waiting; you are just not sure of the amount. N The most useful information is both relevant and precise. Totally inaccurate infor, mation is useless. Likewise, irrelevant information is useless regardless of its accuracy. Q Quantitative versus Qualitative Characteristics of Decision Making U Relevant information can have both quantitative and qualitative characteristics. The A previous examples focused on quantitative data. Now consider qualitative issues. Suppose you are deciding which ofS laptop computers to purchase. Computer A costs two $300 more than Computer B. Both computers satisfy your technical requirements; howH ever, Computer A has a more attractive appearance. From a quantitative standpoint, you would select Computer B E because you could avoid $300 of cost. However, if the laptop will be used in circumstances where clients need to be impressed, appearancea qualitative characteristicmay be more important than minimizing cost. You might 1 purchase Computer A even though quantitative factors favor Computer B. Both qualitative and quantitative data are9 relevant to decision making. As with quantitative data, qualitative features must differ between the alternatives 9 to be relevant. If the two computers were identical in appearance, attractiveness would 7 not be relevant to making the decision. B Differential Revenue and Avoidable Cost U Since relevant revenue differs among the alternatives, it is sometimes called differential revenue. To illustrate, assume Pecks Department Stores sells men's, women's, and children's clothing and is considering eliminating the children's line. The revenue generated by the children's department is differential (relevant) revenue because Pecks' total revenue would be different if the children's department were eliminated. Why would Pecks consider eliminating the children's department and thereby lose the differential (relevant) revenue? Pecks may be able to save more by eliminating the cost of operating the department than it loses in differential revenue. Some but not all of the costs associated with operating the children's department can be saved. For example, if Pecks Department Stores eliminates the children's department, the company can eliminate the cost of the department manager's salary but cannot get rid of the salary edm10890_ch06_252-303.indd Page 257 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions 257 of the company president. The costs that stay the same are not relevant. The costs that can be avoided by closing the department are relevant. Indeed, relevant costs are frequently called avoidable costs. Avoidable costs are the costs managers can eliminate by making specific choices. In the Pecks example, the cost of the department manager's salary is an avoidable (relevant) cost. The cost of the president's salary is not avoidable and is not relevant to the elimination decision. RELATIONSHIP OF COST AVOIDANCE TO A COST HIERARCHY Classifying costs into one of four hierarchical levels helps identify avoidable costs.1 1. Unit-level costs. Costs incurred each time a company generates one unit of product are unit-level costs.2 Examples include the cost of direct materials, direct labor, inspections, packaging, shipping, and handling. Incremental (additional) unit-level W costs increase with each additional unit of product generated. Unit-level costs can be avoided by eliminating the production of a single unitIof product. 2. Batch-level costs. Many products are generated in L batches rather than individual units. For example, a heating and air conditioning technician may service a batch S of air conditioners in an apartment complex. Some of the job costs apply only to O individual units, and other costs relate to the entire batch. For instance, the labor to service each air conditioner is a unit-level cost, but the cost of driving to the site is N a batch-level cost. , Classifying costs as unit- versus batch-level frequently depends on the context rather than the type of cost. For example, shipping and handling costs to send 200 computers to a university are batch-level costs. In contrast, the shipping and hanQ dling cost to deliver a single computer to each of a number of individual customers is a unit-level cost. Eliminating a batch of work avoids both batch-level and unitU level costs. Similarly, adding a batch of work increases batch-level and unit-level A costs. Increasing the number of units in a particular batch increases unit-level but not batch-level costs. Decreasing the number of units in a batch reduces unit-level S costs but not batch-level costs. H 3. Product-level costs. Costs incurred to support specific products or services are E called product-level costs. Product-level costs include quality inspection costs, engineering design costs, the costs of obtaining and defending patents, the costs of regulatory compliance, and inventory holding costs such as interest, insurance, maintenance, and storage. Product-level costs can1 avoided by discontinuing a be product line. For example, suppose the Snapper Company makes the engines used 9 in its lawn mowers. Buying engines from an outside supplier instead of making 9 them would allow Snapper to avoid the product-level costs such as legal fees for patents, manufacturing supervisory costs of producing the engines, and 7 the maintenance and inventory costs of holding engine parts. B 4. Facility-level costs. Facility-level costs are incurred to support the entire company. They are not related to any specific product, U batch, or unit of product. Because these costs maintain the facility as a whole, they are frequently called facility-sustaining costs. Facility-level costs include building rent or depreciation, personnel administration and training, property and real estate taxes, insurance, maintenance, administrative salaries, general selling costs, landscaping, utilities, 1 R. Cooper and R. S. Kaplan, The Design of Cost Management Systems (Englewood Cliffs, NJ: Prentice-Hall, 1991). Our classifications are broader than those typically presented. They encompass service and merchandising companies as well as manufacturing businesses. The original cost hierarchy was developed as a platform for activity-based costing, a topic introduced in the previous chapter. These classifications are equally useful as a tool for identifying avoidable costs. 2 Recall that we use the term product in a generic sense to represent producing goods or services. LO 2 Distinguish between unit-level, batchlevel, product-level, and facility-level costs and understand how these costs affect decision making. edm10890_ch06_252-303.indd Page 258 258 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 and security. Total facility-level costs cannot be avoided unless the entire company is dissolved. However, eliminating a business segment (such as a division, department, or office) may enable a company to avoid some facility-level costs. For example, if a bank eliminates one of its branches, it can avoid the costs of renting, maintaining, and insuring that particular branch building. In general, segment-level facility costs can be avoided when a segment is eliminated. In contrast, corporate-level facility costs cannot be avoided unless the corporation is eliminated. Precise distinctions between the various categories are often difficult to draw. One company may incur sales staff salaries as a facility-level cost while another company may pay sales commissions traceable to product lines or even specific units of a product line. Cost classifications cannot be memorized. Classifying specific cost items into the appropriate categories requires thoughtful judgment. LO 3 Make appropriate special order decisions. RELEVANT INFORMATION AND W SPECIAL DECISIONS I Five types of special decisions are frequently encountered in business practice: (1) special order, (2) outsourcing, (3) segment elimination, (4) asset replacement, and (5) scarce L resource allocation. The following sections discuss using relevant information in making S the first four types of special decisions. The Appendix to this chapter discusses scarce resource decisions. O N Special Order Decisions , Occasionally, a company receives an offer to sell its goods at a price significantly below its normal selling price. The company must make a special order decision to accept or reject the offer. Q EXHIBIT 6.1 Budgeted Cost for Expected Production of 2,000 Printers Unit-level costs Materials costs (2,000 units 3 $90) Labor costs (2,000 units 3 $82.50) Overhead (2,000 units 3 $7.50) Total unit-level costs (2,000 3 $180) Batch-level costs Assembly setup (10 batches 3 $1,700) Materials handling (10 batches 3 $500) Total batch-level costs (10 batches 3 $2,200) Product-level costs Engineering design Production manager salary Total product-level costs Facility-level costs Segment-level costs: Division manager's salary Administrative costs Allocatedcorporate-level costs: Company president's salary Building rental General expenses Total facility-level costs Total expected cost Cost per unit: $658,500 4 2,000 5 $329.25 $180,000 165,000 15,000 U A S H E $360,000 17,000 5,000 14,000 63,300 1 9 9 22,000 7 B 77,300 U 85,000 12,700 43,200 27,300 31,000 199,200 $658,500 Quantitative Analysis Assume Premier Office Products manufactures printers. Premier expects to make and sell 2,000 printers in 10 batches of 200 units per batch during the coming year. Expected production costs are summarized in Exhibit 6.1. Adding its normal markup to the total cost per unit, Premier set the selling price at $360 per printer. Suppose Premier receives a special order from a new customer for 200 printers. If Premier accepts the order, its expected sales would increase from 2,000 units to 2,200 units. But the special order customer is willing to pay only $250 per printer. This price is well below not only Premier's normal selling price of $360 but also the company's expected per unit cost of $329.25. Should Premier accept or reject the special order? At first glance, it seems Premier should reject the special order because the customer's offer is below the expected cost per unit. Analyzing relevant costs and revenue leads, however, to a different conclusion. The quantitative analysis follows in three steps. Step 1. Determine the amount of the relevant (differential) revenue Premier will earn by accepting the special order. Premier's alternatives are (1) to accept or (2) to edm10890_ch06_252-303.indd Page 259 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions 259 T There are several factors that enable drug companies to reduce their prices Answers to The Curious Accountant to certain customers. One significant t factor is the issue of relevant cost. f Pharmaceutical manufacturers have a substantial amount of fixed cost, such as research and development. For example, in 2008 Pfizer Inc. had research and development expenses that were 16.5 percent of sales, while its cost of goods sold expense was almost the same at 16.8 percent of sales. With respect to a special order decision, the research and development costs would not change and therefore would not be relevant. In contrast, the unit-level cost of goods sold would increase and therefore would be relevant. Clearly, relevant costs are significantly less than the total cost. If Canadian prices are based on relevant costs, that is, if drug companies W I even though they are significantly less than the prices charged in the United States. L S O reject the special order. If Premier accepts the special order, additional revN enue will be $50,000 ($250 3 200 units). If Premier rejects the special order, additional revenue will be zero. Since the amount of revenue differs between , view Canadian sales as a special order opportunity, the lower prices may provide a contribution to profitability the alternatives, the $50,000 is relevant. Determine the amount of the relevant (differential) cost Premier will incur by accepting the special order. Examine the costsQ Exhibit 6.1. If Premier acin cepts the special order, it will incur additional unit-level costs (materials, labor, U and overhead). It will also incur the cost of one additional 200-unit batch. A The unit- and batch-level costs are relevant because Premier could avoid them by rejecting the special order. The other costs S Exhibit 6.1 are not relevant in because Premier will incur them whether it accepts or rejects the special order. H Step 3. Accept the special order if the relevant revenue exceeds the relevant (avoidable) E cost. Reject the order if relevant cost exceeds relevant revenue. Exhibit 6.2 summarizes the relevant figures. Since the relevant revenue exceeds the relevant cost, Premier should accept the special order because profitability will increase 1 by $11,800. Step 2. 9 9 EXHIBIT 6.2 7 Relevant Information for Special Order of 200 Printers B U Differential revenue ($250 3 200 units) $50,000 Avoidable unit-level costs ($180 3 200 units) Avoidable batch-level costs ($2,200 3 1 batch) Contribution to income (36,000) (2,200) $11,800 Opportunity Costs Premier can consider the special order because it has enough excess productive capacity to make the additional units. Suppose Premier has the opportunity to lease its excess capacity (currently unused building and equipment) for $15,000. If Premier uses the excess capacity to make the additional printers, it must forgo the opportunity to edm10890_ch06_252-303.indd Page 260 260 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 lease the excess capacity to a third party. Sacrificing the potential leasing income represents an opportunity cost of accepting the special order. Adding this opportunity cost to the other relevant costs increases the cost of accepting the special order to $53,200 ($38,200 unit-level and batch-level costs 1 $15,000 opportunity cost). The avoidable costs would then exceed the differential revenue, resulting in a projected loss of $3,200 ($50,000 differential revenue 2 $53,200 avoidable costs). Under these circumstances Premier would be better off rejecting the special order and leasing the excess capacity. Relevance and the Decision Context Assume Premier does not have the opportunity to lease its excess capacity. Recall the original analysis indicated the company could earn an $11,800 contribution to profit by accepting a special order to sell 200 printers at $250 per unit (see Exhibit 6.2). Because Premier can earn a contribution to profit by selling printers for $250 each, can the company reduce its normal selling price (price charged to existing customers) to $250? The answer is no, as illustrated in Exhibit 6.3. W I EXHIBIT 6.3 L S Projections Based on 2,200 Printers at a Sales Price of $250 per Unit O Revenue ($250 3 2,200 units) N Unit-level supplies and inspection ($180 3 2,200 units) $396,000 Batch-level costs ($2,200 3 11 batches) 24,200 , Product-level costs 77,300 Facility-level costs Total cost Projected loss $ 550,000 199,200 (696,700) Q $(146,700) U A If a company is to be profitable, it must ultimately generate revenue in excess of S total costs. Although the facility-level and product-level costs are not relevant to the H special order decision, they are relevant to the operation of the business as a whole. E Qualitative Characteristics Should a company ever reject a special order if the relevant revenues exceed the relevant 1 costs? Qualitative characteristics may be even more important than quantitative ones. If Premier's regular customers learn the company sold printers to another buyer at $250 9 per unit, they may demand reduced prices on future purchases. Exhibit 6.3 shows 9 Premier cannot reduce the price for all customers. Special order customers should therefore come from outside Premier's normal sales territory. In addition, special order custom7 ers should be advised that the special price does not apply to repeat business. Cutting B off a special order customer who has been permitted to establish a continuing relationU ship is likely to lead to ill-feelings and harsh words. A business's reputation can depend on how management handles such relationships. Finally, at full capacity, Premier should reject any special orders at reduced prices because filling those orders reduces its ability to satisfy customers who pay full price. Outsourcing Decisions LO 4 Make appropriate outsourcing decisions. Companies can sometimes purchase products they need for less than it would cost to make them. This circumstance explains why automobile manufacturers purchase rather than make many of the parts in their cars or why a caterer might buy gourmet desserts from a specialty company. Buying goods and services from other companies rather than producing them internally is commonly called outsourcing. edm10890_ch06_252-303.indd Page 261 7/16/10 7:51 AM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions Quantitative Analysis Assume Premier Office Products is considering whether to outsource production of the printers it currently makes. A supplier has offered to sell an unlimited supply of printers to Premier for $240 each. The estimated cost of making the printers is $329.25 per unit (see Exhibit 6.1). The data suggest that Premier could save money by outsourcing. Analyzing relevant costs proves this presumption wrong. A two-step quantitative analysis for the outsourcing decision follows: 261 That test was so easy. Why is your score so bad? I outsourced my homework. Step 1. Determine the production costs Premier can avoid if it outsources printer production. A review of Exhibit 6.1 discloses the costs Premier could avoid by outsourcing. If Premier purchases the printers, it can avoid the unitlevel costs (materials, labor, overhead), and the batch-level costs (assembly setup, and materials handling). It can also avoid the product-level costs (engineering design costs and production manager salary). Deciding to outsource will not, however, affect the facility-level costs. Because Premier will incur them whether or not it outsources printer production, the W facility-level costs are not relevant to the outsourcing decision. Exhibit 6.4 shows the avoidable (relevant) costs of outsourcing. I Step 2. Compare the avoidable (relevant) production costs with the cost of buying L the product and select the lower-cost option. Because the relevant production cost is less than the purchase price of the printers ($229.65 per unit S versus $240.00), the quantitative analysis suggests that Premier should O continue to make the printers. Profitability would decline by $20,700 [$459,300 2 ($240 3 2,000)] if printer production were outsourced. N , Opportunity Costs EXHIBIT 6.4 Suppose Premier's accountant determines that Q the space Premier currently uses to manufacture Relevant Cost for Expected Production for Outsourcing printers could be leased to a third party for U 2,000 Printers $40,000 per year. By using the space to manufacA ture printers, Premier is forgoing the opportunity Unit-level costs ($180 3 2,000 units) $360,000 to earn $40,000. Because this opportunity cost S Batch-level costs ($2,200 3 10 batches) 22,000 can be avoided by purchasing the printers, it is Product-level costs 77,300 H relevant to the outsourcing decision. After addTotal relevant cost $459,300 ing the opportunity cost to the other relevant E Cost per unit: $459,300 4 2,000 5 $229.65 costs, the total relevant cost increases to $499,300 ($459,300 1 $40,000) and the relevant cost per unit becomes $249.65 ($499,300 4 2,000). Since Premier1 purchase printers for $240, can it should outsource printer production. It would be better off buying the printers and 9 leasing the manufacturing space. 9 Evaluating the Effect of Growth on the Level of Production 7 The decision to outsource would change if expected production increased from 2,000 B to 3,000 units. Because some of the avoidable costs are fixed relative to the level of U production, cost per unit decreases as volume increases. For example, the product-level costs (engineering design, production manager's salary, and opportunity cost) are fixed relative to the level of production. Exhibit 6.5 shows the relevant cost per unit if Premier expects to produce 3,000 printers. At 3,000 units of production, the relevant cost of making printers is less than the cost of outsourcing ($230.10 versus $240.00). If management believes the company is likely to experience growth in the near future, it should reject EXHIBIT 6.5 Relevant Cost for Expected Production for Outsourcing 3,000 Printers Unit-level costs ($180 3 3,000 units) Batch-level costs ($2,200 3 15 batches) Product-level costs Opportunity cost Total relevant cost Cost per unit: $690,300 4 3,000 units 5 $230.10 $540,000 33,000 77,300 40,000 $690,300 edm10890_ch06_252-303.indd Page 262 262 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 FOCUS ON INTERNATIONAL ISSUES ARE YOU SURE YOUR GERMAN CAR WAS MADE IN GERMANY? In recent years there has been much discussion about American companies outsourcing work to other workers in other countries. However, some activities that are seldom outsourced by American companies are routinely outsourced by companies in other countries. In fact, sometimes the \"foreign country\" who provides the outsourcing is the United States. Consider an example from the automotive industry. While American automobile companies may use parts that were manufactured in another country, the final assembly of cars they sell in the United States is usually performed in their own plants in the United States or Canada. Japanese auto companies also tend to perform the final assembly of their cars in their own plants, which may be located in another country. In contrast, European car makers W are more willing to outsource the final assembly, as well as engineering and parts production, to independent companies. For example, most, if not all BMW X3s are not assembled at a BMW plant, but by the employees of Magna Steyr in Graz, Austria. This I company, by the way, is a subsidiary of Magna International, which is a Canadian company. And that Porsche Boxster or Cayman you are hoping to receive as a graduation giftit almost certainly L be built by Valmet Automotive in Finland. In fact, Valmet will assembled 22,356 of the 105,162 vehicles that Porsche produced in S 2008. Source: Companies' annual reports. O N , the outsourcing option. Managers must consider potential growth when making outsourcing decisions. Q U Qualitative Features A A company that uses vertical integration controls the full range of activities from S acquiring raw materials to distributing goods and services. Outsourcing reduces the level of vertical integration, passing some of a company's control over its products H to outside suppliers. The reliability of the supplier is critical to an outsourcing deciE sion. An unscrupulous supplier may lure an unsuspecting manufacturer into an outsourcing decision using low-ball pricing. Once the manufacturer is dependent on the supplier, the supplier raises prices. If a price sounds too good to be true, it probably 1 is too good to be true. Other potential problems include product quality and delivery commitments. If the printers do not work properly or are not delivered on time, 9 Premier's customers will be dissatisfied with Premier, not the supplier. Outsourcing requires that Premier depend 9 the supplier to deliver quality products at desigon nated prices according to a specified schedule. Any supplier failures will become 7 Premier's failures. B To protect themselves from unscrupulous or incompetent suppliers, many compaU nies establish a select list of reliable certified suppliers. These companies seek to become the preferred customers of the suppliers by offering incentives such as guaranteed volume purchases with prompt payments. These incentives motivate the suppliers to ship high-quality products on a timely basis. The purchasing companies recognize that prices ultimately depend on the suppliers' ability to control costs, so the buyers and suppliers work together to minimize costs. For example, buyers may share confidential information about their production plans with suppliers if such information would enable the suppliers to more effectively control costs. Companies must approach outsourcing decisions cautiously even when relationships with reliable suppliers are ensured. Outsourcing has both internal and external effects. It usually displaces employees. If the supplier experiences difficulties, reestablishing internal production capacity is expensive once a trained workforce has been edm10890_ch06_252-303.indd Page 263 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions released. Loyalty and trust are difficult to build but easy to destroy. In fact, companies must consider not only the employees who will be discharged but also the morale of those who remain. Cost reductions achieved through outsourcing are of little benefit if they are acquired at the expense of low morale and reduced productivity. In spite of the potential pitfalls outsourcing entails, the vast majority of U.S. businesses engage in some form of it. Such widespread acceptance suggests that most companies believe the benefits achieved through outsourcing exceed the potential shortcomings. CHECK YOURSELF 6.2 Addison Manufacturing Company pays a production supervisor a salary of $48,000 per year. The supervisor manages the production of sprinkler heads that are used in water irrigation systems. Should the production supervisor's salary be considered a relevant cost to a special W order decision? Should the production supervisor's salary be considered a relevant cost to an outsourcing decision? I The production supervisor's salary is not a relevant cost to a special order L decision because Addison would pay the salary regardless of whether it accepts or S rejects a special order. Since the cost does not differ for the alternatives, it is not O relevant. In contrast, the supervisor's salary would be relevant to an outsourcing decision. Addison could dismiss the supervisor if it purchased the sprinkler heads N instead of making them. Since the salary could be avoided by purchasing heads instead , of making them, the salary is relevant to an outsourcing decision. Answer Q U Businesses frequently organize their operations into subcomponents called segments. A Segment data are used to make comparisons among different products, departments, or divisions. For example, in addition to the companywideS income statement provided for external users, JCPenney may prepare separate income H statements for each retail store for internal users. Executives can then evaluate managerial performance by comparing E profitability measures among stores. Segment reports can be prepared for products, serSegment Elimination Decisions vices, departments, branches, centers, offices, or divisions. These reports normally show segment revenues and costs. The primary objective of segment analysis is to determine 1 whether relevant revenues exceed relevant costs. 9 Quantitative Analysis 9 Assume Premier Office Products makes copy equipment and computers as well as 7 printers. Each product line is made in a separate division of the company. Division (segment) operating results for the most recent year are shown in Exhibit 6.6. Initial B review of the results suggests the copier division should be eliminated because it is U operating at a loss. However, analyzing the relevant revenues and expenses leads to a different conclusion. A three-step quantitative analysis for the segment elimination decision follows: Step 1. Determine the amount of relevant (differential) revenue that pertains to eliminating the copier division. The alternatives are (1) to eliminate or (2) to continue to operate the copier division. If Premier eliminates the copier line it will lose the $550,000 of revenue the copier division currently produces. If the division continues to operate, Premier will earn the revenue. Since the revenue differs between the alternatives, it is relevant. Step 2. Determine the amount of cost Premier can avoid if it eliminates the copier division. If it eliminates copiers, Premier can avoid the unit-level, batch-level, LO 5 Make appropriate segment elimination decisions. 263 edm10890_ch06_252-303.indd Page 264 264 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 EXHIBIT 6.6 Projected Revenues and Costs by Segment Copiers Projected revenue Projected costs Unit-level costs Materials costs Labor costs Overhead Batch-level costs Assembly setup Materials handling Product-level costs Engineering design Production manager salary Facility-level costs Segment level Division manager salary Administrative costs Allocatedcorporate-level Company president salary Building rental General facility expenses Projected income (loss) Computers Printers Total $550,000 $850,000 $720,000 $2,120,000 (120,000) (160,000) (30,800) (178,000) (202,000) (20,000) (180,000) (165,000) (15,000) (478,000) (527,000) (65,800) (15,000) (6,000) (26,000) (8,000) (17,000) (5,000) (58,000) (19,000) (10,000) (12,000) (55,800) (14,000) (63,300) (36,000) (171,100) (92,000) (13,200) (85,000) (12,700) (259,000) (38,100) (46,000) (29,750) (31,000) $136,250 (43,200) (27,300) (31,000) $ 61,500 (123,200) (76,300) (93,000) $ 175,500 W (52,000) I L (82,000) S (12,200) O (34,000) (19,250) N (31,000) , $ (22,250) Q product-level, and segment-level facility-sustaining costs. The relevant revenue U and the avoidable costs are shown in Exhibit 6.7. Premier will incurA corporate-level facility-sustaining costs whether it the eliminates the copier segment or continues to operate it. Since these costs do not S differ between the alternatives, they are not relevant to the elimination decision. H Step 3. If the relevant revenue is less than the avoidable cost, eliminate the segment (division). If not, continue to operate it. Because operating the segment is contributE ing $62,000 per year to company profitability (see Exhibit 6.7), Premier should not eliminate the copiers division. Exhibit 6.8 EXHIBIT 6.7 shows 1 Premier's estimated revenues and costs if the computers Relevant Revenue and Cost Data for Copier and printers divisions were operated without the copiers divi9 Segment sion. Projected company profit declines by $62,000 ($175,500 2 $113,500) without the copiers segment, confirming that elimi9 Projected revenue $550,000 nating it would be detrimental to Premier's profitability. Projected costs Unit-level costs Materials costs Labor costs Overhead Batch-level costs Assembly setup Materials handling Product-level costs Engineering design Production manager salary Facility-level costs Segment level Division manager salary Administrative costs Projected income (loss) (120,000) (160,000) (30,800) (15,000) (6,000) (10,000) (52,000) (82,000) (12,200) $ 62,000 7 B Qualitative Considerations in Decisions to Eliminate Segments U As with other special decisions, management should consider qualitative factors when determining whether to eliminate segments. Employee lives will be disrupted; some employees may be reassigned elsewhere in the company, but others will be discharged. As with outsourcing decisions, reestablishing internal production capacity is difficult once a trained workforce has been released. Furthermore, employees in other segments, suppliers, customers, and investors may believe that the elimination of a segment implies the company as a whole is experiencing financial difficulty. These individuals may lose confidence in the company and seek business contacts with other companies they perceive to be more stable. edm10890_ch06_252-303.indd Page 265 7/15/10 8:11 PM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions EXHIBIT 6.8 Projected Revenues and Costs without Copier Division Computers Projected revenue Projected costs Unit-level costs Materials costs Labor costs Overhead Batch-level costs Assembly setup Materials handling Product-level costs Engineering design Production manager salary Facility-level costs Segment level Division manager salary Administrative costs Allocatedcorporate-level* Company president salary Building rental General facility expenses Projected income (loss) Printers $850,000 $720,000 $1,570,000 (178,000) (202,000) (20,000) (180,000) (165,000) (15,000) (358,000) (367,000) (35,000) (26,000) (8,000) (17,000) (5,000) (43,000) (13,000) (14,000) (26,000) (119,100) (12,000) (55,800) (92,000) (13,200) (63,000) (39,375) (46,500) $ 94,125 W (63,300) I L (85,000) S (12,700) O (60,200) (36,925) N (46,500) , $ 19,375 Total (177,000) (25,900) (123,200) (76,300) (93,000) $ 113,500 *The corporate-level facility costs that were previously allocated to the copier division have been reassigned on the basis of one-half to the computer division and one-half to the printer division. Q U Management must also consider the fact that sales of different product lines are A frequently interdependent. Some customers prefer one-stop shopping; they want to buy all their office equipment from one supplier. If Premier no longer sells copiers, customS ers may stop buying its computers and printers. Eliminating one segment may reduce H sales of other segments. What will happen to the space Premier used to make the copiers? Suppose Premier E decides to make telephone systems in the space it previously used for copiers. The contribution to profit of the telephone business would be an opportunity cost of operating the copier segment. As demonstrated in previous examples, adding the opportunity cost 1 to the avoidable costs of operating the copier segment could change the decision. 9 As with outsourcing, volume changes can affect elimination decisions. Because 9 many costs of operating a segment are fixed, the cost per unit decreases as production increases. Growth can transform a segment that is currently producing real losses into a 7 segment that produces real profits. Managers must consider growth potential when B making elimination decisions. U CHECK YOURSELF 6.3 Capital Corporation is considering eliminating one of its operating segments. Capital employed a real estate broker to determine the marketability of the building that houses the segment. The broker obtained three bids for the building: $250,000, $262,000, and $264,000. The book value of the building is $275,000. Based on this information alone, what is the relevant cost of the building? The book value of the building is a sunk cost that is not relevant. There are three bids for the building, but only one is relevant because Capital could sell the building only once. The relevant cost of the building is the highest opportunity cost, which in this case is $264,000. Answer 265 edm10890_ch06_252-303.indd Page 266 266 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 Summary of Relationships between Avoidable Costs and the Hierarchy of Business Activity LO 2 Distinguish between unit-level, batch-level, product-level, and facility-level costs and understand how these costs affect decision making. A relationship exists between the cost hierarchy and the different types of special decisions just discussed. A special order involves making additional units of an existing product. Deciding to accept a special order affects unit-level and possibly batch-level costs. In contrast, outsourcing a product stops the production of that product. Outsourcing can avoid many product-level as well as unit- and batch-level costs. Finally, if a company eliminates an entire business segment, it can avoid some of the facility-level costs. The more complex the decision level, the more opportunities there are to avoid costs. Moving to a higher category does not mean, however, that all costs at the higher level of activity are avoidable. For example, all product-level costs may not be avoidable if a company chooses to outsource a product. The company may still incur inventory holding costs or advertising costs whether it makes or buys the product. Understanding the relationship between decision type and level of cost hierarchy helps when identifying avoidable costs. The relationships are summarized in Exhibit 6.9. For each type of decision, look for avoidable costs in the categories marked with an X. Remember also W that sunk costs cannot be avoided. I L EXHIBIT 6.9 S Relationship between Decision Type and Level of Cost Hierarchy O Decision Type Unit level N Batch level Product level Special order X X , Outsourcing Elimination LO 6 Make appropriate asset replacement decisions. X X X X X X Facility level X Q U Equipment Replacement Decisions A Equipment may become technologically obsolete long before it fails physically. Managers should base equipment replacement decisions on profitability analysis rather than S physical deterioration. Assume Premier Office Products is considering replacing an H existing machine with a new one. The following table summarizes pertinent information about the two machines: E Old Machine Original cost Accumulated depreciation Book value Market value (now) Salvage value (in 5 years) Annual depreciation expense Operating expenses ($9,000 3 5 years) 1 90,000 9 $(33,000) 9 $ 57,000 7 $ 14,000 B 2,000 11,000 U New Machine Cost of the new machine Salvage value (in 5 years) Operating expenses ($4,500 3 5 years) $29,000 4,000 22,500 45,000 Quantitative Analysis First determine what relevant costs Premier will incur if it keeps the old machine. 1. The original cost ($90,000), current book value ($57,000), accumulated depreciation ($33,000), and annual depreciation expense ($11,000) are different measures of a cost that was incurred in a prior period. They represent irrelevant sunk costs. 2. The $14,000 market value represents the current sacrifice Premier must make if it keeps using the existing machine. In other words, if Premier does not keep the edm10890_ch06_252-303.indd Page 267 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions machine, it can sell it for $14,000. In economic terms, forgoing the opportunity to sell the machine costs as much as buying it. The opportunity cost is therefore relevant to the replacement decision. 3. The salvage value of the old machine reduces the opportunity cost. Premier can sell the old machine now for $14,000 or use it for five more years and then sell it for $2,000. The opportunity cost of using the old machine for five more years is therefore $12,000 ($14,000 2 $2,000). 4. Because the $45,000 ($9,000 3 5) of operating expenses will be incurred if the old machine is used but can be avoided if it is replaced, the operating expenses are relevant costs. Next, determine what relevant costs will be incurred if Premier purchases and uses the new machine. 1. The cost of the new machine represents a future economic sacrifice Premier must incur if it buys the new machine. It is a relevant cost. W 2. The salvage value reduces the cost of purchasing the new machine. Part ($4,000) of the $29,000 cost of the new machine will be recovered at the end of five years. The I relevant cost of purchasing the new machine is $25,000 ($29,000 2 $4,000). 3. The $22,500 ($4,500 3 5) of operating expenses willL incurred if the new machine be is purchased; it can be avoided if the new machine is not purchased. The operating S expenses are relevant costs. O N , The relevant costs for the two machines are summarized here: Old Machine Opportunity cost Salvage value Operating expenses Total New Machine $14,000 (2,000) 45,000 $57,000 Cost of the new machine Q Salvage value U Operating expenses Total A $29,000 (4,000) 22,500 $47,500 S H The analysis suggests that Premier should acquire the new machine because buying it produces the lower relevant cost. The $57,000 cost of using the old machine can be E avoided by incurring the $47,500 cost of acquiring and using the new machine. Over the five-year period, Premier would save $9,500 ($57,000 2 $47,500) by purchasing the new 1 machine. One caution: this analysis ignores income tax effects and the time value of money, which are explained later. The discussion in this chapter focuses on identifying 9 and using relevant costs in decision making. 9 7 AB Look U Back > A Look Forward 9 The next chapter introduces planning and cost control, including how to prepare bud7 gets and projected (pro forma) financial statements. In addition to quantitative aspects, it illustrates the effects of the budgeting process on human behavior. B U APPENDIX Short-Term versus Long-Term Goals LO 7 Explain the conflict between short-term and long-term profitability. To examine conflicts between short-term versus long-term goals, we return to the equipment replacement decision made by the management team of Premier Office Products (see page 266 for details). Suppose that the final equipment replacement decision is made by a departmental supervisor who is under significant pressure to maximize profitability. She is told that if profitability declines, she will lose her job. Under these circumstances, the supervisor may choose to keep the old machine even though it is to the company's advantage to purchase the new one. This occurs because the beneficial impact of the new edm10890_ch06_252-303.indd Page 269 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Relevant Information for Special Decisions 269 machine is realized in the second through fifth years. Indeed, replacing the equipment will result in more expense/loss recognition in the first year. To illustrate, study the following information. Year First Keep old machine Depreciation expense* Operating expense Total Replace old machine Loss on disposal Depreciation expense Operating expense Total Second Third Fourth Fifth Totals $11,000 9,000 $20,000 $11,000 9,000 $20,000 $11,000 9,000 $20,000 $11,000 9,000 $20,000 $11,000 9,000 $20,000 $ 55,000 45,000 $100,000 $43,000 5,000 4,500 $52,500 $ $ $ $ $ 43,000 25,000 22,500 $ 90,500 0 5,000 4,500 $ 9,500 0 5,000 4,500 $ 9,500 0 5,000 4,500 $ 9,500 0 5,000 4,500 $ 9,500 W I L This analysis verifies that total cost at the end of the five-year period is $9,500 less S if the equipment is replaced ($100,000 2 $90,500). Notice, however, that total costs at O the end of the first year are higher by $32,500 ($52,500 2 $20,000) if the old machine is replaced. A decision maker under significant pressure toN report higher profitability may be willing to sacrifice tomorrow's profits to look better today. By emphasizing short, term profitability, she may secure a promotion before the long-term effects of her deci*($57,000 book value 2 $2,000 salvage) 4 5 years 5 $11,000 ($57,000 book value 2 $14,000 market value) 5 $43,000 ($29,000 cost 2 $4,000 salvage) 4 5 years 5 $5,000 sion become apparent. Even if she stays in the same position, her boss may be replaced by someone not so demanding in terms of reported Q profitability. The department supervisor's intent is to survive the moment and let the future take care of itself. MisU guided reward systems can be as detrimental as threats of punishment. For example, a manager may choose short-term profitability to obtain a bonus that is based on A reported profitability. It is the responsibility of upper-level management to establish S policies and procedures that motivate subordinates to perform in ways that maximize the company's long-term profitability. H E Decisions Regarding the Allocation of Scarce Resources Suppose that Premier Office Products makes two types of computers: a high-end network server and an inexpensive personal computer. The1 relevant sales and variable cost data for each unit follow. 9 Network Server Sales price Less: Variable cost Contribution margin $4,000 (3,760) $ 240 9 Personal Computer 7 Sales price B Less: Variable cost Contribution margin U LO 8 Make decisions about allocating scarce resources. $1,500 (1,370) $ 130 In many circumstances, variable costs act as proxies for avoidable costs. For example, by definition, unit-level costs increase and decrease in direct proportion with the number of units of product made and sold. As previously indicated, unit-level costs are avoidable with respect to many special decision scenarios. To the extent that variable costs are proxies for avoidable costs, the contribution margin can be used as a measure of profitability. Other things being equal, higher contribution margins translate into more profitable products. If Premier could sell 1,000 computers, the company would certainly prefer that they be network servers. The contribution to profitability on those machines is almost double the contribution margin on the personal computer. edm10890_ch06_252-303.indd Page 270 270 7/15/10 4:33 PM user-f497 /Volumes/105/PHS00142/work/indd Chapter 6 Even though the contribution margin is higher for network servers, selling personal computers may be more profitable. Why? If Premier can sell considerably more of the personal computers, the volume of activity will make up for the lower margin. In other words, selling three personal computers produces more total margin (3 3 $130 5 $390) than selling one network server (1 3 $240). Many factors could limit the sales of one or both of the products. Factors that limit a business's ability to satisfy the demand for its product are called constraints. Suppose that warehouse space is limited (i.e., the warehouse is a scarce resource that constrains sales). Accordingly, Premier cannot warehouse all of the computers that it needs to satisfy its customer orders. If a network server requires considerably more warehouse space than a personal computer, stocking and selling personal computers may be more profitable than stocking and selling network servers. To illustrate, assume that it requires 5 square feet of warehouse space for a network server and 2 square feet for a personal computer. If only 2,100 square feet of warehouse space are available, which computer should Premier stock and sell? In this case, the warehouse space is considered a scarce resource. The computer that produces the highest contribution margin per unit of scarce resource (i.e., per square W foot) is the more profitable product. The per unit computations for each product are shown here. I L S O Contribution margin per unit (a) N Divide by warehouse space needed to store one unit (b) Contribution margin per square foot of warehouse space (a 4 b) , Network Server Personal Computer $240 45 $ 48 $130 42 $ 65 Q The data suggest that Premier should focus on the personal computer. Even though the personal computer producesUlower contribution margin per product, its contribution a margin per scarce resource is higher. The effect on total profitability is shown as follows. A S H Amount of available warehouse space in square feet (a) E Divided by warehouse space needed to store one unit (b) Warehouse capacity in number of units (a 4 b) 5 (c) Times contribution margin per unit (d) 1 Total profit potential (c 3 d) Network Server Personal Computer 2,100 5 420 3$ 240 $100,800 2,100 2 1,050 3$ 130 $136,500 4 4 9 9 Although the quantitative data suggest that Premier will maximize profitability by 7 limiting its inventory to personal computers, qualitative considerations may force the B company to maintain a reasonable sales mix between the two products. For example, a U business that buys several personal computers may