Question

a.) The Regal Cycle Company manufactures three types of bicycles—a dirt bike, a mountain bike, and a racing bike. Data on sales and expenses for the past quarter follow:

	Total			Dirt Bikes			Mountain Bikes			Racing Bikes
Sales	$	926,000		$	263,000		$	409,000		$	254,000
Variable manufacturing and selling expenses		480,000			114,000			207,000			159,000
Contribution margin		446,000			149,000			202,000			95,000
Fixed expenses:
Advertising, traceable		69,400			8,300			40,600			20,500
Depreciation of special equipment		43,400			20,500			7,500			15,400
Salaries of product-line managers		114,900			40,400			38,400			36,100
Allocated common fixed expenses*		185,200			52,600			81,800			50,800
Total fixed expenses		412,900			121,800			168,300			122,800
Net operating income (loss)	$	33,100		$	27,200		$	33,700		$	(27,800)

*Allocated on the basis of sales dollars.

Management is concerned about the continued losses shown by the racing bikes and wants a recommendation as to whether or not the line should be discontinued. The special equipment used to produce racing bikes has no resale value and does not wear out.

1. What is the financial advantage (disadvantage) per quarter of discontinuing the Racing Bikes?

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

	Per Unit				16,000 Units Per Year
Direct materials	$	13		$	208,000
Direct labor		13			208,000
Variable manufacturing overhead		2			32,000
Fixed manufacturing overhead, traceable		9	*		144,000
Fixed manufacturing overhead, allocated		12			192,000
Total cost	$	49		$	784,000

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

Required:

1b). Assuming the company has no alternative use for the facilities that are now being used to produce the carburetors, what would be the financial advantage (disadvantage) of buying 16,000 carburetors from the outside supplier?

2b) Suppose that if the carburetors were purchased, Troy Engines, Ltd., could use the freed capacity to launch a new product. The segment margin of the new product would be $160,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 16,000 carburetors from the outside supplier?

Answer 1

Solution 1:

Please note that:

• Depreciation of Special Equipment is a sunk and irrelevant cost hence it need not be considered for decision making purpose.
• Also, Allocated common fixed expenses will continue to be incurred whether racing bike line is continued or discontinued.

Net Operating loss given for racing bike line is $27,800.

Revised Operating Profit (loss) for racing bike division will look like below (after adding back irrelevant costs)

Revised Operating Profit (Loss) = -$27,800 + $15,400 + $50,800

Revised Operating Profit = $38,400

In case the racing bikes line is discontinued; Regal Cycle Company will lose a financial advantage of $38,400 per quarter.

Solution 2:

1. Since there is a decision to be taken whether to manufacture carburetor in-house or it should be outsourced and bought from outside.

For In-house production, let’s find out the relevant cost of carburetor:

• Direct Material cost of $13, direct labor cost of $13 and variable overhead of $2 per unit are relevant costs since it will be incurred for production of every carburetor.
• For the fixed manufacturing overhead ($9 per unit); 2/3^rd is for depreciation which is a sunk cost and hence irrelevant cost for decision making purposes. 1/3^rd is for Supervisory salaries which is relevant cost. Had company not produced carburetor inhouse; there wouldn’t be requirement of supervisor. Hence $3 per unit (1/3 * $9) is relevant cost for decision making purposes.
• Allocated fixed overheads are sunk cost hence irrelevant cost. This cost will continue to happen whether if it is producedin house or bought from outside. Hence $12 of allocated fixed overhead is irrelevant cost.

Total relevant cost for production is $13 + $13+ $2 + $3 = $31 per unit

Vendor quoted price is $35 per unit. Hence if bought outside, it will create a disadvantage of $4 per unit for every carburetor bought.

For 16,000 carburetors, Financial disadvantage = $4 * 16,000 = $64,000

2. Supposing Troy Engines decided to buy it from outside; it will face a disadvantage of $64,000 per year. Additionally, the freed capacity can generate a margin of $160,000 per year; Net advantage to Troy Engines would be $96,000 ($160,000 - $64,000).

Please feel free to comment if the concept is unclear, happy to help. As always, keep studying, grind hard

Answer 2

A)

Financial   Disadvantage	$           (38,400)
Note 1:
Loss of   Contribution margin by dropping Racing Bikes segment	$         (95,000)
Add:   Saving in traceable fixed cost belongs to racing bike segment	$            56,600	(20500+36100)
Financial   Disadvantage	$         (38,400)	(-95000+56600)

B)

1b.

Financial   (Disadvantage)	$              64,000
	Make	Buy	Advantage/Disadvantage
Direct Material	$          208,000		$             208,000
Direct labour	$          208,000		$             208,000
Variable manufacturing Overhead	$            32,000		$               32,000
Fixed manufacture overhead (Only   supervisor salary)	$            48,000		$               48,000	(144000*0.33)
Purchase Price		$         560,000	$          (560,000)	(16000*35)
Total Relevant cost	$          496,000	$         560,000	$             (64,000)

No, due  to financial disadvantage of $64000

2b.

Financial   Advantage	$              96,000
	Make	Buy	Advantage/Disadvantage
Direct Material	$          208,000		$             208,000
Direct labour	$          208,000		$             208,000
Variable manufacturing Overhead	$            32,000		$               32,000
Fixed manufacture overhead (Only   supervisor salary)	$            48,000		$               48,000
Purchase Price		$         560,000	$          (560,000)
Segment margin of new product due to   freed capacity		$       (160,000)	$             160,000
Total Relevant cost	$          496,000	$         400,000	$               96,000
Yes, due to financial   advantage of $96000