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CHAPTER 6

DECISION MAKING IN THE SHORT TERM


SOLUTIONS
REVIEW QUESTIONS
6.1 The temporary gaps between the demand and supply of available capacity.
6.2 The maximum volume of activity that a company can sustain with available
resources.
6.3 Because organizations make capacity decisions based on the expected volume of
operations over a horizon spanning many years. They build plants, buy
equipment, rent office space, and hire salaried personnel in anticipation of the
demand for their products and services.
6.4 (! "ecisions that deal with excess supply. #xamples include reducing prices to
stimulate demand, running special promotions, processing special orders, and
using extra capacity to make production inputs in$house% (&! "ecisions that deal
with excess demand. #xamples include increasing prices to take advantage of
favorable demand conditions, meeting additional demand by outsourcing
production, and altering the product mix to focus on the most profitable ones.
6.5 This method focuses only on those costs and revenues that differ from the
benchmark option.
6.6 This method considers the gross revenues and costs associated with each option,
rather than the incremental amounts relative to the benchmark option.
6.7 The totals approach requires more computations because it includes some
noncontrollable benefits and costs.
6.8 'n decisions involving many costs and benefits ( it helps us ensure that we do not
)forget* to include a relevant cost or benefit.
6.9 #xcess supply ( usually, the firm cuts prices to stimulate demand.
6.1 'n a make or buy decision, the firm is deciding whether to make a product, or
piece thereof, internally or outsource and buy them from a supplier.
6.11 +hen demand is high and a resource is in short supply.
6.12 To maximize profit when capacity is in short supply, maximize the contribution
margin per unit of capacity.
6.13 Typically on a qualitative basis ( by considering how customers, suppliers, and
competitors might respond to the decision being made.
DISCUSSION QUESTIONS
6.14 ,es, the definition of what is short$term and what is long$term depends on the
business context. -or .eneral /otors anywhere from few weeks to a few months
may be considered short$term, as pricing and promotion decisions depend on how
fast different models of cars and trucks are moving from the dealers0 inventories.
-or a baker, a day or two days may be too long as baked goods do not retain their
)freshness00 for long. Thus, product characteristics often play a critical role in
determining how )long* the short$term horizon is.
6.15 The reason why the lots are overflowing is that vehicles are not being sold at the
expected rate. 1nsold vehicles occupy space in the lot. Thus, it is not correct to
define capacity in terms of the lot space available. 2ather, capacity should be
defined in terms the number of vehicles that can potentially be sold per day. +hen
demand falls short of supply based on the anticipated number of vehicles to be sold
per day, lots overflow, and price$cutting and other promotions become necessary to
move the vehicles.
6.16 2aising prices, when unexpected demand for any product or service creates
temporary shortages, can often hurt businesses in the long run because such actions
can create customer ill will and lead to a loss in reputation. This is especially the
case when it comes to emergency situations. Think of how you will feel when a
grocery store that you frequent in your neighborhood raises prices on bottled water
as you prepare to deal with an approaching 3ategory 4 hurricane5
6.17 /ost of us drive to work, and so the demand for gasoline is fairly stable. 6ne way
to economize on gasoline consumption is to car pool effectively with your
colleagues or others that work near where you work.
6.18 ,es, it is. The gross method considers all cash inflows and cash outflows that are
associated with the options being considered in the context of a particular decision,
even though some of them may be non$controllable. But, it does not consider cash
flows associated with many other decisions that the companies may be considering.
-rom an overall organizational standpoint, each decision has an incremental effect,
and, therefore, the gross method is also incremental when viewed in this context.
6.19 'ncreasing prices is a natural way of decreasing demand. 'n fact, in most market
settings, demand for a product decreases as its price increases. +hen a firm does
not have enough capacity to meet a sudden spurt in demand, it can reduce the
demand by increasing prices and )turning away* some customers to a point where
the demand can be met. The airline industry is a good example. 'n peak times, an
increase in airfare induces some travelers to seek other means of travel or postpone
their travels. 6nly those that are able to afford the higher prices, or have rigid and
noncancelable schedules, will continue to travel.
7irline companies usually face no long$term adverse implications from increasing
prices to deal with peak demand situations. 7ir travelers usually understand this
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behavior and plan their travel accordingly. 6n the other hand, consulting companies
rely on longstanding relationships with their customers. 2aising their rates when
their business is good usually backfires because it hurts reputation and goodwill in
the long$run.
6.2 ,es, it does. This is typically referred to as )production smoothing* and makes good
business sense as long the product is storable for sale in the future period, and as
long as inventory carrying costs are manageable. The toy industry and the apparels
industry are good examples.
6.21 3ompanies can produce and stock up during periods of lean demand to be ready for
peak periods whenever demand outstrips capacity. <owever, such use of inventory
is beneficial when demand follows reasonably predictable cycles of high and low
demand. 6n the other hand, whenever demand is low and there is considerable
uncertainty as to whether demand would rise again, producing and stocking for
future may backfire.
6.22 6ne strategy is to invest less in capacity and rely more on outsourcing. By doing so,
the company would embrace a cost structure with less fixed costs and more variable
costs i.e., a cost structure with lower operating leverage. 7nother strategy to find
other uses for capacity so that excess capacity can be put to profitable alternate use
during periods of lean demand (such as accepting special custom =obs, turn key
pro=ects and so on!.
6.23 The idea is to make the most profitable use of critical and most expensive resources.
The opportunity cost of such a resource is by assumption, high. 7ny situation in
which such a resource has to wait because some other )cheaper* resource is in short
supply is undesirable. To avoid such situations, it makes more economic sense to
install excess capacity in other resources.
6.24 +hen a resource is in short supply, and it is used in a lumpy manner, calculating
contribution margin per unit of the resource to allocate its use to various products is
at best approximate and can often lead to wrong decisions. 7dvanced techniques
such as integer programming may have to be employed to come up with the right
way to allocate scarce resources to products in such settings.
6.25 >roducts requiring minimum production quantities involve committing requisite
amounts of capacity to these products if they are chosen production. +henever
capacity is in short supply, such products may well necessitate leaving out products
with higher contribution margins per scarce capacity unit in order to meet their
minimum production requirements. The alternative is to not lock up capacity by
scheduling such products, but instead use the capacity to schedule products that
yield lower contribution margins per unit of the scarce capacity resource. The
consequent trade$off will determine whether it is profitable to make products with
minimum production requirements.
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6.26 6utsourcing reduces the amount of capital that needs to be invested in capacity
resources. 't reduces the fixed costs in the cost structure, but increases the variable
costs. 'n other words, outsourcing increases the operating leverage. 1nit variable
costs are usually higher with outsourcing relative to in$house production because
the profit margins of suppliers are part of the variable costs with outsourcing.
Therefore, unit contribution margins are usually lower with outsourcing. <owever,
outsourcing helps companies respond quickly to competitive pressures and to
advances in technology. 'nvesting in capacity resources commits a company to a
certain technology over the longer term. 'f the technology becomes obsolete and the
demand drops, it is much costlier for the company to divest its assets and change
course.
6.27 Test marketing is a way to minimize risk associated with large investments.
6ffering a new product often involves putting in place and committing to various
organizational resources. 6nce the product is launched it is often extremely costly
to cut back should the product fail. >lants and offices have to be closed down and
people have to be fired and so on. 2isk of failure is an inherent part of business, and
products do fail. But one way to reduce this risk is to do a small scale launch aimed
at representative customers. 'f this test marketing effort fails, then a larger scale
launch is unadvisable. /oreover, feedback from the test market is often useful in
redesigning the product to reduce the risk of failure subsequently.
6.28 #mployee morale is an important factor in outsourcing decisions, especially if
outsourcing is a sign of things to come. :oss of morale leads to a loss in
productivity which might make outsourcing even more attractive. The company
may lose talented and experienced personnel, who may prefer =obs elsewhere to
being fired. /anagers therefore have to be clear about the impact of outsourcing on
employee morale so that they can make the appropriate trade$off between
immediate cost savings from outsourcing and longer$term adverse impact of a loss
in morale. 3ertain critical activities are better done in$house for strategic reasons,
while others can be outsourced. <owever, decision making with respect to
outsourcing has to be clearly communicated to the employees to avoid
disgruntlement.
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E!ERCISES
6.29
a. 7=ay0s decision deals with excess demand. "ue to the holidays, 7=ay expects a
surge in gift$wrapping needs. To handle this surge, 7=ay is considering hiring
a helper. This is akin to a manufacturing firm outsourcing some production in
periods of high demand.
b. :et us calculate profit @ revenues ( variable costs ( fixed costs. +e can
construct the entire 3A> model for 7=ay. +e then compare the profit under
each option, selecting the option with the higher profit. +ith the information
provided, we haveB
+ithout <elper +ith <elper
;C packages
>er day
C packages
per day
"aily revenue (D? ;C% D? C! DEC.CC D??C.CC
"aily variable costs (D ;C% D C! ;C.CC C.CC
"aily pay for help (C% DE.FC C! C.CC EF.CC
"aily contribution 2ow ( rows & G ? D&C.CC D?F.CC
Total contribution 2ow 4 ?C D?,;CC.CC D4,CFC.CC
Total fixed costs .iven ;CC.CC ;CC.CC
>rofit "3#. "3#45.
3omparing the total profit, we find that 7=ay0s profit increases by "45 (D?,4FC (
D?,CCC! for the season, if he hires the helper. 7ccordingly, if he wishes to
maximize profit then 7=ay $%&'() %*+, -%, %,(.,+.
'n constructing the income statement for each option, we could leave out the non$
controllable fixed costs of D;CC. +hile the absolute profit numbers would change,
the difference in profit would be preserved. Thus, the gross approach provides
decision makers some flexibility in terms of what is included and excluded from
the income statement.
c. 1nder this approach, we compute only the incremental revenues and costs
associated with a particular decision option relative to the status quo. 9ince
operating without the helper is the status quo, we haveB
'ncremental revenue FC packages per day D? DFC
'ncremental variable cost (packages! FC packages per day D FC
'ncremental cost (helper! DE.FC C hours EF
'ncremental profit per day DF
V/(', &0 %*+*12 %,(.,+ DF ?Cdays "45
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7gain, we see that 7=ay increases monthly profit by "45 if he hires a helper. The
difference in profit derived with controllable cost analysis exactly equals the
difference in profit under the gross approach. This underscores the equivalence of
the two approaches. <owever, controllable cost analysis usually requires fewer
calculations.
d. 7ssuming 7=ay seeks to maximize profit, the 3%/12, *1 0*4,) 3&$-$ 5*(( 1&-
/(-,+ %*$ ),3*$*&1 -& %*+, -%, %,(.,+. The fixed costs are equal under each
option and, as a result, they are not relevant for this particular problem.
/oreover, we see that (by inspection! controllable costs analysis ignores fixed
costs as they are non$controllable. <owever, even though the gross approach
uses fixed costs, they )wash* because they are included in the total cost for
both options.
N&-,B The magnitude of the fixed costs would be relevant if 7=ay were deciding
whether to pursue this business venture. This relevance is because 7=ay would not
incur the fixed costs if he did not pursue the venture. .enerally, we need to define
the time frame for the decision before we can classify a cost as a fixed cost.
3onsequently, the relevance of a fixed cost depends on the decision0s horizon.
7=ay0s costs are fixed for the short$term decision of whether to hire a helper, but
are not fixed for the longer$term decision of whether to stay in the gift$wrapping
business.
6.3
a. /agic /aids0 decision appears to feature both excess supply and excess
demand. 't is likely that /agic /aids fixed overhead costs (rent and
administrative salaries! will not change due to the special =ob ( it appears that
there is enough administrative capacity to handle the =ob. There is excess
demand for cleaning supplies% if the current =obs do not use up available stock,
the firm could store the supplies for use later. -inally, there might be limited
excess capacity for some resources. 'f ;CH of the =ob could be completed
during normal business hours, then the company clearly has some slack and
excess capacity in terms of labor hours. -or the remaining 4CH of the =ob,
however, /agic /aids0 employees will have to work overtime ( thus, there is
excess demand for this input. This shows us that different resources in the
firm have differing capacity levels ( a decision may impose constraints on one
resource but not another. +e have to consider the opportunity cost of each
resource when computing the total cost of a =ob.
N&-,B 7 precise definition of capacity is at the level of individual resources. Thus,
when computing the cost of an option, we have to consider opportunity costs at the
level of individual resources.
b. The following table details the incremental cost associated with cleaning the
FC offices, compared to the status quo of not cleaning the officesB
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'tem "etail 7mount
3leaning materials FC offices I J&.FC per office J,EKF
:abor

FC I ? I .4C I F I .F J4,CFC
Aariable overhead FC offices I JK.FC per office J,&F
'ncremental cost 67#5

B There are FC offices that need to be cleaned, and each office requires ? hours
to clean. 9ince ;CH of the =ob could be completed during regular business
hours, /agic /aids will only have to provide extra remuneration for 4CH of
the hours. -urther, employees are paid .FC times their hourly wage of JF for
each overtime hour worked.
8ote that fixed overhead, which is comprised of rent and administrative salaries,
is not relevant as it is very unlikely that the total amount of fixed overhead will
change if /agic /aids accepts the engagement.
/agic /aids incremental costs associated with cleaning the conglomerates FC
offices amount to 67#5.
c. /agic /aids can use the cost number for pricing the local conglomerate0s
request to clean the FC offices. JK,CFCLFC @ J4K per office likely would
represent the minimum price that /agic /aids would charge. This price is
well below /agic /aids normal price of J&C.
The actual price charged will consider other factors. -or instance, the client0s
other options become relevant. 'f this is a one$time deal with no prospect of repeat
business, then /agic /aids might well charge a premium over the normal price.
The prospect of )getting a foot in the door* to bid for future business would push
the price downward. :ong$term implications also matter. 'f the conglomerate
becomes part of /agic /aids client base, then the company likely would wish to
make sure that the price charged in the long term would cover all incremental
costs (measured over the long term!, and not only the incremental costs measured
over the short$term.
6.31
a. +hile set in a service setting, this is a classic example of an organization that
has excess capacity and is attempting to figure out how to price a special
order. 't is like having open seats at a sporting event ( it appears that the
rooms would otherwise remain idle if #rin and Myle do not accept the
customer0s offer.
b. Because the rooms would otherwise remain idle, the lost profit associated with
turning down the customer is D&CC ( (? DC! @ DKC per customer, for a total
of DKC 4 @ "78 0&+ 0&'+ 3'$-&7,+$. 8otice that the standard rate of DEC
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per day is not relevant for computing this amount.
#rin and Myle might be concerned that renting the rooms for a substantial
discount will tarnish the image of their 'nn or adversely affect weekend (or other!
rentals. 't is unlikely that this will occur because )time$based0 pricing is very
common. <otels, airlines, and utility companies all charge more when demand is
expected to be high and less when demand is expected to be low. (Think about the
cost of renting a hotel room in 8ew 6rleans during /ardi .ras versus renting the
same hotel room in mid$7ugust when the temperatures and humidity are high5! 'n
other words, customers naturally expect prices to reflect demand.
7ll things considered, #rin and Myle would be hard pressed not to accept the offer
or to at least make a reasonable counter$offer (e.g., ask for D&FC per person or
require the customers to share a room!. /oreover, #rin and Myle probably should
consider running weekday specials, perhaps reducing the rate to DCC a night
during the week to increase occupancy and maximize contribution margin.

<owever, we also note that such strategies might tarnish the )exclusive* nature of
the facility, depressing #rin0s ability to charge premium rates during the weekend.
7lso, there would be higher wear$and$tear costs in the long run if occupancy were
to increase substantially. #rin0s decision turns on whether she considers this to be
a one$time deal or if this is the start of a new business strategy.
6.32
a. Nen0s decision deals with excess supply ( due to the reduced demand for her
work, Nen finds herself with time to spare.
b. Nen0s variable cost of 0+/7*12 %,+ &51 5&+8 *$ "3 @ DC ?C. <er
payments to the 0+/7*12 $%&. would be "75 @ D&F ?C.
T%'$# 9,1 5*(( $/:, "45 *0 $%, )&,$ %,+ &51 0+/7*12. 8otice that this
estimate is over$stated because it ignores the cost of the additional time it will
take Nen to frame her prints. The additional time has value because Nen could use
it for other activities that she might en=oy more than framing.
c. Nen0s problem is now more complex. By outsourcing the framing, Nen is able
to produce and sell an additional F prints% in turn, these prints generate an
additional contribution margin of DKF ( D&F ( D E @ D4& per print or D4& F
@ D;?C in total. 2ightfully, we should add this amount to the cost of framing
of DCC per print or DCC F @ DFC for F prints, to obtain a total framing
cost of DFC O D;?C @ DKEC. 8ow, we see that Nen prefers to use the framing
shop rather than do her own framing.
+hat does our answer changeP 3ompared to part QbR, Nen does not have enough
idle time to keep up her current volume of prints and do her own framing. Thus,
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the problem switches from one of excess supply (where we assumed the
opportunity cost of Nen0s time to be DC! to one with excess demand, where we find
the opportunity cost of Nen0s time to be D;?C. The nature of the imbalance drives
Nen0s preferred solution.
N&-,B 7 superior option is to frame some but not all of the prints. 1sing the
notion of allocating time per the contribution margin per unit of the scarce
resource, we could derive this formally.
6.33
a. The following table provides the estimated profit impact at the two prices
consideredB
'tem >rice for valet
parking
DF per
month
DC per
month
2evenue from service
(4CC I DF% ?CC I DC!
D&,CCC D?,CCC
2evenue from new members
(&C I DCC% C I DCC!
&,CCC ,CCC
3ost of new members
(&C I D?F% C I D?F!
KCC ?FC
3ost of valet service
(given!
&,FCC &,FCC
8et profit "8 D,FC
Based on the above estimates alone, Tom and :ynda should offer the valet service
and price it at DC per month (not DF!.
>lease note the tradeoff between price and quantity. 7t a lower price, the feature
has more takers. This tradeoff depends on how much demand (for different
products! changes as price changes. The tradeoff from increasing price is
favorable if we consider the revenue from current members only. <owever, the
effect on new members is unfavorable and large. 7lso taking into consideration
the increases in variable costs due to additional membership, it appears that
asking for DC provides the best tradeoff.
>lease also note that we are not considering any change in the club0s fixed costs
from adding new members. 7s we know from the earlier chapters, <ercules has
been losing members to 7pex, meaning that it has excess capacity in terms of
members.
b. There are several qualitative considerations. -irst, we need to consider the
effect on other members. Aalet parking means reserving a section (usually a
desirable section! of the parking lot. This means that other members would be
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inconvenienced, leading to some lost memberships. 9econd, we have to
consider if the service sets the club on the path of tiers of members, which
feature has both costs and benefits. <owever, this is a move with long$term
consequences for the club0s clientele. Third, Tom and :ynda must consider
that demand for valet parking is not likely even through the day. #ven if they
ad=ust staffing somewhat, it is likely that some patrons will encounter delays
in getting a valet to attend to them. 9uch delays might prompt complaints,
create ill will and otherwise detract from a positive experience (and consume
managerial time!. 6verall, the ),3*$*&1 *$ 1&- 3(,/+ 3'-, particularly because
the monetary benefit is not very large.
6.34
a. Tom and :ynda0s decision turns on alternate uses for the space, or its
opportunity cost. The problem indicates the room is unused during this time.
There is minimal disruption of operations. 'ncreases to direct costs, if any, are
small. Thus, the D;CC offered by /ar=orie would flow directly to profit.
Tualitatively, the service might even attract new membersUfor example, the
expectant women might wish to use the swimming pool or the sauna to relax,
and see <ercules as a one$stop shop. 6verall, T&7 /1) L;1)/ $%&'() /33,.-
-%, &00,+.
b. The change in class timings changes the problem from one of excess supply to
one of excess demand. "uring the peak evening hours, there is considerable
demand for the room (which is why scheduling /ar=orie0s class will displace
existing classes!. Tom and :ynda therefore need to consider the best use of the
space during the evening hours. 1sing it for regular classes benefits the
membership, and prevents loss of members. 1sing it for /ar=orie0s classes
generates additional revenue. But, the opportunity cost is the loss of members,
valued at E I (DCC $ D?F! @ DF&C per month. The net gain from accepting
/ar=orie0s offer is DKCC $ DF&C @ DEC per month.
<owever, qualitative factors are salient in this case. /embers might get upset at
seeing a big part of the club reserved for use by non$members during peak times.
The perception that <ercules is not really a gym for fitness buffs might lead to
long$term erosion of reputation, and consequent loss of membership. 6verall, *-
$,,7$ '15*$, -& +*$8 $'3% +,.'-/-*&1 (&$$,$ 0&+ (,$$ -%/1 "2 .,+ 7&1-%.
c. +e haveB
'ncremental fee due to evening class DCC DKCC$D;CC
'ncremental membership fee lost (DECC! E I DCC
'ncremental variable costs saved D&EC E I D?F
'ncremental profit <"42=
Based on the above, adding the evening class is an unwise move.
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8otice that the value of the daytime only option is D;CC (as calculated in part QaR.!
The incremental value of the evening class, relative to the daytime class, is a loss
of D4&C, as calculated above. 7dding these two numbers together, leads to DEC,
the value (relative to status quo or doing nothing! for the evening option.
6.35
9imilar to the 9uperior 3ereals problem in the text, the key to this problem is to
realize that the variable costs associated with manufacturing the greeting cards are
sunk ( thus, they are not relevant to "V=W Au0s decision. 7dditionally, "V=W Au0s
fixed costs are non$controllable for the decision, as they are not expected to
change. Thus, the problem is one of revenue maximization.
7t a FCH off sale, "V=W Au0s profit increases by DC.FC I ,FCC @ DKFC.
7t an ECH off sale, "V=W Au0s profit increases by DC.&C I 4,CCC @ DECC.
Thus, "V=W Au maximizes its profit by holding the ECH off sale, even though the
resulting price is below the DC.&? (@ DC.FODC.CE! in variable costs associated
with producing and selling a card. +hat we need to remember is that this is the
variable cost of a card yet to be produced, not a card that has already been
produced.
N&-,> This problem links to a common business practice. 9pecifically, we often
observe stores employing a staggered discounting strategy ( the store starts with,
for example, a &FH discount and increases the discount rate over time (perhaps by
as much as F$&FH a week!. 'n this way, the store attempts to capture as much
consumer surplus (gross revenue! as possible by grouping customer types
according to their willingness to wait and run the risk of having the item selling
out. 9uch a strategy may work quite well for "V=W Au ( i.e., the company could
sell the first ,FCC cards at DC.FC and 4,CCC ( ,FCC @ &,FCC cards at DC.&C. By
employing such a strategy, "V=W Au could earnB
#xpected >rofit @ (DC.FC I ,FCC! O (DC.&C I &,FCC! @ D,&FC.
This amount represents a D4FC (@ D,&FC $ DECC! increase over its best option.
6.36
a. 1nder the gross approach, we include all of the costs connected with each
decision. +e do not worry too much about whether they are controllable or
not. <owever, all of the costs listed in the problem appear to be related to the
trip and are controllable ( costs such as apartment or dormitory rent and
tuition, which are not mentioned in the problem, clearly would not be related
to the decision being made. That said, we could include them under the gross
approach as they would preserve the rank ordering of options.

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1sing the gross approach, we arrive at the following per$person, round$trip cost of
drivingB
'tem "etail Total 3ost
3ost per
>erson
7utomobile$related costs DC.?C per mile I ECC miles
I & segments
D4EC DS;
3ost of refreshments D&C per person per
segment I F persons I &
segments
D&CC D4C
Total 3ost D;EC "136
The following table summarizes the per$person, round$trip cost of flyingB
'tem
"etail Total 3ost
3ost per
>erson
7irline ticket D;S I F persons DE4F D;S
3ost of refreshments DF per person per segment
I F persons I & segments
DFC DC
3ost of travel to and
from airport
D; per person per segment
I F persons I & segments
D;C D&
Total 3ost DSFF "191
't is DS ( D?; @ "55 .,+ .,+$&1 3%,/.,+ -& )+*:, -%/1 -& 0(;. -rom a cost
structure perspective, the bulk of the savings obtain because the auto$related costs
are fixed. The automobile operating costs will be DC.?C per mile, or D4EC in total
for the round$trip, regardless of the number of persons traveling. 9plitting this
cost five ways results in a relatively low cost per person. 'n contrast, the cost of
airfare is variable with respect to the number of persons traveling. There is no
)scale economy* that results.
7lternatively, with the airline trip, the cost is DS for each person traveling,
regardless of the number of people. 'n contrast, the additional cost for person X&
in the auto trip is only D&C each way ( the remainder of the cost is committed
even if only one person is traveling. The scale economy for driving results
because the cost structure contains more fixed and less variable cost (per person!
than the amounts for flying.

N&-,: This problem also highlights the subtle distinction between the timing of
cash flow and cost. The immediate cash outflow connected with flying will equal
the number computed above. <owever, the current cash outflow connected with
driving is likely lower. This is because the DC.?C cost per mile includes an
allowance for depreciation, repairs, insurance and so on. These costs eventually
will be paid out in cash (e.g., when you actually pay for repairs! but the timing
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need not coincide with the duration of the trip. 8aturally, costs related to gas
(which are included in the DC.?C per mile rate! will lead to immediate cash
outflows.
b. The key here is to realize that the per$person cost of flying will not change
even though the group0s size has changed. The entire cost of flying is variable
with respect to the number of persons traveling. Thus, the total cost will
change, but the per$person cost (DS! will be the same regardless of group
size. This can readily be seen in the following tableB
'tem "etail Total 3ost
3ost per
>erson
7irline ticket D;S I & persons D??E D;S
3ost of refreshments DF per person per segment
I & persons I & segments
D&C DC
3ost of travel to and
from airport
D; per person per segment
I & persons I & segments
D&4 D&
Total 3ost D?E& "191
The per$person cost of driving, however, will change. <ere, the fixed costs of
driving will be spread over two rather than five people. 'n essence, the per$person
cost of driving will increase substantially because the total cost of driving does
not decrease much (it only decreases by the round trip cost of refreshments for ?
people!. The following table provides the revised computationsB
'tem "etail Total 3ost
3ost per
>erson
7utomobile$related costs DC.?C per mile I ECC miles
I & segments
D4EC D&4C
3ost of refreshments D&C per person per
segment I & persons I &
segments
DEC D4C
Total 3ost DF;C "28
't is now cheaper to fly than to drive. The logic essentially is the same as in part
QaR. -rom a cost structure perspective, the cost of driving is essentially fixed ( in
other words, it will be DC.?C per mile, or D4EC in total for the round$trip,
regardless of the number of persons traveling. 9plitting this cost only two ways,
rather than five ways, results in a relatively high cost per person. 'n contrast to
part QaR, you are not taking advantage of the potential scale economies associated
with driving.
N&-,: 'nstructors also can relate the above discussion to the rationale for a
monopoly, as discussed in students0 economics courses. +hat is the scale
economy associated with a cable company or an electric utilityP
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
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c. There are numerous other factors that might come into play regarding this
decision, including the following threeB
-rom an en=oyment perspective, the trip is potentially a great deal more
fun, if you drive together rather than fly separately (i.e., road trip5!.
#ach method offers differing types of flexibility. "riving allows the group
to plan around the weather, while internet$only tickets come with
numerous restrictions and change penalties. "riving also provides you
with available transportation at home over winter break. <owever, unlike
flying, driving also requires that you and your friends coordinate your
schedules.
-rom a safety perspective, statistics show that flying is safer than driving.
'ndeed, many parents might worry about five college students taking a
long road$trip over the winter months.
d. +e characterize this problem as one of excess demand. /oney is the resource
in short supply. Then, because the )revenue* is the same for both options, we
wish to find the option that uses the smallest amount of the scarce resource, or
equivalently, has the lowest cost.
6.37
a. :et us begin by calculating relative sales values.
.ravelB S,CCC tons I C.E I D?C D&;,CCC
9andB S,CCC tons I C.& I D4C DK&,CCC
Total D&EE,CCC
Thus, KFH of the =oint cost (@D&;,CCCLD&EE,CCC! would be allocated to gravel
and the &FH to sand. +e have the cost allocated as C.KF I D&&F,CCC @ D;E,KFC
and C.&F I D&&F,CCC @ DF;,&FC.
7lternatively, we can calculate the rate per sales D at the split off as
D&&F,CCCLD&EE,CCC @ DC.KE&F. +e then allocate D&;,CCC I DC.KE&F @
"168#75 to gravel and DK&,CCCI C.KE&F @ "56#25 to sand.
b. +e know that only incremental revenues and costs are important for this
decision. :et us therefore calculate the net gain from processing the sand
further.
Aalue of sandbox quality SCC tons I D;C D44,CCC
:ost value at split off S,CCC tons I C.& I D4C DK&,CCC
8et gain in revenue DK&,CCC
3ost of additional processing given (DE,CCC !
8et value "54#
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4
Thus, M;,+$ $%&'() .+&3,$$ -%, $/1) /- $.(*- &00 *1-& $/1)?&4 @'/(*-; $/1)
?,3/'$, *- *13+,/$,$ .+&0*- ?; "126#
1
A "72# B "54#.
8oteB The important point to note is that the =oint cost, or how it is allocated, is
not relevant for the decision in QbR. That =oint cost is sunk for this decision. These
allocations are usually done only for the purpose of valuing inventory.
6.38
/ihir has two optionsB (! run the promotion or (&! do not run the promotion.
6ption (!, or not running the promotion, is the status quo. +e can then answer
the question regarding whether /ihir should run the promotion by calculating the
incremental costs and revenues associated with running the promotion. Based on
the information provided, the incremental revenues and costs areB
"ecreased ticket sales (&CC tickets Y D?.SF per ticket! (DKSC!
'ncreased profit from concession standB
8umber of customers &FC @ FCH of FCC
7verage revenue D;.CC per patron
'ncreased concessions sales (&FC patrons Y D;.CC per patron! D,FCC
7verage cost DC.SC @ C.F D;.CC
'ncreased concessions cost (&FC patrons Y DC.SC per patron (D&&F!
8et profit D,&KF
Aalue of promotion D4EF
/ihir should run the promotion as weekly profit is expected to increase by D4EF.
N&-,B This problem is one of excess supply as /ihir has available seats during the
matinee shows.
6.39
a. 6ne approach is to construct a profit model for the laser tag arena, a profit
model for the video arcade, and a profit model for :azer:ite as a whole. This
problem, though, lends itself nicely to employing an incremental approach.
Because we know the status quo, we can figure out controllable costs and
revenues.
-rom .reg0s perspective, we can delineate the following incremental benefits and
costsB
'ncrease in contribution margin from customers attracted by after$school special @
FCC I (DF.CC ( D?.CC! @ D,CCC
"ecrease in contribution margin from losing customers paying normal price @ ?CC
I (DK.FC ( D?.CC! @ D,?FC

D&;,CCC @ Aalue of sandbox quality minus further processing costs @ D44,CCC $ DE,CCC.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$F
'ncremental fixed costs @ DFC
The overall effect is to ),3+,/$, -%, (/$,+ -/2 /+,1/ .+&0*-/?*(*-; ?; "5 .,+
5,,8 @ D,CCC ( D,?FC ( DFC.
Thus, from .reg0s standpoint the after$school special probably is not such a hot
idea. The annual profit of the laser tag arena will decrease by DFCC I F& weeks @
"26#.
8oteB 't is also possible to solve the problem by computing the profit under two
options. That is, we could employ the gross approach. 1nder this approach, the
profit reported decreases from D?,ECC per week to D?,?CC per week.
b. -rom :azer:ite0s perspective, we also need to consider the effect of the after$
school special on the video arcade. The effect on the video arcade can be
calculated as followsB
'ncremental profitarcade @ (net increase in laser tag customers I .KF! I Q;.CC ( (.C
I ;.CC!R
@ (&CC I .KF! I (;.CC ( .;C! @ "81 *13+,/$, .,+ 5,,8.
Thus, L/C,+L*-, /$ / 5%&(, *13+,/$,$ 5,,8(; .+&0*-$ ?; "31 .,+ 5,,8 @ DEC
( DFCC, or approximately D?C I F& weeks @ "16#12 .,+ ;,/+. 3onsequently, the
after$school special is a profitable move for :azer:ite as a whole.
The key point of this exercise is to emphasize that we cannot look at each product
in isolation (e.g., laser tag sales only! when the business model has considerable
product interdependencies. /oreover, numerous laser tag operations attempt to
lure customers in with the hopes that they will spend considerable sums of money
on video games and other ancillary activities. 6ther examples of this behavior
include software firms giving away the reader (e.g., 7dobe 7crobat! in the hope
of making money selling the writing software. This idea of a loss leader, covered
in microeconomics, often occurs in casinos (cheap food and free drinks! and
supermarkets (low milk prices! or restaurants (kids eat free!.
N&-,> .reg0s compensation arrangement appears to be misaligned with the
company0s goals. To this end, :azer:ite probably is better off if .reg0s
compensation is linked to overall company profitability. 'n this way, .reg will not
believe that he is competing for customers with the video arcade.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$;
6.4
a. Based on the problem data, .erry has two optionsB (! 3ontinue with the
current arrangement of using the upstairs space for music lessons, or (&!
3onverting the upstairs space to retail space. 6ption (! is the status quo, and
evaluating option (&! relative to the status quo yieldsB
'tem "etail Total
2evenue from new space FC square feet I DF,CCC per
square foot
DKFC,CCC
Aariable costs from new space DKFC,CCC I KFH variable costs DF;&,FCC
3ontribution margin from retail
space
DKFC,CCC I &FH contribution
per D of revenue DEK,FCC
$ 2evenue from cubicle rentals ; cubicles I 4C rentals per
week I FC weeks per year I DF
per rental
;C,CCC
$ 3ost of additional sales persons & I FC,CCC CC,CCC
$ 7dditional fixed costs DC,CCC ( DK,FCC &,FCC
I13+,/$, *1 .+&0*- "25#
6ur calculations reveal that .erry0s profit will increase by D&F,CCC if he decides
to convert the upstairs to retail space. 'n arriving at this solution, notice that the
contribution margin from the existing retail space is not included because it is
assumed to be the same with and without the remodel. 7dditionally, the cost of
existing sales persons is also constant in the decision to remodel as are the
downstairs fixed costs of DS&,FCC (@ DCC,CCC ( DK,FCC!.
b. 6ftentimes, decision makers need to consider the implicit assumptions
contained in the numerical computations. The following assumptions seem
particularly importantB
The lessons must surely generate a lot of goodwill and traffic through the
store. They also help .erry keep himself in the )loop* of the music
business in the city. 3losing the cubicles likely will trigger a loss in sales.
't is unlikely that the new space will have the same sales per square foot.
'ndeed, closing the cubicles may lower the sales in the existing space as
well.
The above computations also ignore the one$time cost of the remodel.
.erry0s decision has to incorporate whether the remodel will cost DF,CCC,
DF,CCC, or DFC,CCC. The latter involves a much riskier gamble.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$K

6.41
a. The key is to realize that Nustin has ,43,$$ ),7/1) as the pumps currently use
all available capacity. Thus, taking the order requires Nustin to give up some
pumps. 7t FCC valves x ? hours per valve, the valve order will consume ,FCC
hours. "ividing the total C,CCC hours available by the total production of
&,FCC pumps, Nustin calculates that it takes 4 hours to produce a pump. 7t this
rate, ,FCC hours can be used to make ?KF pumps. Nustin divides the D&F,CCC
in monthly contribution by &,FCC pumps to calculate that each pump yields
DFC in contribution margin. Thus, we haveB
3ontribution from Aalves FCC valves I D?C per valve DF,CCC
:essB :ost contribution from pumps ?KF pumps I DFC per pump E,KFC
N,- 3%/12, *1 .+&0*- <"3#75 =
Nustin will lose D?,KFC if it takes the order. The fixed costs of DKF,CCC (3/ of
D&F,CCC ( profit of DFC,CCC! are not relevant for this decision.
Alternate approach
+e could also solve the problem by examining the contribution per labor hour.
#ach pump yields a contribution of DFC L 4 hours @ D&.FC per labor hour. 'n turn,
each valve yields a contribution of only D?CL? hours @ DC per labor hour.
7ccepting the valve order diverts resources toward less profitable uses. Because
,FCC hours would be diverted, the loss is ,FCC hours I (D&.FC ( DC.CC! per
hour @ D?,KFC.
b. >rofit will be unchanged if valves also contributed DE,KFC to profit. Thus, the
price per valve should be DE,KFCLFCC valves @ "37.5 .,+ :/(:,.
7lternately, profit will be unchanged if valves also contribute D&.FC per labor
hour. 7s each valve consumes three hours, the minimum price is D&.FC x ? hours
@ D?K.FC per valve.
c. There are many potential qualitative factors. -irst, Nustin0s management has
been trying to diversify into valves. This order might give them an
opportunity to test out their production methods and establish their reputation
for quality valves. The order might also help them learn the process and reap
the cost gains from such learning. 9econd, the order might be the precursor to
a larger order at better prices. Third, this might be an order from a large
customer (for pumps!, prompting Nustin to accommodate the order even it
means losing money. 't is difficult to estimate the monetary value of these
considerations. 8evertheless, managers routinely make such tradeoffs
everyday.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$E
6.42
a. The )traditional* allocation of a sales person0s &F hours would lead to the
following revenue per month for a typical sales territoryB
C'$-&7,+
T;., D &0
C'$-&7,+$
T*7,
.,+ V*$*-
T&-/(
T*7,
E
T*7,
L,0-
EE
R,:,1',
.,+ V*$*-
T&-/(
R,:,1',
:arge C F hours FC hours KF hours D4F,CCC D4FC,CCC
/edium &F & hours FC hours &F hours D?C,CCC DKFC,CCC
9mall &F hour &F hours C DF,CCC D?KF,CCC
Total Revenue
"1#575#
Z @ (X of customers! (Time per visit!.
ZZ @ &F hours ( cumulative total time.
Thus, the typical sales person generates monthly revenue of "1#575#.
b. The key to Trey0s success is to realize that time is a scarce resource. 9ince
sales persons cannot visit all potential customers, the revenue$maximizing
strategy prioritizes customers by their revenue per hour of time (spent in
visits!. 7s shown below, this ranking changes the traditional ordering of
customersB
C'$-&7,+
T;.,
T*7,
.,+ V*$*-
R,:,1',
.,+ V*$*-
R,:,1', .,+
H&'+ &0 T*7,
:arge F.C hours D4F,CCC DS,CCC
/edium &.C hours D?C,CCC DF,CCC
9mall .C hours DF,CCC DF,CCC
Thus, medium and small customers should get top priority because they generate
DF,CCC in revenue per hour of time spent whereas large customers generate only
DS,CCC in revenue per hour of time spent.
9uch an allocation leads to the following revenue per monthB
C'$-&7,+
T;., D &0
C'$-&7,+$
T*7,
.,+ V*$*-
T&-/(
T*7,
E
T*7,
L,0-
EE
R,:,1',
.,+ V*$*-
T&-/(
R,:,1',
/edium &F & hours FC hours KF hours D?C,CCC DKFC,CCC
9mall FC hour FC hours &F hours DF,CCC DKFC,CCC
:arge F
Z
F hours &F hours C D4F,CCC D&&F,CCC
Total Revenue
"1#725#
Z @ (X of customers! (Time per visit!.
ZZ @ &F hours ( cumulative total time.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$S
Thus, we see why Trey is 9uper9ound0s top sales person ( he generates revenue
of "1#725#, or D,K&F,CCC ( D,FKF,CCC @ DFC,CCC more than other sales
persons. /oreover, Trey optimally allocates his time across 9uper9ound0s
customer base.
8oteB "oes prioritizing by sales per visit hour maximize not only revenue but also
company profitP The answer is )it depends* ( such a strategy also maximizes
profit only if the contribution margin ratio is the same for all three customer types.
'f different customer groups order a different mix of products (resulting in
different contribution margin ratios!, the firm needs to prioritize customers by
their contribution per visit hour to maximize profit.
8ote (advanced!B 'nstructors could also use this problem to underscore the agency
conflict and choice of performance measures. -or instance, the provided solution
of maximizing revenue might be optimal from the sales person0s perspective if
their incentives are based on revenue. <owever, the effort allocation might not be
optimal from the firm0s perspective. The store can manage this discrepancy by
compensating the sales person based on contribution margin. <owever, there is
more room for dispute in measuring contribution margin, which reduces its value
as a performance measure. -ormally, while contribution margin aligns incentive
more (is more congruent!, it also is harder to measure (has greater noise! than
revenue.
6.43
a. The following table summarizes the quantitative analysis, or the net monetary
benefit associated with accepting the assignment (compared to the status quo
of not accepting the assignment!B
I-,7 D,-/*( A7&'1-
-ee from new assignment .iven DFC,CCC
$ 7dditional tuition cost .iven E,CCC
$ 9alary given up due to
delayed graduation
DC,CCC per month
I 4 months
4C,CCC
8et benefit to accepting offer "2#
-rom a purely financial perspective, 3hristine should accept the assignment. 'n
this context, notice thatB
3hristine0s savings prior to entering the /B7 program and the amount of
her loan are not relevant as they do not differ between her two decisions.
The D&,CCC a month in living expenses (e.g., rent, utilities, and groceries!
is not relevant as 3hristine will incur this cost regardless of her decision.
That is, 3hristine expects to spend D&,CCC a month in living expenses
regardless of whether she is working or in college.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$&C
b. The net QimmediateR monetary benefit associated with accepting the assignment
is somewhat small and likely is not large enough for 3hristine to accept the
assignment. 3onsequently, 3hristine0s decision likely will hinge on qualitative
considerations. 9ome qualitative considerations includeB
"oes 3hristine desire to return to her old employer upon graduatingP 'f so,
the prospects for doing so certainly increase if she accepts the assignment.
+ill the assignment help 3hristine land a better =ob by, for example,
demonstrating how her /B7 degree has allowed her to go solo on
pro=ectsP
+ill this assignment provide a nice change of pace from the grind of
schoolworkP
+ill accepting the assignment unduly disrupt 3hristine0s /B7 studiesP
3hristine may worry about getting off track andLor being able to even take
the same classes next trimester (i.e., some classes are only offered
periodically! andLor graduating with her cohort (classmates and friends she
developed in the first & trimesters!.
7ll in all, 3hristine0s decision is not clear cut. <er presumed friendly relationship
with her ex$employer, the reputation value of being known as a team player, and
her desire to be a partner in a consulting firm might propel 3hristine toward
accepting the assignment.
6.44
a. 3harlie0s decision deals with ,43,$$ ),7/1). There are competing demands
for 3harlie0s time this evening, as he could either attend the Mnick0s game or
have dinner with the important client. 3harlie cannot perform both activities
this evening, giving rise to his dilemma.
b. The price paid for the two tickets is sunk and is not relevant to 3harlie0s
decision. The D;CC is spent regardless of whether 3harlie attends the game or
has dinner with the client. /oreover, 3harlie faces the same tradeoff if he had
found the tickets on the street or if he had paid D&,CCC for the tickets.
N&-,B 'n such decisions, many people do consider the price paid for the
tickets, in seeming contradiction to the idea that a sunk cost is not relevant.
One explanation could be that the price paid is a good measure of the
minimum opportunity cost of attending the game. (3harlie must expect to get
at least D;CC worth of =oy from the game. +hy else would he pay that much
for the ticketsP!. -rom a psychological perspective, having a readily available
estimate of the lower bound for a qualitative cost may cause people to focus
on the number as the opportunity cost.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$&
c. 1nless 3harlie can sell the tickets under the )dinner with the client* option,
his decision hinges on qualitative factors. 3harlie needs to weigh the lost
en=oyment from not being able to attend the Mnicks game against the cost of
upsetting the client if 3harlie chooses to go to the game (and not have dinner
with the client!. Both of these factors are qualitative ( the en=oyment from the
game is a function of 3harlie0s interest in sports, who he is going with, the
Mnicks0 chances of winning the series, and so on. 9imilarly, the cost of
upsetting the client depends on the client0s personality, the volume of
business, the client0s options, and so on. #ssentially, 3harlie has to
sub=ectively determine which option has the greater utility per hour. 3harlie
has a difficult decision to make.
PROFLEMS
6.45
a. 'n this problem, it perhaps is easiest to construct an entire income statement
for >ete0s >ets assuming he drops the birds and fish line and compare overall
profit to that reported in the problem text.
The following table computes the profit associated with the choice to discontinue
selling birds and fish, and use the space to expand dog and cat offerings.
D&2$ C/-$ T&-/(
2evenue

D&44,;C DFS,;CC D4C?,K;C


Aariable costs
&
SK,;;4 4K,EEC 4F,F44
3ontribution margin D4;,4S; D,K&C D&FE,&;
Traceable fixed costs
?
44,CCC ?C,;CC K4,;CC
3ommon fixed costs
4
F&,FCC F&,FCC CF,CCC
>rofit D4S,SS; D&E,;&C DKE,;;

B "og revenue @ D&E,CCC .& @ D&44,;C% 3at revenue @ D4&,FCC .& @


DFS,;CC.
&
B "og variable costs @ DEK,&CC .& @ DSK,;;4% 3at variable costs @ D4&,KFC
.& @ D4K,EEC.
?
B "og traceable fixed costs @ D?,FCC O D&,FCC @ D44,CCC% 3at traceable fixed
costs @ D&&,;CC O DE,CCC @ D?C,;CC.
4
B The common fixed rental cost would not decrease as >ete would incur this cost
whether or not he chooses to discontinue selling birds and fish. <owever, the
traceable fixed costs associated with this product line are avoidable. -or instance,
>ete would not need aquariums and equipment for cleaning fish tanks.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$&&
F/$,) &1 &'+ /1/(;$*$# P,-, $%&'() 1&- )*$3&1-*1', $,((*12 F*+)$ /1) G*$% /$
)&*12 $& (&5,+$ %*$ .+&0*- ?; "11#584# 0+&7 "9#2 -& "78#616.
This problem helps reinforce that, while change can be good, oftentimes
individuals and organizations are often doing better than we think we are doing5
<opefully, this will help students remember that the )grass is not always greener
on the other sideU*
b. 7s alluded to in the problem, >ete organizes his data at a very broad level,
classifying all revenues and costs vis$W$vis the type of pet (i.e., is the item
related to dogs, cats, or birds and fish!. +hile this presents one snapshot of the
business, it is possible that >ete would benefit from organizing the data
differently. -or example, the current format does not lend itself to examining
whether certain types of dogs or dog supplies are losing money. 't may be that
the overall profitability of dogs is hiding losses on a certain types of dog
treats, dog apparel, etc. To examine such issues, >ete may opt to report data at
a finer level ( for example, in the )dogs* category he may wish to report data
by breed of dog and type of supply. 'n such a way, it may be possible for >ete
to perform a more comprehensive evaluation of his business. 8aturally, >ete
needs to balance the benefits of more detailed reporting against the increased
costs of collecting and reporting more disaggregated data. -or instance, detail
might lead to more classification errors (e.g., it may be difficult to parse out
the direct fixed costs associated with a particular breed of dog or dog supply!.
'n turn, this error may lead >ete to draw an incorrect inference about the
profitability of a particular breed or supply!.
6.46
a. 9ince fixed costs are unlikely to change, the criterion is that the incremental
contribution margin should be at least equal to the value of the prize (D;,CCC!.
7ccordingly, we start by figuring out the contribution margin on each table.
1sing the data provided, we haveB
3ontribution margin per table @ DEK,FCCL,FCC @ D&F. Thus, salespersons
would need to sell an additional D;,CCCLD&F @ 48 -/?(,$ ,/3% @'/+-,+ -& H'$-*0;
+'11*12 -%, $/(,$ 3&1-,$-.
3ompanies frequently offer a bonus or prize only after a certain goal is met% this
goal may be based on sales in units, sales in dollars, net income, return on
investment, or residual income. 'n this example, >ippin may stipulate that the
prize will only be awarded if at least ,FFC tables are sold, which is FC more than
the current level of table sales. This effectively ensures that >ippin will not lose
money on the contest, thereby minimizing the downside risk of offering the prize.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$&?
b. 1sing the information from part QaR, the incremental contribution margin
associated with selling &EE more tables at D&F per table is D?;,CCC. Thus,
profit on the tables product line is expected to increase by D?;,CCC ( D;,CCC @
"3#.
c. /erry0s concerns probably are well founded. 'ndeed, the contest will stir most
salespersons0 competitive =uices and, as a result, shift much of their attention
to the sales of tables. >eople have limited attention and effort (there are only
so many hours in the day! ( thus, while the contest may increase salespersons0
overall effort somewhat, it is bound to re$allocate effort from the chairs
product line to the tables product line. 'n turn, sales of chairs likely will suffer.
+e calculated in part QbR that the sales contest is expected to increase profit on
tables by D?C,CCC. Thus, profit on chairs could decrease by D?C,CCC before overall
company profit decreases. 9ince the contribution margin on each chair @
D?&C,CCCLE,CCC @ D4C, this translates to D?C,CCCLD4C @ 75 3%/*+$.
>ippin would need to assess whether the sales contest will actually decrease sales
on chairs by this amount. >ippin may wish to consider offering trips to <awaii for
the salesperson selling the most tables and the salesperson selling the most chairs.
/oreover, with two product lines, >ippin needs to ensure that any incentive he
provides encourages salespersons to allocate their effort in a manner that
maximizes overall company profits, not =ust the profit on one product line.
d. 'n addition to concerns about whether the contest will adversely affect chair
sales, there are several other considerations, includingB
The contest is based on units. >ippin would need to put controls in place to
ensure that salespersons do not offer price discounts to increase their sales
numbers. That is, sales persons could actually sell more units without
increasing overall profit (i.e., there is a price, quantity tradeoff!. This is
perhaps why companies frequently set fixed prices on their products and
do not allow salespersons much leeway in altering prices.
>ippin would need to consider the effect on employee morale. 9uch
contests pit salesperson against salesperson and could adversely affect
cooperation.
6.47
a. Based on the information provided, 3ottage Bakery0s opportunity set consists
of three options ( the first option is the status quo and, indeed, this option is
viableB
. "o nothing with the remaining counter space. That is, continue to donate the
excess muffins and do not sell raspberry$filled croissants.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
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&. 1se the remaining counter space to sell day$old muffins. That is, do not
donate the excess muffins to the homeless shelter and do not sell raspberry$
filled croissants.

?. 1se the remaining counter space to sell raspberry$filled croissants. That is,
continue to donate the excess muffins to the homeless shelter and donate any
excess raspberry$filled croissants to the homeless shelter.
b. 6ption &B 1se the remaining counter space to sell day$old muffins. That is, do
not donate the excess muffins to the homeless shelter and do not sell
raspberry$filled croissants.
2evenue from )day old* muffins F D.FC FCH D.&F per day
8et increase in profit "11.25 .,+ )/;
8otice that the cost of making the muffins is not relevant ( it is a sunk
cost. 3ottage incurs this cost regardless of whether the excess muffins are
sold as )day old* or donated to the homeless shelter.
6ption ?B 1se the remaining counter space to sell raspberry$filled croissants. That
is, continue to donate the excess muffins to the homeless shelter and donate any
excess raspberry$filled croissants to the homeless shelter.
2evenue from raspberry croissants &C D&.CC D4C.CC per day
3osts of making raspberry croissants && D.&C (D&;.4C! per day
8et increase in profit "13.6 .,+ )/;
8otice that the cost of making the croissants is relevant because this cost will
only be incurred if management decides to make the raspberry$filled
croissants.
c. The C&--/2, F/8,+; $%&'() 3%&&$, &.-*&1 3 and use the remaining counter
space to sell raspberry$filled croissants, continuing to donate the excess
muffins to the homeless shelter, in addition to donating any excess raspberry$
filled croissants to the homeless shelter. This option leads to the largest
increase in 3ottage Bakery0s daily profit, or D?.;C. This option also seems to
be preferred from a social standpoint ( the homeless shelter will now receive
an average of & croissants per day, in addition to the &C muffins they currently
receive.
N&-,B +hile the problem examines profit before tax, we note that tax
considerations also arise. -or example, the donation to the charity might be tax
deductible.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
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6.48
a. :et us begin by calculating relative revenue.
N7A$CC B DEC,CCC
,7[$&CC D4C,CCC
Total D&C,CCC
Thus, &L?
rd
of the =oint cost (@ (DEC,CCCLD&C,CCC! I DCC,CCC @ D;;,;;K! would
be allocated to N7A$CC and the remainder to ,7[$&CC.
+e then haveB
'tem N7A$CC ,7[$&CC Total
2evenue DEC,CCC D4C,CCC D&C,CCC
7llocated cost D;;,;;K D??,??? DCC,CCC
>rofit "13#333 "6#667 D&C,CCC
b. :et us begin by calculating relative revenue.
N7A$CC DEC,CCC
,7[$4CC DEC,CCC
Total D;C,CCC
Thus, half the =oint cost is allocated to either product.
'tem N7A$CC ,7[$4CC Total
2evenue DEC,CCC DEC,CCC D;C,CCC
7llocated cost FC,CCC DFC,CCC DCC,CCC
Traceable cost &F,CCC &F,CCC
>rofit "3# "5# D?F,CCC
c. 3omparing the product$level profits alone, it would appear that 3hemco
should not process ,7[$&CC further. "oing so reduces profit from D;,;;K to
DF,CCC. <owever, we know that such a conclusion is erroneous because only
incremental revenues and costs are important for this decision. :et us
therefore calculate the net gain from processing ,7[$&CC further.
Aalue of ,7[$4CC DEC,CCC
:ost of ,7[$&CC lost (D4C,CCC!
8et gain in revenue D4C,CCC
3ost of additional processing (D&F,CCC!
8et value "15#
Thus, C%,73& 2/*1$ "15# ?; .+&3,$$*12 IAJA2 0'+-%,+. The amount of
the =oint cost, or how it is allocated, is not relevant for this decision.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
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6.49
a. The following table classifies each of the aforementioned items as being
relevant or not relevant and provides a succinct explanation for each
classification.
I-,7
R,(,:/1-K
<I &+ N= R,/$&1
2egular selling price
(DKF!
N& The regular sales price is not relevant
because 7ward >lus will not receive
this amount from the little$league
organization. 7dditionally, even with
the special order, 7ward >lus will be
operating below CCH of their
production capacity (i.e., K,FCC O
,ECC \ C,CCC!% thus, 7ward >lus
will not sacrifice any regular business
by accepting the special order.
9pecial order selling price
(DCC!
I,$ The additional revenue associated
with the special order clearly depends
on this value.
"irect materials cost I,$ >resumably, the special order medals
will require the same amount of
materials as other medals. Thus, the
cost is relevant.
"irect labor cost I,$ >resumably, the special order medals
will require the same amount of labor
as other medals. Thus, the cost is
relevant.
-ixed manufacturing cost N& -ixed manufacturing costs will be the
same in total regardless of whether
the special order is accepted. (9ince
7ward >lus will still be operating in
the relevant range if they accept the
special order!.
-ixed marketing G
administrative cost
N& -ixed marketing and administrative
costs will be the same in total
regardless of whether the special
order is accepted. (9ince 7ward >lus
will still be operating in the relevant
range if they accept the special
order!.
b. 1sing the classifications in the above table, the following table summarizes
the amounts by which each relevant cost or revenue will change if the special
order is accepted. The net of the increased revenues less the increased costs
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$&K
provides us with the incremental profit (or loss! associated with accepting the
special order. That is, we are using the incremental approach with status quo
as the benchmark option. ('n the text, we also called this method )3ontrollable
3ost 7nalysis.*!
'tem "etail Total
7dditional revenue DCC I ,ECC medals DEC,CCC
"irect materials cost DFC I ,ECC medals DSC,CCC
"irect labor cost D4C I ,ECC medals DK&,CCC
I13+,7,1-/( .+&0*- "18#
Thus, 7ward >lus0s profit is expected to *13+,/$, ?; "18# if they accept the
special order.
c. 2eferring to part QaR of the problem, the regular sales price is now relevant
since, by accepting the special order, 7ward >lus will sacrifice sales of ?CC
medals to their regular customers. /oreover, 7ward >lus will lose (DKF (
DFC ( D4C! ?CC @ D&F,FCC in contribution margin on regular business if they
accept the special order. Thus, the net benefit from accepting the special order
@ DE,CCC ( D&F,FCC @ (DK,FCC!. 'n other words, A5/+) P('$L$ .+&0*- 5*((
),3+,/$, ?; "7#5 *0 -%,; /33,.- -%, $.,3*/( &+),+.
+e can also see this effect by comparing the contribution margins from accepting
or not accepting the special order (since fixed costs will be the same across
decisions!. <ere, we employ the gross method to compute the contribution from
the two options.
3ontribution /argin (accept special order! @ QK,&CC (DKF ( DFC ( D4C!R O
Q,ECC (DCC ( DFC ( D4C!R @ D;?C,CCC.
3ontribution /argin (re=ect special order! @ K,FCC (DKF ( DFC ( D4C! @
D;?K,FCC.
7gain, we see that 7ward >lus0 profit is DK,FCC higher if they re=ect the special
order.
This problem reinforces that, in the short$term, capacity is fixed and, accordingly,
short$term decisions center on the best use of available capacity. 6ftentimes, it is
profitable to find uses for excess capacity, as shown in part QbR. <owever, there
also are situations where it is best to let some capacity remain idle, as shown in
part QcR. In short, the optimal use of available capacity does not necessarily mean
that all available capacity should be used.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$&E
6.5
<]gyoku has two optionsB (! run the special promotion or (&! do not run the
special promotion. 3alculating the incremental revenues and costs associated with
running the promotion is more difficult than it first appears. -irst, we need to keep
in mind that, while the price charge on winter items will decrease to D;, the
variable cost per item will not decrease. That is, the variable cost per winter item
will equal DS .4C @ D?.;C. This implies that the incremental contribution margin
due to the increased sales volume @ (D;.CC ( D?.;C! ,FCC @ D?,;CC. 9econd, we
need to consider the lost contribution margin on regular business related to winter
items ( that is, the D4,FCC in regular business means that <]gyoku typically
cleans D4,FCCLS @ FCC winter items each month. >resumably, these customers (in
the coming month! also will be charged D; for each winter item cleaned, implying
that the contribution margin on )regular* winter item business will go down by
FCC (DS ( D;! @ D,FCC. These two numbers, coupled with the increased
advertising expenditure, allow us to calculate the change in profit from running
the special promotionB
'ncremental contribution margin
from increased sales
(;.CC ( ?.;C! ,FCC D?,;CC
:ost contribution margin on
regular winter item business
FCC (DS ( D;! (D,FCC!
'ncremental advertising .iven (D,CCC!
8et change in monthly profit D,CC
<]gyoku should run the promotion as her profit in the coming month is expected
to *13+,/$, ?; "1#1.
6.51
a. 'n this problem, it is important to recognize that all of the common fixed costs
allocated to the dry cleaning operations would not disappear if the dry
cleaning business were to be closed. 9pecifically, the dry cleaning business
currently generates a segment margin of D?CC,CCC (DECC,CCC ( DFCC,CCC!.
This margin would not be available if the dry cleaning business were to close.
<owever, the common fixed costs would decrease by D&CC,CCC% thus, the net
reduction in profit is D?CC,CCC ( D&CC,CCC @ "1#. That is, 9pring-resh0s
profit will decrease by DCC,CCC to D&CC,CCC if it eliminates the dry cleaning
department.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$&S
This effect is perhaps most easily seen (and verified! by constructing an income
statement without the dry cleaning business. +e present such an income statement
belowB
:aundry 6nly
2evenue D?,CCC,CCC
Aariable costs D,CCC,CCC
3ontribution margin D&,CCC,CCC
"irect fixed costs D,CCC,CCC
3ommon fixed costs
Z
DECC,CCC
P+&0*- "2#
Z @ D,CCC,CCC ( D&CC,CCC.
7gain, we see that 9pring-resh0s overall profit ),3+,/$,$ ?; "1# -&
"2#. 7ssuming the accuracy of the estimate of the reduction in common
fixed costs, 9pring-resh should not eliminate its dry cleaning operations.
This particular problem underscores that income statements can be misleading in
terms of what a particular department or product actually contributes to overall
profitability. The key in making this assessment is determining what revenues and
costs actually disappear if the department is eliminated.
b. 'ncreasing the volume of laundry will increase the contribution margin
available to cover fixed costs. Based on the data provided, we find that each
D.CC of revenue in laundry provides DC.;K in contribution margin
(D&,CCC,CCC in contribution margin divided by D?,CCC,CCC in revenue!. Thus,
an increase of CH in laundry sales will increase the laundry contribution
margin by CH as well. This implies that the laundry contribution margin will
increase to D&,&CC,CCC. 6ur revised income statement with laundry only looks
as followsB
:aundry 6nly
2evenue D?,?CC,CCC D?,CCC,CCC .
Aariable costs D,CC,CCC D,CCC,CCC .
3ontribution margin D&,&CC,CCC D&,CCC,CCC .
"irect fixed costs D,CCC,CCC
3ommon fixed costs
Z
DECC,CCC D,CCC,CCC ( D&CC,CCC
P+&0*- "4#
<ere, we see that 9pring-resh0s overall profit *13+,/$,$ ?; "1# -& "4#.
7ssuming the accuracy of the estimates, 9pring-resh should eliminate its dry
cleaning operations as profit increases.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?C
'n constructing this income statement, however, notice the assumption that neither
the traceable fixed costs nor the common fixed costs would increase if the volume
of laundry were to increase by CH. This is a questionable assumption.
/anagement =udgment is key in determining whether the increase in the fixed
costs, if any, would exceed DCC,CCC, or the expected net increase in the firm0s
profit.
6.52
a. .o.o Nuice0s decision deals with ,43,$$ $'..(;. The competition has moved
in, soaking up some of .o.o Nuice0s monthly gasoline and merchandise sales.
3onsequently, .o.o Nuice finds itself in a position with )excess* gasoline and
merchandise (i.e., .o.o Nuice has the supply to accommodate more
customers!. 7 short$term promotion is one way to spur additional demand.
b. Because the question asks for the change in profit, we employ the incremental
approach with the status quo as the benchmark option. That is, we employ
controllable cost analysis. The following table calculates the expected change
in monthly profit if .o.o Nuice runs the special promotionB
I-,7 D,-/*( T&-/(
7dditional sales of gasoline .CE I DFC,CCC D&,CCC
7dditional sales of merchandise .& I DKF,CCC S,CCC
$ 3ost of additional gasoline sales C.KF I D&,CCC (S,CCC!
$ 3ost of additional merchandise sales C.FC I DS,CCC (4,FCC!
$ -ree merchandise sales C.C I Q(DFC,CCC
O D&,CCC!LDC.&CR
(E,CC!
I13+,7,1-/( .+&0*- <"6=
.o.o Nuice0s monthly fixed costs are not relevant to running the special
promotion because they will be incurred regardless of whether .o.o Nuice runs
the special promotion. 'n short, running the special promotion does not appear to
be a good idea because G&G& 9'*3,L$ 7&1-%(; .+&0*- *$ ,4.,3-,) -& ),3+,/$, ?;
"6.
c. By using a threshold, .o.o Nuice is trying to give customers the impression
that they are receiving DC.C in free merchandise for every DC.&C spent on
gasoline (after all, DC.FCLDC.CC @ DC.CF per D.CC, or DC.C per DC.&C!. 'n
reality, this is not the case since customers only receive DC.C per DC.&C spent
on gasoline if their purchase equals DC, D&C, D?C, etc. (i.e., some whole
number multiple of DC!. 6therwise, customers receive strictly less than DC.C
per DC.&C spent. -or example, a customer spending DS.SS on gasoline receives
DC.CC per DC.&C spent on gasoline in free merchandise and a customer
spending D&.FC on gasoline receives DC.FCLD&.FC @ DC.C4 per D.CC, or
DC.C per DC.&F in free merchandise. 3onceptually, the scheme converts a
variable discount to a step$discount, with DC as the step$size. This change
ensures that the actual discount provided will always be lower than DC.C per
DC.&C of gasoline sales.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?
/anagement of .o.o Nuice may believe that such a threshold will stimulate the
same increase in gas sales as before, thereby increasing monthly gas profit by
D?,CCC (@ D&,CCC $ DS,CCC% as shown in part QbR!. 7dditionally, because of the
threshold the scheme would reduce the )loss* on free merchandise sales (since
customers effectively receive less than DC.C per DC.&C spent on gasoline, there
will be less than DE,CC in free sales!. The cost (or risk! is that some savvy
customers may not respond to .o.o Nuice0s promotion and, as a result, demand
for both gasoline and merchandise will not increase as expected.
N&-,> 6rganizations devote much time and resources to structuring coupons and
promotions that look more attractive to customers than actually is the case. -or
example, businesses frequently offer rebates, but require customers to fill out
detailed paperwork to receive the rebate. The rebate then comes ;$E weeks later in
a package that looks like )=unk mail* (the company is hoping that the consumer
throws the letter away along with the other =unk mail!. 'n a similar fashion,
companies often issue coupons that can only be used later ( here, the company is
hoping the person will lose the coupon, thus lowering the redemption rate.
9imilarly, lottery organizations advertise the total payout in the =ackpot without
taking into the present value for money or taxes ( such accounting would reduce
the prize from say, DCC million, to D&F million5 The lesson is that organizations
frequently do what they can to increase sales, but minimize the cost of increasing
sales. 9pecial promotions and coupons are one way of providing consumers with
the )illusion of value.* The amount the firm saves is )breakage,* and could be in
the millions of dollars for firms such as Best Buy and <ome "epot.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?&
6.53
a. Timmy0s overall profit equals all revenues less all costs. 6ne could quickly
calculate profit for ?/--,+; -,$-,+$ as (D?F ( D&E! &C,CCC @ "14# and
profit for $&(,1&*) -,$-,+$ as (D&C ( D&&! C,CCC @ <"2#=. Thus, &:,+/((
.+&0*- @ D4C,CCC O (D&C,CCC! @ "12#.
/ore formally, one might depict overall profit and the profit for each product as
followsB
F/--,+;
T,$-,+$
S&(,1&*)
T,$-,+$ T&-/(
2evenue D?F &C,CCC%
D&C C,CCC
DKCC,CCC
D&CC,CCC DSCC,CCC
-ixed costsB
/anufacturing DC &C,CCC%
DC C,CCC
(&CC,CCC!
(CC,CCC! (?CC,CCC!
/arketing G
administrative
D4 &C,CCC%
D4 C,CCC
(EC,CCC!
(4C,CCC! (&C,CCC!
Aariable costsB
/anufacturing D& &C,CCC%
D; C,CCC
(&4C,CCC!
(;C,CCC! (?CC,CCC!
/arketing G
administrative
D& &C,CCC%
D& C,CCC
(4C,CCC!
(&C,CCC! (;C,CCC!
P+&0*- "14# <"2#= "12#
b. Timmy0s contribution margin equals revenues less all variable costs. Thus,
Timmy0s contribution margin on ?/--,+; -,$-,+$ equals QD?F.CC ( (D& O D&!R
&C,CCC @ "42# and Timmy0s contribution margin on solenoid testers
equals QD&C.CC ( (D; O D&!R C,CCC @ "12#. Thus, the -&-/(
3&1-+*?'-*&1 7/+2*1 @ D4&C,CCC O D&C,CCC @ "54#. /ore formally, one
might show overall contribution margin and contribution margin for each
product as (by re$arranging the income statement calculated in part QaR!B
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$??
F/--,+;
T,$-,+$
S&(,1&*)
T,$-,+$ T&-/(
2evenue D?F &C,CCC%
D&C C,CCC
DKCC,CCC
D&CC,CCC DSCC,CCC
Aariable costsB
/anufacturing D& &C,CCC%
D; C,CCC
(&4C,CCC!
(;C,CCC! (?CC,CCC!
/arketing G
7dministrative
D& &C,CCC%
D& C,CCC
(4C,CCC!
(&C,CCC! (;C,CCC!
C&1-+*?'-*&1 M/+2*1 "42# "12# "54#
-ixed costsB
/anufacturing DC &C,CCC%
DC C,CCC
(D&CC,CCC!
(DCC,CCC! (D?CC,CCC!
/arketing G
7dministrative
D4 &C,CCC%
D4 C,CCC
(EC,CCC!
(4C,CCC! (&C,CCC!
P+&0*- D4C,CCC (D&C,CCC! D&C,CCC
c. The key here is to realize that, as stipulated in the problem, the overall fixed
costs of D4&C,CCC will not decrease if Timmy drops the solenoid testers. Thus,
if Timmy stops producing the solenoid testers %*$ .+&0*- 5*(( ),3+,/$, ?;
"12#, which is the contribution margin from the solenoid testers
calculated in part QbR. 'n essence, this question illustrates the value associated
with restating income statements using a contribution margin format. The
profit effect of dropping solenoid testers also can be verified by constructing
an income statement with battery testers. 9uch an income statement is
presented belowB
F/--,+; T,$-,+$
2evenue DKCC,CCC
Aariable costsZ (&EC,CCC!
3ontribution margin D4&C,CCC
-ixed costs (4&C,CCC!
P+&0*- "
Z @ D&4C,CCC O D4C,CCC
7gain, we see that Timmy0s overall profit is expected to ),3+,/$, ?; "12# -&
".
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?4
d. +e see that unitizing fixed costs (expressing them on a per$unit basis! can
allow us to quickly calculate overall profitability or the reported profitability
of any particular product. That is, we can simply take the price per unit less
the cost per unit multiplied by the number of units sold. 1nfortunately,
unitizing fixed costs could lead to disastrous effects in terms of decision$
making. This outcome occurs because decision makers can be tempted to
multiply the unitized fixed cost by some new level of volume to arrive at total
fixed costs. 6ver many ranges of activity, however, fixed costs in total will not
change ( thus, it is important to remember that total fixed costs equal the fixed
cost per unit multiplied by the level of volume used to arrive at the fixed cost
per unit. By using one volume to calculate the fixed cost per unit and
multiplying it by another volume, the decision maker is treating the fixed cost
as if it were variable, which it is not. This feature QagainR underscores that
fixed costs often are not relevant to short$term decisions.
6.54
a. The incremental cost associated with the show appears to be D&FC, or the
variable cost of running the show. The QallocatedR fixed cost per show is not
relevant because the total amount of fixed costs for the year will not change as
a result of the special screening. -urther, the stated ticket prices are not
relevant because the show will take place in the mid$morning hours when the
'/7^ is not traditionally open ( thus, the students will not be displacing any
regular customers. Based on the financial data provided, the minimum price
quote appears to be "25.
b. 7t a minimum, 2andy should consider the followingB
"oes the 9cience 9tation have a gift shop andLor cafeteriaP 'f so, many students
are likely to buy food andLor gift items, thereby increasing the 9cience 9tation0s
contribution margin. 'n turn, this would reduce the minimum price quote in part
QaR.
+hat is the impact on future revenueP +hat proportion of the students and
teachers would have seen the show at the regular priceP (That is, what is the
opportunity cost in the form of lost revenueP!. 7lternatively, after seeing the show,
many students may return with their parents, thereby increasing future revenue.
7re there costs associated with the special showing that are not captured by the
D&FC variable cost numberP -or example, will the 9cience 9tation have to pay an
overtime premium for a pro=ectionist andLor usherP
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?F
c. 2andy probably should consider the educational mission of the 9cience
9tation. 9uch screenings directly contribute to this mission, the station, and,
hopefully, the betterment of the students. The special screening may be an
excellent way to expose some students to science ( these students may have
never gone through the 9cience 9tation if it were not for the school outing.
6verall, the )best* price to charge is unclear and requires some managerial
=udgment as 2andy needs to balance an array of financial and non$financial
factors.
6.55
+e can address this problem from both quantitative and qualitative perspectives.
-rom a quantitative perspective, the incremental costs and revenues associated
with reducing the length of stay from .E days to .F days are as followsB
I13+,7,1- )', -&
+,)'3*12 LOS
8umber of patients C,CCC
2eduction in average :69 C.?C
"ecrease in number of days (C,CCC .?C! ?,CCC
Aariable cost per day D&F
3ost savings from reducing :69 (?,CCC &F! D?KF,CCC
2evenue from increased re$admissions (&CC
FCC!
CC,CCC
3ost of increased re$admissions (FC,CCC!
T&-/( /))*-*&1/( $/:*12$M3%/12, *1 .+&0*- "425#
-rom a financial perspective, Tuincy0s plan makes sense ( the analysis suggests
that the hospital0s annual profit would increase by "425#. 6ne might also
sympathize with Tuincy0s logic ( the quest for survival in an era where hospital
revenues are fixed and medical costs are increasing have pushed many healthcare
administrators into making similar decisions (for example, maternity stays have
been reduced dramatically in recent years!.
There are, however, other important considerations. 6ne has to consider the effect
on patients being discharged )early.* 7t a minimum, numerous patients will
experience added discomfort and disruption in their lives. -urther, approximately
&CC patients will have to be re$admitted and undergo additional treatment ( there
are both monetary and non$monetary costs that will be borne by these individuals.
-inally, some patients may even die as a consequence of being discharged early.
<ere, the hospital0s and the management0s value systems play a key role in
determining these intangible, but very real and relevant, costs. -inally, one might
reasonably argue that by discharging patients early the hospital will incur negative
reputation costs or come under the scrutiny of the pressLmedia andLor medical
review boards.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?;
There is no )correct* answer to this problem ( the problem shows that for many
decisions in life it is important to balance quantitative and qualitative
considerations. "ecision models invariably incorporate both types of factors, and
students QrightfullyR may place different weights or values on the various factors.
/oreover, it is important to recognize and think about such tradeoffs ( hopefully,
the lively discussion the problem generates helps demonstrate the value of
viewing decision making as an exercise in model building and measurement, and
also see that decision models are unique, somewhat like an individual0s
fingerprints.
6.56
a. +e first calculate the incremental cost associated with offering the free web$
based tax$filing product, which isB
3ost of developing product $'18
3ost of maintaining product given D4&C,CCC
Aalue of names obtained &FC,CCC C.EC DC.CS (E,CCC!
'ncremental cost D4C&,CCC
8ext, since the unit contribution margin from the personal$finance software is
D&F.CC ( D.CC @ D&4.CC, the increased volume required can be calculated as
D4C&,CCCLD&4.CC @ 16#75 software packages. Because &FC,CCC individuals are
expected to use the free web$based product, the required proportion is
;,KFCL&FC,CCC @ 6.7N. This seems eminently reasonable.
b. There are many other factors to consider. >erhaps the most prominent relates
to the cannibalization of the stand$alone tax product. That is, offering the free$
web$based tax product is likely to eat into the sales of the stand$alone tax
product. The lost contribution margin on these sales needs to be factored in as
an incremental cost ( the problem does not, however, provide us with enough
information to calculate this opportunity cost.
There also are likely to be legal liability issues ( in offering the free web$based
product, Tax>lan needs to be concerned about system breakdown, loss of data,
incorrect transmission, and so on. 9hould the system fail for any reason, Tax>lan
likely exposes itself to legal action as well as negative publicity. 6ther factors
may relate to issues of how long returns need to be stored and how many names
will be )new* to the system.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
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c. The '29 has a financial interest because the costs (to the '29! associated with
receiving paper returns are substantially higher than the costs of receiving
electronic returns. 9ome of the incremental costs include having staff to
receive and open the paper returns, keying (inputting! the data from the paper
returns into the computer, correcting any errors in keying, storing the paper
returns, handling any checks, and so on. Thus, the '29 vastly prefers
electronic filing5 This aspect of the problem reminds students of the
importance in considering externalities in their decision making ( invariably,
the decisions we make affect others.
6.57
a. 3ompared to the status quo of keeping the recently acquired machines, the
table below presents the change in profit associated with acquiring the better
video poker machinesB
>roceeds from sale of
recently purchased
machines
D,CCC &FC D&FC,CCC
>rofit from increased
wagering on better
machines
D?C,CCC &FC .C
& years
,FCC,CCC
3ost of better machines DF,FCC &FC (,?KF,CCC!
I13+,/$,) P+&0*- "375#
The casino would gain D?KF,CCC over the two years by replacing the recently
acquired video poker machines with the better model. 8otice that the cost of the
recently acquired video poker machines, or D,&FC,CCC, is sunk and not relevant
to the analysis.
b. 7s shown above, the casino gains D?KF,CCC by replacing the recently acquired
video poker machines. The original acquisition cost is sunk and is not relevant
for this decision. <owever, if :ucy goes forward with the purchase of the
better machines, she risks damage to her reputation. 7fter all, it is her =ob to
foresee industry trends and she might appear to be careless or sloppy in her
duties. /oreover, management of the "iamond Nubilee might attribute a
D,CCC,CCC )error* to :ucy (D,CCC,CCC @ (DF,CCC ( D,CCC! &FC, or the
difference between the purchase and disposal price of the recently purchased
video poker machines multiplied by &FC machines!. The magnitude of this
error may be difficult to forget or live down. 7ll in all, :ucy probably would
think long and hard before she recommends acquiring the better machines.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?E
c. -rom the standpoint of the "iamond Nubilee, the change has no effect ( the
cost is still sunk and the casino would still favor acquiring the better machines
as &$year profit increases by D?KF,CCC.
6ne could argue, however, that the potential damage to :ucy0s reputation
increases as the magnitude of the price paid for the recently acquired machines
increases. The )error* attributed to :ucy would no longer be D,CCC,CCC but,
rather, D?KF,CCC (D?KF,CCC @ (D&,FCC ( D,CCC! &FC!. That is, from :ucy0s
perspective, the cost to acquire the old machines is not sunk because it affects the
magnitude of the damage to her reputation. 3ompared to our earlier analysis,
:ucy likely will be more inclined to recommend purchasing the better machines.
The classification of a cost as sunk is only valid within a decision context and for
the specified decision maker (please also see the continuation problem!. This is
because a sunk cost can influence the value for relevant items such as reputation.
Because different parties may care differently about factors such as personal
reputation, a cost that is sunk for one decision maker may be a relevant item for
another decision maker.
6.58
a. 7s shown in part QaR to previous problem, the D,&FC,CCC cost of the recently
acquired video poker machines does not affect the decision to purchase the
better video poker machines. This cost is sunk and it does not lead to
differential cash flows across options. /oreover, in a world without taxes it
does not matter whether the acquisition cost was D,&FC,CCC or, for that
matter, DC,CCC,CCC.
b. 'n this case, the acquisition cost, while sunk, does lead to differential cash
flows across options. 9uppose the new machines are not purchased. Then, the
existing machines will be depreciated over the next two years. The
depreciation expense will reduce taxable income, thereby reducing taxes paid.
(9pend a few minutes reviewing the difference between a cash outflow and an
expense.!
.iven the data for the "iamond Nubilee, keeping the existing machines produces
an overall tax benefit of C.&F I D,&FC,CCC @ "312#5.
8ow, consider the option of buying the new machines. The acquisition cost of the
old machines affects taxes paid in this case as well. 'f the better video machines
are purchased, the "iamond Nubilee will reap a tax benefit from the loss on selling
the )old* machines. This loss and concomitant tax benefit are shown belowB

>urchase price D,&FC,CCC
>roceeds from sale of recently purchased
machines (D,CCC &FC! &FC,CCC
:oss D,CCC,CCC
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$?S
Tax 2ate .&F
T/4 S/:*12$ "25#
The important points to notice are that the tax in either case depends on the
purchase price of the old machine and that the tax benefit is different across
options. That is, the tax effect is not a wash. K,,.*12 -%, &() 7/3%*1,$ ;*,()$ /1
/))*-*&1/( -/4 $/:*12$ &0 "62#5 @ D?&,FCC $ D&FC,CCC.
The acquisition cost, while sunk, clearly )matters* in a world with taxes because
it leads to differential cash flows between the options.
c. 7bove and beyond our calculations in part QbR, there are two other tax effects
we need to consider when we compute the profit impact of replacing the old
machinesB (! The taxes on profit from wagering, and (&! the tax shield due to
the depreciation on the new machine.
>roceeds from sale of
recently purchased
machines
D,CCC &FC D&FC,CCC
>rofit from increased
wagering on better
machines
D?C,CCC &FC .C & ,FCC,CCC
Tax on profit from
increased wagering >revious row I C.&F (?KF,CCC!
3ost of better machines DF,FCC &FC (,?KF,CCC!
Tax benefit due to
depreciation on new
machine
DF,FCC I &FC I &FH ?4?,KFC
8et tax benefit lost if old
machines are sold 3omputed in part b (;&,FCC!
I13+,/$,) P+&0*- <V/(', &0 7/3%*1,= "281#25
The casino would gain D&E,&FC over the two years by replacing the recently
acquired video poker machines with the better model.
The above table presented the incremental approach for buying the new machines,
with status quo as the benchmark (i.e., performed controllable cost analysis!. -or
completeness, we present the gross approach. -irst, we compute the profit if we
keep the old machines. (8oteB Because we do not know the wagers over the two
years associated with the recently acquired )old* machines, let us call it W. This
term )washes* out because it is common to both options.!
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4C
+agers on old machine 8ot known W
Tax on profit from wagers
in old machine W I &FH (C.&FW!
Tax shield because of
depreciation of old
machines
D,&FC,CCCI C.&F ?&,FCC
P+&0*- *0 5, 8,,. &()
7/3%*1,$
"312#5O .75 W
8ext, we compute the profit if the casino purchases the new machines.
>roceeds from sale of recently
purchased machines D,CCC &FC D&FC,CCC
Tax shield because of loss due
to sale
(DF,CCC$D,CCC! I
&FC I C.&F &FC,CCC
>rofit from wagering on better
machines
W O (D?C,CCC &FC
.C &!
W O D,FCC,CCC
Tax on profit from wagering >revious row I
&FH
(C.&FW O D?KF,CCC!
Tax shield because of
depreciation of new machines
DF,FCC I &FC I
&FH
D?4?,KFC
3ost of better machines
DF,FCC &FC (D,?KF,CCC!
P+&0*- *0 5, ?'; -%, 1,5
7/3%*1,$
.75W O "593#75
The difference in profit is D&E,&FC, as calculated before. The incremental method
has fewer steps and is less tedious. <owever, the gross method has fewer chances
for omitting items, and often is preferred by decision makers when the number of
options becomes large andLor the cash flow pattern is complex.
d. 9imilar to the previous problem, this problem reinforces the notion that the
classification of a cost as sunk and irrelevant is only valid within a decision
context and for a specified decision maker. +hile the earlier problem focused
on a multi$person, or strategic, setting the current problem illustrates that the
relevance can change in a single$person setting. This is because a sunk cost
can influence the value for relevant items such as taxes. /oreover, a cost that
is sunk and irrelevant for one decision context may be relevant for another
decision context.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
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6.59
a. The key aspect of this problem is to recognize that the original cost of the
existing case (D&C,CCC! is a sunk cost and, therefore, is not relevant for the
decision to repair the existing case or buy a new case. 7dditionally, the book
value of the existing case also is not relevant. The controllable costs
associated with each option follow (8oteB rather than deducting the utility
costs from the purchase price of the new case, these savings could be added to
the costs of repairing and keeping the existing case ( the net difference is still
D4,FCC in favor of repairing the existing case!B
3ost of the 8ew 3ase
>urchase price D&,CCC
1tility savings CC & CZ (&,CCC!
8et 3ost "9#
3ost to 2epair #xisting 3aseB
8ew motor and wiring "4#5
Z DCC per month for C years
+e see that it is cheaper for .ina to fix the existing case than buy the new case.
.ina saves "4#5 by repairing the existing case.
b. This information does not change the analysis in any way. The purchase price
of the existing machine and its current book value are simply not relevant for
the analysis (given the current setup!.
N&-,B The current book value could become relevant for the analysis if .ina could
claim a tax deduction for the loss incurred on the sale of the existing case. Thus, a
seemingly sunk cost (the book value of the old case! can become relevant because
it influences the value of a relevant cost (the tax loss!. This issue is more fully
explored in requirement QdR below.
c. 7bsolutely. The ability to sell the existing case for DF,CCC reduces the cost of
buying the new case from DS,CCC to "4# (alternatively, one could view this
as an opportunity cost associated with keeping the existing case% here, we
would add the DF,CCC to the cost of the existing case!. The cost of repairing
the existing case remains unchanged at "4#5. 3onsequently, .ina now
favors buying the new case by "5.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4&
d. .ina0s tax status can affect her decision because taxes will alter .ina0s out$of$
pocket costs associated with repairing the existing case versus buying the new
case. -or example, if .ina sells the existing case then she can claim the loss
on the sale as a tax deduction. 7dditionally, .ina0s expenses associated with
operating the cases will be deductible for tax purposes. That is, each dollar of
expense will reduce taxable income by D, thereby saving DC.?C in taxes. The
net after$tax cost of a dollar is thus only DC.KC. 9uch savings frequently are
referred to as a )tax shield.*
The controllable after$tax costs associated with each option follow. (7gain, please
note that costs such as expenditures on utilities can be framed as either reducing
the cost of buying the new case or increasing the cost of repairing the existing
case!% the net difference between the options is what we are afterB
3ost of the 8ew 3ase
>urchase price D&,CCC
>roceeds ( sale of old case not taxed (F,CCC!
1tility savings DCC & C (&,CCC!
Tax savings from purchase of new
case
.?C D&,CCCZZ (;,?CC!
Taxes on utility savings .?C D&,CCC ?,;CC
Tax savings ( loss on sale of old case .?C D,CCCZ (?,?CC!
8et 3ost <"2#=
3ost to 2epair #xisting 3aseB
Before tax cost for motor and wiring D4,FCC
Tax savings of ?CH
ZZ
.?C D4,FCC (,FCC!
Tax savings from depreciating
current
3ase
.?C I D;,CCC (4,ECC!
8et 3ost <"1#8=
Z
:oss @ D;,CCC (book value! ( DF,CCC (proceeds! @
D,CCC
ZZ
Both the original book value and the cost of
improvements will be depreciated over time, yielding a tax
shield.
.ina is better off (to the tune of "2! if she buys the new case. 'ndeed, the
negative cost of getting the new case suggests that .ina should have purchased
the new case even if the motor had not burned out ( perhaps .ina should thank
her assistant for leaving the case0s door open5
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4?
N&-,B The conclusion about a mistake increasing profit is, of course, tongue in
cheek...if the assistant had not made the mistake, no repairs would be necessary.
.ina would have had a net cost of (D4,ECC! from retaining the old case. +e do not
have enough data to say if the new case is preferred in this event. >resumably, the
resale price for the old case also would increase from DF,CCC if it were not broken.
N&-,B This problem features a non$standard treatment of the tax shield on the
purchase of the new case. Typically, the new case would be depreciated over time,
and the depreciation provides a tax shield. 7bsent a time value for money,
however, the net effect is a tax shield on the purchase price.
e. These types of )open$ended* questions are important to address because there
are numerous factors that are relevant to any decision but may be difficult to
quantify. 9uch measurement difficulties, however, do not relieve us from our
obligation to consider certain variables in the decision model. 'n this particular
example, .ina likely should consider whether the new case would have better
climate control and extend the shelf life of her flowers (this could increase
sales andLor reduce costs!. The new case also may be more or less attractive,
have a larger or smaller storage capacity, and so on. 'n turn, these factors
likely affect sales and, as such, can tilt the analysis in favor of buying the new
case or repairing the existing case.
6.6
a. -irst, we should determine Bob0s capacity to ensure that the professor0s order
will not impose any constraints on Bob0s business. 7t D;KF,CCC in sales, Bob
expects to operate at SCH of capacity% thus, we can calculate Bob0s capacity as
D;KF,CCCL.SC @ DKFC,CCC. 9ince the order is for DFC,CCC (with pre$discount
price!, Bob has enough idle capacity to fulfill the order without eating into his
regular business.
The next key is to realize that fixed costs would not change whether Bob provides
the professor with a discount. -urther, Bob will incur DC.4F in variable costs for
each pre$discount sales dollar.
+e are now in a position to calculate, relative to the status quo of not accepting
the order, the incremental costs and benefits of accepting the order asB
'ncremental revenue DFC,CCC .KF D?K,FCC
'ncremental costs DFC,CCC .4F (D&&,FCC!
N,- I13+,/$, *1 P+&0*- "15#
Thus, Bob0s profit increases by "15# as a result of providing the professor with
the &FH discount. This assumes, of course, that some of Bob0s other customers
also will not demand a similar discount, in which case, Bob needs to factor in the
lost contribution margin on these orders.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$44
b. 'f Bob is operating at S;H of capacity at a sales level of D;KF,CCC we can
calculate Bob0s capacity in sales dollars as D;KF,CCCL.S; @ DKC?,&F. 9ince
the order is for DFC,CCC, this implies that Bob will have to sacrifice DK&F,CCC
(D;&F,CCCODFC,CCC! ( DKC?,&F @ D&,EKF in regular business.
'f Bob sacrifices D&,EKF in regular business he will lose D&,EKF .FF @
D&,C?.&F in contribution margin. This amount reduces the increase in profit we
arrived at in part QaR, resulting in a net increase in profit of DF,CCC ( D&,C?.&F
@ "2#968.75 by providing the professor with the discount.
c. 'n this case, Bob will lose DFC,CCC in regular business, which amounts to
DFC,CCC .FF @ D&K,FCC in lost contribution margin. 'n turn, by providing the
professor with the discount Bob0s profit will decrease by DF,CCC ( D&K,FCC @
"12#5. 8otice that this corresponds perfectly to the amount of the discount,
or DFC,CCC .&F @ "12#5. Barring some unusual circumstances, Bob should
not provide the professor with the discount.
This problem helps illustrate the opportunity cost of capacity. 'n part QaR capacity
was not binding and, as a result, the opportunity cost of capacity was DC. 'n part
QbR, acceptance of the special order meant that capacity did bind, resulting in a
loss of some regular business. <owever, the opportunity cost of capacity was such
that it did not exceed the increased contribution margin associated with giving the
professor the &FH discount. 'n part QcR, acceptance of the special accepting again
meant that capacity did bind, in this case resulting in a $for$ loss of regular
business. <ere, the opportunity cost of capacity does exceed the increased
contribution margin associated with giving the professor the &FH discount.
/oreover, the opportunity cost exactly equals the discount itself, as all other costs
are unaffected.
6.61
The incremental revenue to #dmund from accepting the pro=ect @ &C hours C.FC
DCC per hour @ D,CCC. Based on the information provided, the incremental
financial cost appears to be DC as #dmund0s costs are mostly fixed. 7dditionally,
because this is the slow season, #dmund likely has enough free time (idle
capacity! to do the pro=ect. That is, #dmund probably will not be foregoing
another =ob by taking on this pro=ect. Thus, from a purely quantitative standpoint,
#dmund increases his profit by D,CCC from accepting the pro=ect.

-rom a qualitative standpoint, accepting the pro=ect may curtail #dmund0s
recreational activities. Thus, #dmund needs to consider the value he attaches to
his )free* time ( it is quite possible that #dmund values &C hours of free time
during the off$peak months at an amount greater than D,CCC.
-rom a qualitative standpoint, #dmund also needs to consider whether accepting
the pro=ect will lead other clients to demand similar loyalty discounts during the
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4F
slow season ( surely, this is a position #dmund does not wish to be in. -inally,
#dmund needs to assess whether re=ecting the pro=ect will lead to a loss of all
future business with this client.
Because the increase in profit from accepting the pro=ect is rather small, it is
likely that #dmund0s decision will hinge on the qualitative factors.
6.62
a. The first step is to rank$order the products per their contribution margin of the
scarce resource (binding constraint!. -or 9ylvester0s, the cold rolling mill
(32/! is the scarce resource. Thus, we need to calculate each product0s
contribution margin per minute of 32/ usage. "oing so yieldsB
A((&; C&*($
S-,,(
F/+$ W*+,
3ontribution margin per pound
D.4C DC.4F DC.SE DC.KF
/inutes per pound in 32/ C.C C.C? C.?F C.?C
3ontribution per minuteZ "14. "15. "2.8 "2.5
Z @ (contribution margin per pound!L(minutes per pound in 32/!
6ur analysis reveals that coils are the most profitable product, followed by alloy,
steel bars, and then wire. 3oils are most profitable because they make the most
efficient (in the sense of contribution to profit! use of the resource that limits
9ylvester0s profit ( the 3old 2olling /ill. Barring other constraints (see part QbR!,
we would recommend that 9ylvester0s use all of its available 32/ capacity to
produce coils.
9ince the 3old 2olling /ill can be operated for &4,CCC minutes per month and
coils yield DF.CC per minute, 9ylvester0s total contribution margin for the month
@ &4,CCC I DF.CC @ D?;C,CCC. -rom this, we subtract 9ylvester0s monthly fixed
costs of D&CC,CCC (@ D&,4CC,CCCL&! to arrive at a 7&1-%(; .+&0*- &0 "16#.
b. Based on our calculations in part QaR, 9ylvester0s should devote all available
capacity to coils. <owever, this assumes a perfectly competitive market, or a
fixed output price and unbounded demand at this price. 6f course, there may
be market constraints that prohibit 9ylvester0s from producing coils only. ('n
operations, this is called a corner solution.! -or example, our solution calls for
9ylvester to produce &4,CCCL.C? @ ECC,CCC lbs. of coils per month, or
S,;CC,CCC lbs. of coils per year. .iven 9ylvester0s overall size, it is not clear
that the demand for their coils (used in appliances! is this high, requiring
9ylvester0s to use 32/ time to produce other products, as it currently does.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4;
/ore generally, 9ylvester0s would devote as much time as possible to coils until
the contribution per minute in the 32/ (due to market constraints! was lower
than alloys. 't would then turn its attention to alloys and devote the maximum
attention to this product until its contribution margin per minute in the 32/ was
=ust lower than steel bars. This process would be repeated until 9ylvester0s )runs
out* of 32/ time. 'mplementing this strategy, though, requires that we know the
market demand constraints for each of the products. This information is not
available in the problem, but clearly is necessary for optimal decision$making.
'n addition to confirming price, we also would want to check the reliability of the
variable cost number in the computation of the contribution margin. -or example,
9ylvester0s may classify direct labor cost as being variable. <owever, if, as is
typical for steel mills, the company is a union shop where employees have a
guaranteed contract, then 9ylvester0s essentially is committed to paying its
employees regardless of output or product mix. Thus, the labor cost may be more
like a fixed cost than a variable cost.
#ach product0s contribution margin might change if the amount of direct labor
cost that previously was included in the contribution margin differed across the
four products. 'n turn, this could change our rank ordering of products vis$W$vis
product profitability.
N&-,B This problem to the )Theory of 3onstraints* (T63!. The T63 essentially
argues that even variable selling and variable overhead costs are fixed in the short
run. 3onsequently, the contribution under T63 equalsB sales ( materials cost.
7gain, if )variable* overhead and selling costs differ across products, the ranking
of products could change. /oreover, this problem encourages students to think
critically about what is )fixed* and what is )variable.*
6.63
a. 3rash faces a problem of excess demand. <e only has ?CC square feet of space
available.
To install the maximum desired number of each game, he would needB
Aideo games F I FC square feetLgame &FC square feet
"ance games & I KF square feetLgame FC square feet
9imple games ; I C square feetLgame ;C square feet
Total space needed 4;C square feet
Thus, 3rash has to ration available space among the games. 7s detailed in the
text, he could determine the profit$maximizing mix by considering the
contribution margin per unit of the scarce resource. 'n our case, the scarce
resource is space. The following table shows the contribution margin for each
game per square foot.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4K
Aideo
.ame
"ance
.ame
9imple
.ame
2evenue per hour
(fully occupied!
D&C D4C DF
6ccupancy rate 4CH ?CH CH
Total hours available
per week
CC CC CC
2evenue per week (@
revenue per hour I
occupancy rate I
hours available!
DECC D,&CC DFC
/aintenance costs
per week
DCC D?CC DC
3ontribution margin
per week
DKCC DSCC DFC
9quare feet
occupiedLmachine
FC KF C
3ontribution per
square foot
D4 D& DF
Thus, a simple ranking would show 3rash0s optimal allocation of space to beB
; simple games ;C square feet
4 video games &CC square feet.
1nused space 4C square feet.
+ith this solution, we could compute 3rash0s profit asB
; simple games I DFCLweek DSCC per week
4 video games I DKCCLweek D&,ECC per week
Total D?,KCC per week.
b. 6ur solution from part QaR does not use all available capacity because our
three choices involve a minimum amount of spaceB that is, they are )lumpy.*
+e need C square feet for a simple game, FC square feet for a video game,
and KF square feet for a dance game. The left over space of 4C square feet is
too small to accommodate a video game or a dance game, and we do not need
more space for the simple games.
c. Two features of the solution to part QaR are problematic. -irst, the solution
does not include any )dance* games and having at least one dance game
seems very important from a marketing perspective. 9econd, more than CH
of the space is wasted. :et us therefore modify the solution a bit to see if we
could do better.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4E
-irst, let us consider putting in one dance game and then optimally allocate the
remaining space.
dance game KF square feet
; simple games ;C square feet
? video games FC square feet.
1nused space F square feet.
+ith this allocation, we could compute 3rash0s profit asB
dance game I DSCCLweek DSCC per week
; simple games I DFCLweek DSCC per week
? video games I DKCCLweek D&,CC per week
Total profit D?,SCC per week.
7nother possible modification is to only install five simple games (saving C
square feet! and installing five video games. +ith this, we haveB
F simple games FC square feet
F video games &FC square feet.
1nused space C square feet.
+ith this solution, we could compute 3rash0s profit asB
F simple games I DFCLweek DKFC per week
F video games I DKCCLweek D?,FCC per week
Total profit D4,&FC per week.
d. This problem highlights a hidden assumption in the above$cited rule. 'n
particular, the rule implicitly assumes no constraints in how we use capacity
for available uses. 'n the context of 3rash0s problem, this means that we could
install, for example, &.F4 video machines or .&; dance machines. 'n other
words, each of the games must be )smooth* in its use of the scarce resource,
space. This assumption is clearly not tenable in some situations.
<ow can we modify the rule for such situationsP 'n classes on operations
management, we can formulate problems with constraints on use (e.g.,
)lumpy* uses! as integer programming problems and obtain optimal solutions.
The intuition for the solution methodology is to use the rule cited in the
question to identify an initial solution and then to improve on it via various
algorithms.
The overarching point is that the simple rule gives us an excellent starting
point to find the optimal solution even if it ignores some real world
constraints. The rule guarantees the optimal solution only when each resource
is )smooth* in its use of the scarce resource.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$4S
6.64
a. 9pace is the binding constraint in this problem and, accordingly, Aidya needs
to allocate products according to their contribution per unit of space (e.g.,
cubic foot!. 2eferring to newspaper sales per unit of space as x, we can make
this calculation as followsB
CM
<"1 &0 $/(,$=
S/(,$ .,+
'1*- &0 $./3,
CM .,+ '1*- &0
$./3,
8ewspapers C.C x DC.Cx
/agazines C.&F Fx D.&Fx
9nack foods C.&C Cx D&.CCx
Thus, the maximum possible space should be devoted to snack food items and the
least amount of space should be devoted to newspapers. 9ub=ect to the other
constraints identified in the problem, this leaves Aidya with the following
allocation of her available spaceB
CM
.,+ '1*- &0 $./3, S./3, A((&3/-,)
9nack foods D&.CCx CH (limit!
/agazines D.&Fx 4CH (plug!
8ewspapers DC.Cx FCH (minimum!
Thus, Aidya would allocateB
3 .5 B 15 3'?*3 0,,- -& 1,5$./.,+$
3 .4 B 12 3'?*3 0,,- -& 7/2/C*1,$# /1)
3 .1 B 3 3'?*3 0,,- -& $1/38 0&&)$
b. 7 prudent place to start is with the multi$product 3A> model with a weighted
contribution margin ratio (W!R! formulation. 2ecall from 3hapter 4B
"rofit @ (W!R Revenue! ( #ixed costs.
1nfortunately, we do not know the sales prices of each item. 7s in part QaR, we
assume that each cubic foot generates Dx of sales in newspapers. Then, a cubic
foot devoted to magazines and candy will generate DFx and DCx of revenue
respectively. The following table uses these numbers to calculate the total
contribution margin ratio per average sales D
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$FC
I-,7 S./3,
T&-/( S/(,$ B 3'?*3 0,,-
P $/(,$ " .,+ 3'?*3 0&&-
CM BCMR .,+ $/(,$ "
P -&-/( $/(,$
8ewspapers FC cubic foot DFCx (@ FC I Dx! DFx
/agazines &C cubic feet D;CCx (@ &C I DFx! DFCx
9nacks ?C cubic feet D?CC x (@ ?C I DC x ! D;C x
Total D,CFCx D&&Fx
Thus, Aidya expects to make a total contribution of D&&Fx on sales of D,CFCx,
where x is the sales in D per cubic foot devoted to newspapers. "ividing, we
haveB
W!R @ D&&FxLD,CFCx @ &.4&E;H
Thus, the breakeven revenue @ D&,KCCLC.&4&EF @ D&,;CC.
+e can divide the required sales volume (D&,;CC! by the amount of cubic feet
available (?CC cubic feet! to get the sales as "42 .,+ 3'?*3 0&&-.
N&-, : This problem assumes a continuous stocking model ( that is, Aidya never
runs out of any product.
MINI CASES
6.65
a. 3ody faces excess demand for his services% accordingly, 3ody needs to
determine which group he is best off booking. To make this assessment, we
compute the incremental revenues and costs associated with booking each
group.
+e begin by calculating the increase in 3ody0s business incomeB
Trip
'tem "etail 1pper Meys :ower Meys
-are .iven D?CC DFCC
-uel and oil costs
a
;Cmiles D.?C%
4CCmiles D.?C
D4E
D&C
/aintenance costs
a
;Cmiles D.F%
4CCmiles D.F
D&4
D;C
C&1-+*?'-*&1 7/+2*1 "228 "32
a
B 7lthough the trip is only one way, 3ody will incur round$trip costs for fuel, oil,
and maintenance. Thus, the round$trip costs are relevant.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$F
8otice that the cost of the bus, office operating expenses, and advertising costs are
all fixed. These costs do not vary with respect to 3ody0s decision and, thus, are
not relevant. -or a similar reason, the fixed cost associated with insurance also is
excluded.
Based on our calculations, 3ody0s business income will increase by D?&C if he
books the trip to the :ower Meys and by D&&E if he books the trip to the 1pper
Meys.
3ody0s expected tip also is relevant to this decision. The expected tip for a trip to
the :ower Meys @ DFCC .F @ DKF, while his expected tip for a trip to the 1pper
Meys @ D?CC .F @ D4F.
Thus, 3ody0s overall (business O personal! income will increase byB
D?&C O DKF @ "395 *0 %, ?&&8$ -%, -+*. -& -%, L&5,+ K,;$, and
D&&E O D4F @ "273 *0 %, ?&&8$ -%, -+*. -& -%, U..,+ K,;$.
'n short, 3ody0s overall income increases by D?SF ( D&K? @ D&& more by
booking the trip to the :ower Meys versus booking the trip to the 1pper Meys.
7bove and beyond the financial benefits, 3ody would need to consider the
additional hours it will take to the complete the trip to the :ower Meys. By
booking the group going to the :ower Meys, it is likely that 3ody will not return
home until late at night. 'f 3ody has plans for the evening (e.g., a family event,
playing poker with his buddies, watching the big game with friends!, this could
tip the scales in favor of booking the trip to the 1pper Meys. 3ody also likely will
consider whether each group has used his services in the past and is likely to do so
in the future (i.e., is the relationship ongoing or one time!.
b. This piece of information changes the problem in a relatively straightforward
way ( 3ody will now earn a fare on the return trip from the 1pper Meys but
(as assumed in part QaR! not on the return trip from the :ower Meys.
7dditionally, 3ody will earn a tip on the return trip from the 1pper Meys.
Thus, 3ody will be able to put the excess supply on the return trip from the
1pper Meys to profitable use.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$F&
The revised calculations are presented belowB
Trip
'tem "etail 1pper Meys :ower Meys
-are
D?CC &%
DFCC
D;CC
DFCC
Tip
D;CC .F%
DFCC .F
DSC
DKF
-uel G oil costs
;Cmiles D.?C%
4CCmiles D.?C
(D4E!
(D&C!
/aintenance costs
;Cmiles D.F%
4CCmiles D.F
(D&4!
(D;C!
'ncrease in business O
personal income
"618 "395
+e now see that 3ody prefers the trip to the 1pper Meys as his overall (business O
personal! income increases by D;E, or D;E ( D?SF @ "223 relative to booking
the group traveling to the :ower Meys. The switch in 3ody0s preference relative
to part QaR relates to the additional D?CC fee O the D4F tip (@ D?CC I C.F!% in other
words, D?CC O D4F ( D&& @ D&&?.
<ere, we see the importance of the effective utilization of available capacity to
maximize income. 'n this particular setting, the benefit of 3ody to making a trip
to the 1pper Meys or :ower Meys depends crucially on whether he has a paid
return trip.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$F?
c. The following table re$classifies 3adillac 3ody0s business and personal
income data by when the trip was madeB peak season or off$peak season.

>eak Trips 6ff$>eak Trips Total
2evenue
a
DF&,FCC D;K,FCC D&&C,CCC
Tips
b
D&&,EKF DC,&F D??,CCC
-uel G oil costs
c
(DE,KFC! (D,&FC! (D?C,CCC!
/aintenance costs
d
(DS,?KF! (DF,;&F! (DF,CCC!
3ontribution /argin "147#25 "6#75 D&CE,CCC
3ost of bus
e
(D;C,CCC!
'nsurance costs
e
(DC,CCC!
6ffice operating expenses
e
(D4F,CCC!
Brochures G advertising
e
(DF,CCC!
6verall 'ncome "88#
a
B DF&,FCC @ (&KF D?CC! O (4C DFCC!% D;K,FCC @ (&F D?CC! O (;C DFCC!.
b
B D&&,EKF @ DF&,FCC .F% DC,&F @ D;K,FCC .F.
c
B DE,KFC @ ;&,FCC .?C% D,&FC @ ?K,FCC .?C.
d
B DS,?KF @ ;&,FCC .F% DF,;&F @ ?K,FCC .F.
e
B all of these costs are fixed and cannot be traced to the timing of the trip.
9ince both the peak and the off$peak seasons last for ; months (or roughly &;
weeks!, 3ody will lose D4K,&FCL&; @ "5#663 in overall income if he schedules the
trip for M/+3% and D;C,KFCL&; @ "2#337 in overall income if he schedules the trip for
9'(;.
This information is likely to be very useful to 3ody and his wife in planning their
vacation5 2ightfully, this is part of the opportunity cost of going on vacation and
should be added to the other vacation costs. 'n essence, we see that it costs 3ody
substantially less to vacation during Nuly (3ody0s off$peak business season! than
during /arch (3ody0s peak business season! ( C&); (&$,$ (,$$ *13&7, ?;
$3%,)'(*12 %*$ :/3/-*&1 *1 / .,+*&) &0 ,43,$$ $'..(;.
This part of the problem also shows us the importance of taking aggregate data and
breaking it into smaller pieces. 'f 3ody were to use his overall income to guide his
vacation decision, he might erroneously conclude that he would lose only DEE,CCCLF&
weeks @ D,;S& by going on vacation. This calculation, however, ignores both fixed
costs and the timing of the trip. 3ody might do a little better with the overall business
contribution margin data, calculating that he would lose D&CE,CCCLF& @ D4,CCC by
taking the trip. This number, however, still ignores the seasonal nature of 3ody0s
business. 3ody would underestimate the cost of taking a vacation in /arch and
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$F4
overestimate the cost of taking a vacation in Nuly. /oreover, 3ody sacrifices the least
amount of income by taking the trip during the non$peak season.
d. 7ssuming the friend0s calculations are accurate, we calculate 3ody0s
incremental income as followsB
6ff$>eak Trips
(normal fare!
6ff$>eak Trips
(&FH discount!
2evenue
a
D;K,FCC DE,CCC
Tips
b
DC,&F D&,FC
-uel G oil costs
c
(D,&FC! (DF,KFC!
/aintenance costs
d
(DF,;&F! (DK,EKF!
3ontribution /argin
(business and personal income! "6#75 "69#525
a
B D;K,FCC @ (&F D?CC! O (;C DFCC!% DE,CCC @ Q(&F .;C! (D?CC .KF!R
O Q(;C .;C! (DFCC .KF!R.
b
B DC,&F @ D;K,FCC .F% D&,FC @ DE,CCC .F.
c
B D,&FC @ ?K,FCC .?C% DF,KFC @ ?K,FCC .4C .?C.
d
B DF,;&F @ ?K,FCC .F% DK,EKF @ ?K,FCC .4C .F.
8otice that the cost of the bus, office operating expenses, and advertising costs are
all fixed. 9ince these costs do not vary across 3ody0s decision, they are not
relevant. -or a similar reason, the fixed cost associated with insurance also is not
relevant. (7bsent information to the contrary, we are assuming that the additional
mileage will not decrease the bus0s salvage value. 7ny such decrease would
diminish the attractiveness of slashing off$peak fares.!
7ssuming the friend0s numbers are accurate, we see that 3ody0s overall business
and personal income will increase to "69#525, which represents a D;S,F&F (
D;C,KFC @ "8#775 increase in overall income compared to his current pricing
strategy.
'n terms of evaluating the advice, we would first need to consider whether 3ody
actually would want to be this much busier during the off$peak season ( perhaps
3ody en=oys the free time and having a more relaxed schedule for half of the year.
7t another level, we see that such differential pricing strategies (also known as
peak$load pricing! are widely followed. 2eady examples are utility firms that
offer different rates based on time$of$use, airlines offering summer specials,
hotels offering )deals* for weekend getaways, and golf courses offering reduced
rates for winter or mid$week play. The pricing strategy makes sense when fixed
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$FF
costs are relatively high, implying that capacity utilization is key for maximizing
profit.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$F;
+hile this strategy may work well for airlines and hotels, it probably will not
work well for 3adillac 3ody. 9tated simply, the strategy works well for airlines,
hotels, and golf courses because the size of the overall market changes (it
increases! when these organizations cut prices. 'n other words, spurred by a low
airfare or a low green fee, more people will travel or play golf. The increase in the
market size is the source for the incremental revenue. -or 3adillac 3ody,
however, his actions are likely to have minimal impact on market size. 7fter all,
people do not plan a vacation, costing thousands of dollars, based on the prices of
local transportation5 The number of people traveling to the Meys will be the same
regardless of whether 3ody keeps his prices the same or slashes them (similarly, a
relatively small change in shuttle$bus fees are unlikely to affect the number of car
rentals!.
'f 3ody were to cut his prices, it also is likely that other shuttle$bus operators will
cut their prices. 9ince market size and market share are likely to stay the same,
everyone will make a lower profit5 'n other words, the friend0s calculation
assumes that all other persons would stay put, which is not a good assumption in
the real world. .iven this insight and the fact that lowering prices will not affect
the overall size of the market, 3ody would be well advised not to lower his off$
peak prices.
6ne may well ask what prevents 3ody (and the other bus operators! from raising
prices to exorbitant amounts. 9ome amount of price$gouging no doubt takes
place. +e must remember, however, that this is a market with relatively low entry
barriers. 'f shuttle$bus operators start making too much money, competition is
likely to intensify and exert downward pressure on prices. >rice gouging is mostly
likely to occur in settings where the customer is not very price sensitive and non$
market forces prevent competitive entry (e.g., as for a professional or college
sports team!.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$FK
6.66
a. -or all practical purposes, <annah really has only two decision optionsB
6ption B 7ccept >iedmont0s business and re=ect 3apelli0s offer. Thus, in
total, S& suites (@ ?&C I C.;C% KF to >iedmont and K to individuals! will
be booked for each of the three days at the end of -ebruary, with a daily
occupancy rate of ;CH, which is close to the usual level.
6ption &B 7ccept 3apelli0s business and re=ect >iedmont0s offer. Thus, all
available suites or ?&C suites (&&F to 3apelli and SF to individuals! will be
booked for each of the three days.
Technically, <annah has a third decision option. 9he could re=ect both >iedmont
and 3apelli ( this is the status quo. <owever, <annah does not view this option to
be part of her opportunity set. 7s discussed in 3hapter &, <annah has pruned her
opportunity set to focus on her two most viable choices.
b. The table below presents the total costs and total revenues associated with
each of <annah0s decision options. In employing the gross approach, we only
included revenues and costs related to the three days in $uestion. Thus, we did
not include #legant 9uite0s normal revenues or variable costs for the other
days in the month. +e also did not include #legant 9uites0 overall fixed costs.
+e could include any or all of these amounts under the gross approach as they
are the same across <annah0s two options. /oreover, it is the difference in
profit that we ultimately are interested in.
The total revenues for each option comprise monies received from both corporate
and individual suite rentals. 3orporate suite revenues equal the number of
corporate suites for the ?$day period D&C% individual suite revenues equal
number of individual suites for the ?$day period DFC% convention center
revenues are DF,CCC per day, and food, telephone, and movie revenues equal the
total number of suites occupied D&F.
Aariable costs comprise food, laundry, supplies, telephones, and movies (cost @
total number of suites D?C% D?C @ DEC,CCCL;,CCC!, and labor related to cleaning
and cooking (for >iedmont, this is the total number of suites D?F% D?F @
D&C,CCCL;,CCC% for 3apelli, this cost is the total number of suites DF&.FC D?F I
.FC!, since <annah will have to pay an overtime premium if she accepts the
3apelli offer!. -inally, #legant 9uites will spend D?,CCC to build the runway for
3apelli. (8oteB as discussed earlier, the other remaining labor fixed costs for hotel
management and building and grounds are not controllable for this decision and,
thus, we did not include them as part of the total cost of each option!.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$FE

A33,.-
P*,)7&1-
A33,.-
C/.,((*
"ataB
Total suites ( corporate &&F ;KF
Total suites ( individual ?F

&EF
&
>rice per suite ( corporate D&C.CC D&C.CC
>rice per suite ( individual DFC.CC DFC.CC

2evenuesB
9uites ( corporate D&K,CCC DE,CCC
9uites ( individual F&,;FC 4&,KFC
3onvention center F,CCC F,CCC
-ood, telephone, G movies 4,4CC
?
&4,CCC
Total revenues DCS,CFC D;&,KFC

Aariable 3ostsB
-ood, laundry, supplies, etc. DK,&EC D&E,ECC
:abor (kitchen help, maids! &C,;C
4
FC,4CC
C&1-+*?'-*&1 7/+2*1 DK,;C DE?,FFC

7dditional -ixed 3ostsB
Build runway D?,CCC
QP+&0*-R "71#61 "8#55

?F @ Q(?&C I ? days! I C.;CR ( &&F.


&
&EF @ Q(?&C I ? days! $ ;KFR.
?
4,4CC @ (D&F I S;C! I C.;C.
4
&C,;C @ (D?C I S;C! I C.;C.
-rom a profit$maximizing perspective, we find the 3appelli 6ption to be the most
attractive. +e also could verify this using the incremental approach, using either
controllable cost analysis or relevant cost analysis.
c. The new information would have a substantive effect on <annah0s decision.
:et us begin by re$calculating the value of each decision option assuming
minimum possible demand.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$FS

A33,.-
P*,)7&1-
A33,.-
C/.,((*
"ataB
Total suites ( corporate EC 4FC
Total suites ( individual ?F &EF
>rice per suite ( corporate D&C.CC D&C.CC
>rice per suite ( individual DFC.CC DFC.CC

2evenuesB
9uites ( corporate D&,;CC DF4,CCC
9uites ( individual F&,;FC 4&,KFC
3onvention center F,CCC F,CCC
-ood, telephone, G movies ?,&KF E,?KF
Total revenues DC&,F&F D?C,&F

Aariable 3ostsB
-ood, laundry, supplies, etc. DF,S?C D&&,CFC
:abor (kitchen help, maids! E,FEF ?E,FEE
C&1-+*?'-*&1 7/+2*1 D;E,CC D;S,4EE

7dditional -ixed 3ostsB
Build runway D?,CCC
QP+&0*-R "68#1 "66#488
-rom a profit$maximizing perspective, we find the 3appelli option is no longer as
attractive. 'f <annah were sure that demand would be at the low end, it is prudent
to go with the >iedmont option. <owever, as we learned earlier, the 3apelli option
maximizes profit if demand were at the high end.
-rom a purely financial perspective, <annah0s beliefs about possible demand
influence her decision. /any firms construct a )best case, most likely, worst case*
scenario to include uncertainty in their estimates. 9ophisticated analyses could
include a demand distribution and simulations.
<otels routinely buffer themselves against demand fluctuations such as these by
requiring a minimum number of occupied suite$days. /oreover, they might
release the )blocked* rooms &$? weeks prior to the conference to increase the
chance of filling any unused rooms.
d. 'f <annah accepts the 3apelli deal, she will not be able to host >iedmont0s
meeting this year. By turning down >iedmont, a long$time client, <annah may
indeed lose all future business with the company. /oreover, including the
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$;C
possibility of uncertain demand reduces the financial attractiveness of 3apelli,
although it is likely the better financial option. Thus, even though the
profitable short$term decision is to accept 3apelli0s business, <annah probably
will feel uncomfortable making this decision because it could mean losing the
>iedmont contract forever. 's the immediate incremental benefit of DE,S4C (@
DEC,FFC ( DK,;C% see part b. above! worth losing a valued clientP 't may be
advisable for <annah to go with decision option and forgo this short$term
benefit.
6.67
a. Brenda0s decision deals with ,43,$$ ),7/1). There are competing demands
for Brenda0s time this coming 9unday, as she could either hold the open house
or show homes to some of her clients who are looking to buy a house. Brenda
cannot perform both activities on 9unday, giving rise to her dilemma.
b. Brenda0s expected profit is a function of the expected probability of sale, the
expected selling price, her commission rate, and the costs she incurs on the
open house. -ormally, we haveB
#xpected probability of sale CH given
#xpected selling price D&?K,FCC .SF asking price of &FC,CCC
#xpected commission DK&.FC CH ?H D&?K,FCC
Aariable costs of open house D&FC
E4.,3-,) .+&0*- <1,- 3&77*$$*&1= "462.5
c. Brenda0s expected profit is a function of the expected probability of sale, the
expected selling price, and her commission rate (the costs she incurs to show
homes are negligible!. -ormally, we haveB
#xpected selling price D&CS,CCC C.SF D&&C,CCC
#xpected commission (other0s listing! D&FC.EC 4H ?H D&CS,CCC
#xpected commission (own listing! D&F.4C H ;H D&CS,CCC
E4.,3-,) .+&0*- <-&-/( 3&77*$$*&1= "376.2
d. Based on her expected profit (commission!, Brenda should hold the open
house.
e. +e know from part QcR that Brenda0s expected profit from showing homes to
potential buyers is D?K;.&C. 7dditionally, we can model her profit from the
second open house as a function of the likelihood (chance! of selling the
home, orB
#xpected profit from second open house @ (chance of selling D&?K,FCC .C?! (
D&FC.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$;
+e find the probability that makes Brenda0s indifferent between the two options
by setting her expected profit from the second open house equal to D?K;.&C. Thus,
we haveB
D?K;.&C @ (chance of selling D&?K,FCC .C?! ( D&FC, or 3%/13, &0 $,((*12 B .
878. Thus, if the chance of selling the house on the second open house is less
than approximately E.KEH then Brenda should not hold the second open house.
7lternatively, if the chance of selling the house on the second open showing is
greater than approximately E.KSH then Brenda should hold the second open
house.
6.68
a. 'n solving this problem, it probably is best to set$up a profit model for each
option. Based on the information provided, we haveB
>rofit (outsource! @ C.&C whitewater rafting revenue.
>rofit (operate internally! @ (.;C whitewater rafting revenue! ( D4C,CCC.
These models allow us to calculate the profits under each option at the two
different revenue levels. Thus, we haveB
#xpected 2evenue
O.-*&1 "75# "125#
6utsource DF,CCC D&F,CCC
6perate internally DF,CCC D?F,CCC
I0 +,:,1',$ B "75# -%,1 9/38+/??*- T+/*($ $%&'() &'-$&'+3, /$ -%*$
*13+,/$,$ .+&0*- ?; "1#S &1 -%, &-%,+ %/1)# *0 +,:,1',$ B "125# -%,1
9/38+/??*- T+/*($ $%&'() &.,+/-, -%, 5%*-,5/-,+ +/0-*12 -&'+$ *1-,+1/((; /$
-%*$ &.-*&1 (,/)$ -& "1# %*2%,+ .+&0*- -%/1 &'-$&'+3*12.
b. 9etting the two profit models equal to each other we haveB
.&C gross whitewater rafting revenue @ (.;C gross whitewater rafting revenue!
( D4C,CCC.
9olving, we find gross whitewater rafting revenue @ "1#. -urthermore, for
revenue \ DCC,CCC, outsourcing is preferred. -or revenue _ DCC,CCC, it is more
profitable to provide the service in house. /ore generally, the following graph
depicts whitewater rafting profit as a function of whitewater rafting revenue.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$;&
c. There are numerous other factors that Nackrabbit Trails might take into
consideration.
Nackrabbit Trails should consider the quality of the service being offered (
will patrons0 whitewater rafting experience be moreLless en=oyable and
safe with Tributary Tours or the in$house serviceP To this end, the
reliability and trustworthiness of Tributary Tours needs to be established.
Nackrabbit Trails should consider the uncertainty in their estimate of gross
whitewater rafting revenues. They should also consider other sources of
risk such as the liability. By outsourcing, Nackrabbit trails shifts most, if
not all of the risk from themselves to Tributary Tours. Thus, increased
uncertainty would make contracting out the preferred option if
management were averse to risk. (8oteB naturally, one could conceive of
this risk being priced out in the adventure tour market. That is, the price
charged would include a premium for the estimated value of risk in the
venture.!
Nackrabbit Trails needs to consider how offering whitewater rafting will
affect their other activities ( it is quite likely that the revenues on, for
example, sailing or canoeing will decrease ( this opportunity cost would
need to be considered before any decision is made.
6.69
-rom a purely monetary (quantitative! standpoint, the corporate donor is the better
deal. 2obin and the museum net D&,CCC O CH of DF,CCC less the DFCC from the
charity by renting the atrium to the corporate donor. This is before counting any
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
$D4C,CCC
$D&C,CCC
DC
D&C,CCC
D4C,CCC
D;C,CCC
DEC,CCC
C
&C,CCC4C,CCC;C,CCCEC,CCC
CC,CCC &C,CCC 4C,CCC ;C,CCC
EC,CCC &CC,CCC
G+&$$ W%*-,5/-,+ R/0-*12 R,:,1',
R
/
0
-
*
1
2

P
+
&
0
*
-

<
"
=
in$house
outsource
;$;?
)surprise* donation received from the corporate donor and any future events that
the corporate donor might hold.
+eighed against this, however, are the qualitative factors. -irst, there is the loss of
goodwill associated with moving the charitable event. 't appears that a lot of
effort has been vested in the event, and canceling it is likely to trigger much
adverse publicity, perhaps with implications for future donations. 6ne could
imagine the local newspaper writing an article titled something like )/useum
9tiffs Mids for "ough.* 9econd, there is the clear ethical obligation to the charity
( after all, they reserved the atrium first5 There also is a legal obligation to the
extent 2obin has a contract with the charity. There is an implicit long$term value
that arises from these factors. The problem is that the effects are hard to quantify.
/ost managers in this setting probably would call the charity to see if it is
possible to move the date andLor the location (with the museum or the corporate
donor picking up the cost!. 9ome might even have the corporation call the
charity5 'f such a change is not feasible, then the right thing to do is honor the
commitment to the children0s charity. 'n addition to the ethical obligation, the
potential dilution of the /useum0s mission as well as the possibility of substantial
negative publicity are significant. (There also might be a legally binding
obligation, even if no written contract exists.!
2obin0s quandary reminds us that both quantitative and qualitative considerations
factor into most decisions. The quantitative analysis often is only a start, and it is
important to remember that better measurement does not necessarily make the
quantitative aspects more relevant than the qualitative aspects (i.e., issues with
greater measurement error!. 1ltimately, managerial talent lies in the ability to
estimate well the qualitative aspects and to reach a reasoned conclusion. 'n this
particular instance, the qualitative considerations are likely to receive the most
weight and guide 2obin0s decision.
Balakrishnan, /anagerial 7ccounting e -62 '89T213T62 19# 68:,
;$;4