CHAPTER 4

TECHNIQUES FOR ESTIMATING FIXED AND VARIABLE COSTS

SOLUTIONS
Review Questions
4.1

Because the statement groups costs by business function rather than variability.
That is, the traditional income statement combines fixed (non-controllable) and
variable (controllable) costs.

4.2

Revenues less variable costs. It is the amount that contributes toward recovering
fixed costs and earning a profit.

4.3

The GAAP-based income statement, which is used for external reporting, groups
costs by business function, separating product costs from period costs (as
discussed in Chapter 3). In contrast, the contribution margin statement groups
costs by variability, separating fixed costs from variable costs.

4.4

Yes, along with revenues and variable costs.

4.5

By separating out fixed costs, which relate to the costs of capacity resources and
usually do not change in the short-term, from revenues and variable costs, which
vary with activity volume and usually are controllable in the short term.

4.6

Account classification, the high-low method, and regression analysis.

4.7

(1) Sum the costs classified as variable to obtain the total variable costs for the
most recent period; (2) Divide the amount in (1) by the volume of activity for the
corresponding period to estimate the unit variable cost; and (3) Multiply (2) by
the change in activity to estimate the total controllable variable cost.

4.8

The primary advantage is that it can provide very accurate estimates because it
forces us to examine each cost account in detail. The primary disadvantages are
that the method is time-consuming and subjective.

4.9

The two observations pertaining to the highest and lowest activity levels. These
two values are most likely to define the normal range of operations.

4.10

The primary advantage is that the high-low method is easy to use and only
requires summary data. The primary disadvantages are that it only uses two
observations (throwing away much of the data) and yields only rough estimates
of the fixed costs and unit variable costs.

4.11

While the high-low method only uses two observations, regression analysis uses
all available observations to come up with a line that best fits the data.

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4.12

(1) R-square, which indicates the goodness of fit this statistic is between 0 and
1, with values closer to 1 indicating a better fit; (2) p-value, which indicates the
confidence that the coefficient estimate reliably differs from 0.

4.13

The relevant range is the normal range of operations, where we expect a stable
relationship between activity and cost.

4.14

We compute a segment margin by subtracting traceable fixed costs related to the

segment (e.g., a product, customer, geographical region) from its contribution
margin. The two margins differ by the traceable fixed costs.

4.15

(1) products; (2) customers; (3) stores; (4) geographical regions; and, (5)
distribution channels are some of the many ways an organization might segment
its contribution margin statement.

Discussion Questions
4.16 A 5% decrease in selling price would result in a larger decrease in unit contribution
margin than a 5% increase in variable costs. To see why, keep in mind that unit
selling price is a larger number than unit variable cost (otherwise, unit contribution
margin will not be positive). Therefore, a 5% decrease in selling price will also be
proportionately larger than a 5% decrease in variable cost. For example, if the unit
selling price is $10 and the unit variable cost $6, then the unit contribution margin
is $4 (= $10 - $6). With a 5% decrease in selling price, the selling price decreases
by $0.50 to $9.50; the unit contribution margin also decreases by the same $0.50 to
$3.50 (= $9.50 - $6). With a 5% increase in variable costs, the unit variable cost
increases by $0.30 to $6.30, and the unit contribution margin decreases by the same
$0.30 to $3.70 (= $10 6.30).
4.17 Investors are external users of the financial reports prepared by firms. Investors
might prefer the income statement using the gross margin format because the cost
of goods sold as reported in this format includes allocated fixed costs such as
depreciation, factory overhead and so on. These allocated fixed costs represent a
rough measure of the opportunity cost of capacity resources. Thus, investors get an
idea of profitability after taking into account the opportunity cost of the usage of
capacity resources.
4.18 A key aspect of the contribution margin statement is that it clearly separates fixed
costs from variable costs associated with various decision options. Because
contribution margin is revenues less variable costs, the decision maker can correctly
compute the contribution margin associated with each decision option. In the short
run, fixed costs do not change, and therefore contribution margin constitutes the
right basis for decision making. In the long run, however, many fixed costs become
controllable and relevant for decision making.

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4.19 As is often said, A picture is worth a thousand words. Plotting the data helps in
quickly assessing the behavior of various cost items i.e., whether a cost is fixed or
variable with respect to the volume of production, just by inspection. Plotting the
data also helps us determine the appropriate technique to use to estimate fixed and
variable costs. Moreover, plots often reveal a few data points that do not appear to
conform to the general pattern emerging from other data points. Such outliers or
extreme observations are typically the result of recording errors or unusual activities
in a specific period. We can identify and eliminate such observations from
consideration because they are not likely to reflect typical behavior.
4.20 The reason for plotting is to examine how a cost item increases in activity volume.
Some months may have high activity volumes and other months may have low
activity volumes in no particular order. But we would like to know how costs vary
as the activity volume increases or decreases. For this reason, if we sort by activity
volume and plot it on the X-axis, and plot the corresponding cost on the Y-axis, the
resulting plot will indicate how cost increases as the activity volume increases along
the X-axis.
4.21 Account classification requires us to examine each cost account in detail, and
provides very accurate estimates. Often, this analysis requires us to plot each cost
account and examine the graph and exercise some judgment to determine its
behavior. Grant proposals often require the proposal preparers to exercise
considerable judgment. They typically involve a manageable number of line items
so that an accurate line-by-line estimation of costs using the account classification
method is not such a tedious task.
4.22 Large projects are often unique and dissimilar. Smaller and routine decisions tend to
be more alike. Therefore using mechanical methods such as the high-low method
work reasonably well for small and routine decisions. On the other hand, such
methods will likely result in much greater estimation errors for large projects. And,
erroneous estimation of costs can in turn prove quite costly if they lead to bad
decisions relating to large projects. Even though tedious, the account classification
method is more suited for large and unique projects.
4.23 One can visually verify that high and low data points are representative by making
sure they do not seem to be outliers with respect to the rest of the data points.
That is, these points do not seem out of step or pattern with other points.
4.24 One reason could be that either the high data point or the low data point (or both) is
an outlier. Another reason could be a change in the fixed cost that may have
occurred in the interim. The high-low method will not be able to detect this change.
The accounting classification method will.

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4.25 True the high-low method relies completely on just two data points to separate
fixed costs and variable costs. If one of these points turns out to be an outlier, the
estimates can be completely off. In contrast, a regression detects the cost behavior
using all available data points. Consequently, each individual observation has far
less influence on the estimates than the high or low data points in the high-low
method.
4.26 Yes, going back to obtain historical data from many years does increase the number
of data points we use in a regression. However, we would be assuming that the cost
structure the mix of fixed and variable costs stays the same over all these years.
In practice, firms change with time. Fixed costs change as more capacity is added or
some capacity is reduced. Unit variable costs may decrease as production becomes
more efficient. Therefore, the longer is the time period, the less applicable is the
assumption that the cost structure remains the same. And, such cost structure
changes limit the extent to which we can use historical data for estimation purposes.
4.27 We can use number of batches and number of products as additional variables in the
right hand side of the regression equation along with the activity volume. In such a
regression, we can interpret the intercept as facility level costs because these costs
do not vary at all.
4.28 In estimating the revenues and costs using this kind of a two-part fee structure, it
becomes necessary to estimate the number of families, average family size, and the
number of individual memberships. Revenues would be determined by the number
of families multiplied by the family membership fee plus the number of individual
memberships multiplied by the individual membership fee. On the cost side, one
needs to estimate the total membership as number of families multiplied by the
average family size plus number of individual members, and then multiply this total
membership by the cost of serving each member. In principle, this setting is similar
to situations in which firms bundle their products for market penetration (e.g., a
vacation package comprising of airline tickets, hotel costs, and cruises, as
opposed to just airline tickets, hotel costs and cruises). Bundles are priced
differently than individual products, and bundling is an integral part of the
marketing strategy.
4.29 Yes, it does! Such a contribution margin statement will help measure how much
contribution each major customer makes to the fixed costs of the company. It will
help in customer-related decisions such as whether to keep or drop a particular
customer, whether some customer-specific promotions and discounts can improve
the contribution from that customer and so on. Customer Profitability Analysis is
an important strategic tool that we will discuss in Chapter 10.

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4.30 If a grocery store stops selling 1% lowfat milk, its revenues from 2% lowfat milk is
likely to go up, as customers who routinely buy 1% lowfat milk settle for the next
best option. This is an example of a positive spillover effect. On the other hand, if
an automobile repair shop stops doing routine maintenance services, it is likely to
lose revenues from other repair issues that typically crop up during routine
maintenance services. This is an example of a negative spillover effects. Yes,
spillover effects are controllable and must be considered in the decision to drop the
1% lowfat milk in the case of the grocery store, and the routine maintenance service
in the case of the automobile repair shop.
4.31 Here is the income summary of operating segments of General Electric Corporation
extracted from its 2006 Annual Report.

Exercises
4.32

Unit contribution margin = Price all variable costs

We first calculate price = ($15,000 revenue/500 units) = $30 per unit. Given that
variable manufacturing costs = $10 per unit and variable selling costs = $2 per
unit, then unit contribution margin = $30 - $10 - $2 = $18 per unit.
Contribution margin = number of units unit contribution margin

4-6

Thus, contribution margin = 500 units $18/unit = $9,000.

The following is the contribution margin statement.

Revenue

Contribution Margin Income Statement

500 units $30 per unit

Variable manufacturing costs

Variable selling costs
Contribution margin
Fixed manufacturing costs
Fixed selling costs
Profit
4.33

500 units $10 per unit

500 units $2 per unit

$15,00
0
5,000
1,000
$9,000
6,000
2,000
$1,000

The following table presents the required statement.

Ajax Corporation
Contribution Margin Income Statement for
the most recent Year
Revenue
$1,525,000
Cost of goods sold
900,000
Sales commissions
91,500
Variable cost of transport in
6,500
Contribution margin
$527,000
Fixed transportation cost
18,000
Administration costs
220,000
Selling costs
148,500
Profit
$140,500
Notice that the contribution margin statement regroups the costs into fixed and
variable costs. Moreover, because it is a merchandiser, Ajax buys and sells goods
without substantially transforming them. Thus, its cost of goods sold is a variable
cost; this cost is the amount Ajax would have paid its suppliers. We obtain sales
commissions as 6% of sales revenue (0.06 $1,525,000 = $91,500). We then
back out fixed selling costs as the remainder ($240,000- $91,500 = $148,500).

4-7

4.34

The following table presents the required statement.

Jindal Corporation
Contribution Margin Statement for the most
recent Year
Revenue
$2,435,000
Variable cost of goods sold
998,010
Sales commissions
121,750
Contribution margin
$1,315,240
Fixed manufacturing costs
248,750
Fixed administration costs
425,000
Fixed selling costs
437,200
Profit
$204,290
Notice that the contribution margin statement regroups the costs into fixed and
variable costs. We obtain sales commissions as 5% of sales revenue (0.05
$2,435,000 = $121,750) and back out fixed selling costs as the remainder
($558,950 - 121,750 = $437,200).
Note: The instructor can point out that inventories would substantially
complicate this problem. The complication arises because GAAP (which governs
the gross margin statement) classifies fixed manufacturing costs as product costs,
whereas the contribution margin statement classifies them as period costs. We
address this issue in Chapter 9.

4.35

The following table provides the required detail.

Item
Student related variable
costs
Faculty related costs

Estimate
$2,500 50 = $125,000

Building maintenance

2 faculty $150,000 =
$300,000
1 person $60,000 =
$60,000
No change

Total

$335,000

Administration costs

Detail
Variable in number
of students
Variable in number
of faculty hired
Variable in number
of staff hired.
Fixed for this
decision.

Notice that we would find it difficult to make this estimate using techniques such
as the high-low method. Each cost element has a different driver, and major cost
items such as faculty and staff costs are step functions.

4-8
4.36 A simple analysis is to argue that the cost per unit is total product cost / total units
(=$400,400/10,000 units), or $40.04. Adding 2,500 units a month for 2 months would add
5,000 units $40.04 = $200,200 to Megas cost.
However, this approach is incorrect. It does not distinguish between controllable and noncontrollable costs. And, as we know from Chapter 2, the cost of making the additional
units should only include controllable costs. How should we estimate controllable costs
though? The following table identifies controllable costs, making the usual assumption
that all variable costs are controllable and fixed costs non-controllable over the short
term.
Variable items
Materials and components
Direct labor
Supplies
Oils and lubricants
Freight out
Sales commissions
Fixed costs items
Machine depreciation
Plant heating and lighting
Plant rental
Sales office administration
Corporate office costs

These costs vary proportionately with

the number of units made. The logic is
easy to see for items such as materials,
freight out, and labor. However, costs
of supplies and oils also vary with
production volume, even though these
are indirect cost. These costs are the
products variable overhead. The sales
commissions also vary because
revenue varies with volume.
None of these costs change if we
change production volume, especially
in the short-term.

We estimate the total variable costs as $273,500 or $27.35 per unit. (Add up all of the
variable cost amounts to obtain $273,500 as the cost of 10,000 units.) Thus, the expected
increase in costs from adding 2,500 units a month for 2 months is 5,000 units $27.35 =
$136,750.

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4.37
a. The following is the required statement.
Singapore Executive MBA Program
MidWest University
40 students $35,000
Tuition revenue
$1,400,000
Traced
Partner fees
490,000
$200 per course 40 students
Text books etc
128,000
16 classes
Contribution margin
$782,000
$20,000 16 courses
Instructor salaries
320,000
$4,500 16 courses
Instructor travel
72,000
1.5 FTE $54,000 per FTE
Program assistance
81,000
3 trips $6,500 per trip
Program related travel
19,500
Program margin
$289,500
10% of salary
Associate Dean (allocated)
22,500
5% of compensation
Deans time (allocated)
17,500
Profit
$249,500
This statement, which incorporates the cost hierarchy, shows that for each student
enrolled in the class, the program generates 782,000/40 students = $19,550 in
contribution margin. These costs and revenues are controllable for the decision to
add students to the program.
Program related costs amount to $320,000 + $72,000 + $81,000 + $19,500 =
$492,500. These costs are controllable for the decision of whether to keep or drop
the program.
Finally, there is some allocated cost ($40,000) which is not likely controllable for
any decision concerning the program. After all, the dean is unlikely to reduce her
salary if the program shuts down.
b. For this decision, we only consider controllable costs and benefits, at the
participant level. Notice that we cannot directly use the contribution margin
statement because the revenue has changed, which changes some costs as well.
Increase in tuition revenue
Partner fees
Textbooks
Net gain

$75,000
26,250
9,600
$39,150

Thus, it appears that the Dean should accept this offer. However, the Dean also
needs to consider long-term and other spillover effects. For example, other
students might also demand the same discount once word gets out about the fee

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concession. Further, there is a strong price-quality association with graduate
degrees (particularly Executive MBA programs). Thus, lowering the price also
might harm the programs image. Finally, the class is already at a good size;
additional members might put it over the top in terms of a manageable class size.
Overall, the decision is not clear-cut.
Note: The instructor can point out that account analysis is most useful for this
decision. The high-low method or regression analysis is needlessly complex for a
decision that only affects a few costs and revenues.
4.38 a. Silk Flowers and Mores shipping costs likely contain both fixed (e.g., employee
costs) and variable (e.g., cartons, tape, and postage) elements. For convenience, let UVC
(Unit variable cost) represent the variable cost per flower arrangement. Using the highlow method and the data provided, we have:
HIGH (February)
LOW (January)

$33,750 = Fixed costs + (UVC 7,500)

$27,500 = Fixed costs + (UVC 5,000)

Now we can solve for the unit variable cost.

UVC = $33,750 - $27,500 = $6,250 = $2.50 per flower arrangement sold.
7,500 5,000
2,500
Substituting our estimate of UVC into either equation, we find that Fixed costs =
$15,000. For example,
Fixed costs = $33,750 ($2.50 per arrangement 7,500 arrangements) = $15,000
Thus, Silk Flowers & Mores monthly shipping cost equation is:
Total shipping costs per month = $15,000 + ($2.50 Number of flower arrangements
sold)
b. Once we have our cost equation, we can plug in the anticipated sales volume to obtain
an estimate of shipping costs. For June, we have:
Estimated June shipping costs = $15,000 + ($2.50 5,500) = $28,750.
Additionally, based on the data provided, a volume of 5,500 flower arrangements appears
to be well within Silk Flower and Mores relevant range of activity.
c. Stated simply, management would like to know the cost of free shipping. As
estimated in part [b], at a volume of 5,500 arrangements, management should expect
free shipping to cost $28,750 for the month of June. This number allows
management to make an informed comparison between the costs and the benefits of
offering free shipping (presumably, offering free shipping increases sales volume and

4-11
contribution margin). Moreover, separating costs into fixed and variable components
helps managements assess those costs that vary with the number of flower
arrangements sold and those that do not.
Instructors also may wish to point out to students that management of Silk Flowers &
More would be likely to refine their shipping costs equation to incorporate factors
such as the type of package shipped (small versus large), the type of flowers shipped
(some may required more packaging materials and labor), and the distance shipped.
Such refinements allow management to estimate the profit of the various types of
floral arrangements sold and the various customers that they serve (e.g., profit by
region of the country). This may lead management to restrict free shipping to some
product lines.
For a salient example, consider Amazon.com, which offers free shipping.
However, only some products in Amazon.com qualify for free shipping. A book
usually does, but a plasma TV usually does not. In addition, Amazon requires a
minimum order size to qualify for free shipping. Exploring the rationale for these
practices underscores how cost structure influences a firms policies and procedures.
4.39 a. We can use the two data points to decompose supervision costs into fixed and
variable components. Specifically, using the cost information from January and March
(the months with the lowest and highest activity levels), we have:
(January):
$27,500 = FC + (Cost per labor hour 2,400)
(March):
$32,540 = FC + (Cost per labor hour 3,360).
Solving for the unit variable cost, or Cost per Labor Hour, we have:
Cost Per Labor Hour = $32,540 - $27,500 = $5,040 = $5.25 per Labor Hour
3,360 2,400
960
By substituting the cost per labor hour = $5.25 into the cost equation for January (using
March will also work), we find that
FC = $27,500 (2,400 $5.25) = $14,900.
Thus, we express total supervision costs as:
Total supervision costs = $14,900 + ($5.25 Number of labor hours)
Notice that we use the observations with the highest activity level. We do not use the data
for May even though it has the highest cost.
b.
We can use the two data points to decompose total supervision costs into
fixed and variable components. Specifically, using the cost information from
January and May (the months with the lowest and highest activity levels), we have:
(January):
$27,500 = FC + (Cost per machine hour 5,040)
(May):
$32,630 = FC + (Cost per machine hour 6,750).
Solving for the unit variable cost, or Cost per Machine Hour, we have:
Cost Per Machine Hour = $32,630 - $27,500 = $5,130 = $3.00 per Machine Hour
6,750 5,040
1,710
By substituting the cost per machine hour = $3.00 into the cost equation for January
(using May will also work), we find that
FC = $27,500 (5,040 $3.00) = $12,380.

4-12
Thus, we express total supervision costs as:
Total supervision costs = $12,380 + ($3.00 Number of machine hours).
c. We believe that the equation based on labor hours might better represent cost
behavior because supervision is likely related to the number of workers. However,
there usually is a strong correlation between labor and machine hours in many
settings. Thus, we could justify either equation.
d. A manager might believe neither equation to be valid because the data indicate
that supervision might be a step cost. For instance, the cost did not change when the
number of labor hours increased from 2,400 to 2,560 but jumped $2,500 when the
labor hours increased from 2,560 to 2,880. Such jumps and intuition lead us to
conclude that supervision costs might be step costs, which means that our task
changes to estimating the step size. (This material might be covered in an advanced
class.)

4-13

4.40 a. We can use the two data points in the condensed income statements to
decompose Frame & Shows total costs into fixed and variable components.
Specifically, using the cost information from years 1 and 2, we can express Frame &
Shows total costs as:
(Year 1):
(Year 2):

$310,000 = FC + variable cost per frame 3,000

$332,500 = FC + variable cost per frame 3,500.

Solving for the unit variable cost, or variable cost per frame, we have:
Variable cost per frame = $332,500 - $310,000 = $22,500 = $45.00 per frame
3,500 3,000
500
By substituting variable cost per frame = $45 into the cost equation for Year 1 (using
year 2 will also work), we find that
FC = $310,000 (3,000 $45) = $175,000.
Thus, we express Megans annual cost equation as:
Total Costs = $175,000 + ($45 Number of items framed).
b. The cost of participating in the Thieves Market equals the sum of the controllable
fixed and variable costs associated with this decision alternative.
The controllable fixed cost associated with participating in the Thieves Market is the
$2,500 booth fee. Megans annual fixed costs of $175,000 are not controllable for this
short-term decision.
The controllable variable cost equals the number of framings multiplied by the variable
cost per framing. Megan expects to sell 150 framings at the market. From the cost
equation we developed in part [a], the estimated variable cost per framing is $45.
Consequently, Megans expected controllable variable costs = $45 150 = $6,750.
Adding the controllable fixed cost to the controllable variable costs, we have:
Cost of participating in the Thieves Market = $2,500 + $6,750 = $9,250.
To determine the expected profit from participating in the Thieves Market, we need to
determine the revenue from participating in the market. Since revenue = selling price
number of framings, we can use the data in either Year 1 or Year 2 to find the average
selling price. Using the data from Year 2, we find that the sales price per frame =
$318,000/3,000 = $106.
Thus, the revenue from 150 frames = 150 $106 = $15,900.

4-14

Subtracting the cost from the revenue associated with participating in the Thieves Market,
we find that Megans profit is expected to increase by $15,900 $9,250 = $6,650.
Participating in the Thieves Market therefore appears to be a steal!
4.41 a. Following the procedure outlined in the text, we find the following:

Intercept
Number of shipment
R-Square =0.992

Coefficient
s
$15,320.95
$2.445946

Standard
Error
689.8844
0.106834

t Stat
22.20799
22.89489

P-value
0.0002
0.000183

Based on the above data, we estimate the monthly shipping cost equation as:
Total shipping costs per month = $15,320.95 + ($2.446 Number of flower
arrangements sold)
We note that the regression has a high R-square (the Excel output shows an adjusted Rsquare of 0.992) indicating an excellent fit. Moreover, the p values are low, indicating a
statistically meaningful relation between the cost driver (the number of shipments) and
the cost. This statistical relation confirms our intuition about an economic relation
between the cost driver and the cost.
b. Once we have our cost equation, we can plug in anticipated sales volume to obtain an
estimate of shipping costs. For June, we have:
Estimated June shipping costs = $15,320.95 + ($2.445 5,500) = $28,768.45.
Additionally, based on the data provided, a volume of 5,500 flower arrangements appears
to be well within Silk Flower and Mores relevant range of activity.
Note: The instructor can observe that while we obtain similar answers with the high-low
and the regression method for estimating costs, this is often not the case.
4.42 We would argue that the second equation is likely to be a better predictor of monthly
materials handling costs. We base our conclusion on the following reasons.

Equation 2 has a much higher R-square (76.34%) than equation 1

(54.17%). The higher R-square indicates a better fit, meaning that the cost driver
(the independent variable in the regression equation) number of material moves
is able to explain more of the variation in the dependent variable (monthly
materials-handling costs) than the independent variable value of materials
handled.

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The p-values of the coefficients are low in both equations, indicating that
all estimates reliably differ from zero. However, the p-values are lower in
equation 2 than in equation 1, again indicating a stronger association between
material moves and materials-handling costs than the association between the
value of materials and materials-handling costs.

We have to consider more than just R-squares and p-values when choosing
an activity. For example, we need to consider whether there is a cause-effect
relationship between the activity and the cost. The answer for our problem is not
obvious. We can visualize the number of moves being the cause for materialshandling costs. We also can conceive of the value of materials being correlated
with handling expenses because we are likely more careful with more expensive
materials. However, there could be situations where the association between value
of materials and handling cost is weak. Ultimately, we will have to rely on
situation specific knowledge to make the choice.
Overall, this exercise highlights that we can employ many independent variables in a
regression and that the choice among the resulting equations must rely on both statistical
and economic criteria. More sophisticated multiple-regression models can portray the
joint effect of many independent factors.
4.43 a. Using Excel, we obtain the following regression equation and output:
Regression Statistics
R Square
34.57%
Observations
12

Intercept
Cases shipped

Coefficient Standard
s
Error
t statistic
13,059.78 1991.153 6.558907
2.153 0.936829 2.298816

p-value
0.00
0.04

b. This equation indicates a somewhat poor fit. The fit is not excellent as the R-square
value is only around 35%. Moreover, the explanatory variable is only marginally
significant (p of 0.04). OConner would be well advised to consider alternate drivers
and/or to collect more data to refine its estimates.

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4.44 a. The GAAP income statement classifies costs according to their function it
groups costs by whether they pertain to manufacturing (product costs) or nonmanufacturing (period costs) activities. The GAAP income statement also aggregates
the data to the firm level because the income statement pertains to the firm as a
whole and not any particular product, geographical region, or customer. (Note:
Generally, investors buy and sell shares in the entire firm and not individual pieces of
the firm. A few firms do issue tracking shares that permit an investor to invest in
specified operations only.)
In contrast, a contribution margin statement groups costs as per their variability,
presenting the data at the sub-unit level. The sub-unit, which can be products (as in
the Caylor example), divisions, regions, or customers, depends on the decision
context.
Re-grouping costs per their variability gives rise to the following income statement for
Caylor:

Revenues1

Product Contribution Margin Statement

Caylor Company
For the most recent Year
RX-560
VR-990
$5,400,000
$12,000,000

Variable costs (Manufacturing)2

Variable costs (SG&A)3
Contribution margin
Traceable fixed costs
(Manufacturing)
Traceable fixed costs (SG&A)
Product (Segment) margin
Common fixed costs
(manufacturing)
Common fixed costs (SG&A)
Profit before Taxes

Total
$17,400,00

540,000
720,000
$4,140,000

2,000,000
8,000,000
$2,000,000

2,540,000
8,720,000
$6,140,000

$500,000
1,000,000
$2,640,000

$500,000
1,350,000
$150,000

$1,000,000
2,350,000
$2,790,000
$1,300,000
1,200,000
$290,000

$5,400,000 = 180,000 $30; $12,000,000 = 2,000,000 $6.

$540,000 = 180,000 $3; $2,000,000 = 2,000,000 $1.
3
$720,000 = 180,000 $4; $8,000,000 = 2,000,000 $4.
2

b. The product contribution margin statement is much more informative for decision
making than the GAAP income statement. The product contribution margin statement
shows that RX-560 is clearly more profitable than VR-990. (The GAAP income
statement obscures this fact). Thus, management of Caylor may wish to increase its
emphasis on RX-560 and de-emphasize VR-990. Additionally, we clearly see the
traceable fixed and variable costs associated with producing each drug; this information
can facilitate special order decisions, pricing decisions, and keep or drop decisions.

4-17
Note: Caylors profit before taxes is the same regardless of which way we group revenues
and costs. This equivalence occurs because of the absence of inventory. As discussed in a
later chapter (Chapter 9), inventory can cause the two income numbers to differ.

4-18

4.45 a. The following table provides the required calculations:

Omega Corporation
Monthly Contribution Margin Statement
(by Geographical Region)
Eastern
Western
Revenue
$2,000,000
$600,000
1
Variable manufacturing costs
1,300,000
370,000
Variable selling costs2
50,000
16,000
Contribution margin
$650,000
$214,000
Traceable fixed costs
250,000
225,000
Segment margin
$400,000
($11,000)
Common fixed costs
Profit before Taxes

Total
$2,600,000
1,670,000
66,000
$864,000
475,000
$389,000
275,000
$114,000

$1,300,000 = ($1,000,000 0.55) + ($1,000,000 0.75); $370,000 = ($400,000 0.55) +

($200,000 0.75)
2
$50,000 = ($1,000,000 0.03) + ($1,000,000 0.02); $16,000 = ($400,000 0.03) + ($200,000
0.02)

b. The following table provides the required information:

Omega Corporation
Monthly Contribution Margin Statement
(by Product)
Standard
Deluxe
Revenue
$1,400,000
$1,200,000
Variable manufacturing costs1
770,000
900,000
2
Variable selling costs
42,000
24,000
Contribution margin
$588,000
$276,000
Traceable fixed costs
275,000
225,000
Product margin
$313,000
$51,000
Common fixed costs
Net Income

Total
$2,600,000
1,670,000
66,000
$864,000
500,000
$364,000
250,000
$114,000

$770,000 = ($1,000,000 0.55) + ($400,000 0.55); $900,000 = ($1,000,000 0.75) +

($200,000 0.75).
2
$42,000 = ($1,000,000 0.03) + ($400,000 0.03); $24,000 = ($1,000,000 0.02) +
($200,000 0.02).

c. The contribution margin statements clearly show that the Eastern region currently is
more profitable than the Western region and that the standard product is more profitable
than the deluxe product. Thus, management may need to devote more efforts to
increasing the profits associated with the deluxe line. (Management may also use the
information to support a strategy of emphasizing the standard line given the low
contribution margin of the deluxe line relative to the standard line).

4-19
Similarly, management may need to devote even more resources to the Western region to
ensure that its expansion efforts are successful. Alternatively, management may decide,
based on the geographic contribution statement (i.e., the loss in the Western region), to
discontinue its presence in the Western region.
4.46 a. Atman expects to spend 8 20,000 hours = 160,000 hours to assemble 8
satellites. Its expected cost is 160,000 hours $25 per hour = $4,000,000.
b. The following table provides the average hours required with learning
Unit number
1
2
4
8

Average Hours per unit

20,000 (Given)
18,000 (=20,000 0.9)
16,200 (=18,000 0.9)
14,580 (=16,200 0.9)

Thus, the total labor hours needed are 116,640 (8 14,580) and the associated cost is
$2,916,000 ($25 116,640).
Note: Some students erroneously think of 14,580 hours as the time needed for the eighth
unit (i.e., the marginal time for the eighth unit) rather than the average time per unit for
the first eight units. In this context, we note that it is possible to re-express an average
cost learning equation (which we illustrate) into a marginal cost learning equation.
However, such transformations are beyond the scope of this book.
c. Incorporating learning effects reduces Atmans expected cost by more than 25%!
Ignoring this factor could lead to a gross overbid, potentially costing Atman the job.
Problems
4.47 a. The classification of each of Amys costs is as follows:
Cost Item
$1,200 variable
costs per person

Cost Hierarchy
Classification
Unit level

Explanation
Varies directly with
the number of
persons taking the
tour.

$98,000 cost per

tour

Batch level

Varies with the

number of tours.

$50,000 central
office and
administration costs

Facility level

Required to sustain
the business.

4-20

One might be tempted to classify Amys $50,000 in central office costs as product-level
costs because, at the present time, Amy only offers tours to Southeast Asia. These costs,
however, probably are best classified as facility-level because they are required to sustain
Amys business. They probably wont change even if, for example, Amy starts offering
tours to Europe.
b. The table below presents Amys total quarterly costs under each scenario:

Cost item
Variable costs

2 tours
with 40
persons
each
$96,000

5 tours
with 50
persons
each
$300,000

Cost of tours
Fixed expenses
Total costs

$196,000
$50,000
$342,000

$490,000
$50,000
$840,000

Detail
2 40 $1,200; 5 50
$1,200
2 $98,000; 5 $98,000
Facility-level cost

c. Based on our cost classifications, the controllable cost of offering any particular tour =
$98,000 + ($1,200 number of persons on the tour). With 35 persons, this cost = $98,000
+ ($1,200 35) = $140,000. Furthermore, with 35 persons Amy receives 35 $4,000 =
$140,000 in tour revenue. Thus, Amy just breaks even when 35 persons are in the tour
and loses money with fewer than 35 persons. This explains why Amy has this stipulation.
4.48 Let us begin by classifying the items as being controllable or not for this decision.
Item
Direct materials
Direct labor
Departmental overhead: Direct
Departmental overhead: Indirect
Factory overhead
Selling & administration overhead

Classification
Controllable
Controllable
Controllable
Not controllable
Not controllable
Not controllable

How can we make the above classification? Notice the per-unit amounts for the
controllable costs are the same at different production volumes. This equality suggests
that these costs are proportional to production volume, or that they are variable. Thus,
these costs are likely controllable for this decision.
Indirect overhead declines on a per-unit basis as volume increases. This is a classic sign
of a fixed cost. Indeed, we can verify that the amount is $31,000 for both volumes.
We now consider the two allocated amounts: factory overhead and selling costs. From
Chapter 3, we know that allocations take an indirect cost and split it among cost objects
in proportion to the number of cost driver units. Suppose we allocate rent (a fixed cost) in

4-21
proportion to labor hours. Suppose further that we increase production of a product (with
one labor hour per unit) from 1,000 units to 2,000 units. The number of labor hours used
by this product will then double. The mechanics of the allocation then mean that the
amount allocated for rent will also double because the allocated cost is proportional to the
number of driver units! Thus, a casual examination of cost per unit at the different
volumes might well conclude that rent is a variable cost because the allocation process
has made a fixed cost look like a variable cost.
This phenomenon is at work here. Indeed, note that factory overhead is constant per unit,
suggesting that it is variable. But, appearances could be deceiving. The allocated amount
per unit is the same for different volumes because we calculate the allocated amount as
100% of a controllable cost (labor). However, the total amount the firm spends on
factory overhead is likely the same at both volumes. Thus, factory overhead is not
controllable for this decision. A similar logic applies to selling and administration
overhead.
With this classification, we have the controllable costs as $2.50 + 2.14 + $0.45 = $5.09
per unit. Thus, increasing production by 1,500 units will increase costs by $7,635.
Note: This problem underscores that allocated costs, particularly when presented as a cost
per unit, have the potential to confuse. If you encounter an allocated amount in a product
cost report, do not consider just the amount allocated to an individual unit of the product
or to the product line alone to determine whether the cost is controllable. Rather, consider
whether the total expenditure on the cost (across all products) by the firm will change due
to the decision.

4-22
4.49 a. The table below classifies each of Comfort Pillows cost items as being
controllable or non-controllable for accepting the department stores order. The table also
presents the increase in the cost item, if any, as a result of accepting the order and the
detail supporting this calculation. That is, the status quo is not accepting the order.
Cost for
store order
$12,500

Cost Item
Fabric

Controllable?
Controllable. The
cost will increase if
the order is
accepted.

Fill

Controllable. The
cost depends on
whether the order
is accepted.

Industrial sewing
machines

Non-Controllable.
The cost is the
same regardless of
whether the order
is accepted.

$0

Labor

Controllable. The
cost will increase if
the order is
accepted.

$30,000

5,000 pillows hour

per pillow $12 per hour

Plastic wrap & other

packing

Controllable. The
cost increases if the
order is accepted.

$2,500

5,000 pillows $0.50 per

pillow

Cartoning & crating

Controllable. This
batch-level cost
changes because of
the order.

$2,000

(5,000/25) $10

Transportation

Controllable.
Similar to
cartoning and
crating, this is a
batch-level cost.

$3,000

(5,000/2,500) loads
$1,500 per load

Purchasing &
manufacturing support

Controllable. This
cost will increase
since only 12,000
pillows per month
are being produced
currently.

$90,000

$15,000

Detail
5,000 pillows $2.50 per
pillow.

5,000 pillows $18 per

pillow.

Accepting the order will

mean that Comfort will
produce 17,000 pillows
in the coming month,
thereby triggering an
additional $15,000 in
cost.

4-23

Advertising brochures

Non-Controllable.
The cost is the
same whether the
order is accepted or
not.

$0

Office expenses

Non-Controllable.
The cost is the
same whether the
order is accepted or
not.

$0

Sales & support

Controllable.
These costs will
increase if the
order is accepted.

Total cost

$1,000

Additional $1,000 will be

incurred.

$156,000

The controllable cost per pillow is therefore: $156,000/5,000

Markup at 25%
0.25 $31.20
Price per pillow

$31.20
$ 7.80
$39.00

b. The point to note here is that, on a per-pillow basis, the batch- and order- (product-)
level costs will change. The following table (which only shows the controllable costs)
highlights this point.

Item
Fabric
Fill

Per-pillow cost
5,000 pillows
$2.50

Per-pillow
cost
4,000 pillows
$2.50

Detail
$2.50 per pillow

$18.00

$18.00

$18.00 per pillow

Labor cost

$6.00

$6.00

hour $12 per hour

Plastic wrap & other

packing
Cartoning & crating

$0.50

$0.50

$0.50 per pillow

$0.40

$0.40

Although this is a batch

cost, notice that the perunit cost has not changed
because both orders are
divisible by 25, which is
the batch size.

Transport

$0.60

$0.75

$3,000/5,000;

4-24
$3,000/4,000. Still need
two trips even though the
order is smaller.
Purchasing &
manufacturing
support
Sales & support

$3.00

$3.75

$15,000/5,000;
$15,000/4,000

$0.20

$0.25

$1,000 / number of
pillows.

Cost per pillow

$31.20

$32.15

The revised price per pillow is therefore $40.19 = $32.15 (1 + 0.25).

Notice that the unit cost has increased due to the presence of batch- and order-(product-)
level costs. Because the batch size is smaller than the step size for transportation costs
under the revised order, the unit cost will increase. Similarly, the product costs related to
purchasing and manufacturing support and sales support are spread over a smaller
volume level, thereby increasing the cost per pillow.
4.50 a. By inspection, we see that the highest and lowest activity levels (pizzas sold)
occurred in the fourth and first quarter, respectively. Accordingly, we have:
HIGH (Fourth quarter):
LOW (First quarter):

$190,000 = FC + (40,000 cost per pizza sold)

$115,000 = FC + (25,000 cost per pizza sold).

Solving for the UVC, or cost per pizza sold, we find

UVC = $190,000 - $115,000 = $75,000 = $5.00 per pizza
40,000 25,000
15,000
Substituting UVC into either equation, we find that FC = $10,000. Thus, Pizzeria
Paradises total quarterly cost equation is:
Total Quarterly Costs = $10,000 + ($5.00 number of pizzas).
b. As shown in part [a], our estimate of Pizzeria Paradises fixed costs is indeed negative.
Clearly, Pizzeria Paradise will not incur negative fixed costs (i.e., receive money) if it
produces 0 pizzas in a quarter. What we need to keep in mind is that any estimated cost
model is only valid within a particular range of activity usually defined by the range in
the data used to estimate the model. Projections outside of this range may not be accurate
because the linear approximation implied by the model may no longer be valid.
In the Pizzeria Paradise example, we estimated the cost model using activity levels
between 25,000 and 40,000 pizzas. However, interpreting the $10,000 as a fixed cost
requires that we apply the model at a value of 0 pizzas. This value is well outside the

4-25
relevant range. The model likely is only applicable for activity levels between 25,000 and
40,000 pizzas.
c. Using the model developed in part [a], our estimate of total costs at a volume of
50,000 pizzas is:
Estimated Quarterly Costs = $10,000 + ($5.00 50,000) = $240,000.
Building on the discussion in part [b], we need to be concerned about this estimate
because it falls outside the range of data used to estimate the cost equation. Thus, we
should issue a caveat to management that our estimate may not be valid because it falls
outside the relevant range. In addition, it probably also is worth pointing out issues
related to drawing inferences and/or estimating cost from just a years worth of data
particularly the startup year. It will be important to closely monitor Pizzeria Paradises
cost patterns in the coming months/quarters as the business settles into a more stable
pattern.
4.51 a. By inspection, we see that the highest and lowest activity levels (ZAP kits sold)
occurred in the fourth and second quarter, respectively. Accordingly, we have:
HIGH (Second quarter):
LOW (Fourth quarter):

$268,200 = FC + 9,600 Variable cost per kit.

$181,500 = FC + 4,500 Variable cost per kit

Solving for the UVC, or variable cost per kit, we find

UVC = $268,200 - $181,500 = $86,700 = $17.00 per kit
9,600 4,500
5,100
Substituting UVC into either equation, we find that FC = $105,000. Thus, ZAPs
quarterly cost equation is:
Total Quarterly Costs = $105,000 + ($17.00 number of kits sold).
b. The following graph depicts the relation between total quarterly costs and ZAP kits
sold:

4-26

Q2

Q4

Q1

Q3

One of the observations, 9,600 ZAP kits for Quarter 2, does not appear to be in the same
relevant range or fall along the same line as the other three observations. This observation
may reasonably be classified as an outlier or extreme observation and may unduly
influence our cost model.
c. This information confirms our intuition. The observation for the second quarter is not
representative of the model that governs the other observations. Thus, we need to reestimate the quarterly fixed costs and the variable cost per ZAP kit sold.
After eliminating the second quarter, the third and fourth quarter have the highest and
lowest activity levels, respectively. Thus, we have:
(Third quarter):
(Fourth quarter):

$192,000 = FC + (6,000 variable cost per kit),

$181,500 = FC + (4,500 variable cost per kit).

Solving, we find UVC = $7.00 and FC = $150,000. Thus, our cost equation is:
Total Quarterly Costs = $150,000 + (number of kits sold $7.00).
Using this cost equation on the second quarters activity level, we would expect second
quarter total costs to be: $150,000 + (9,600 $7) = $217,200. Because actual total costs
were $268,200 during the second quarter, our model suggests that ZAP spent $51,000 on
advertising. This conclusion, though, should be tempered because the activity level of
9,600 kits is likely beyond the relevant range over which we estimated the cost equation.
Other questions to consider are whether there were any step increases in staff whether
production, order fulfillment, or marketing to go along with the increases in units sold.

4-27
d. Graphing the data and ensuring data reliability are crucial steps before employing any
model to estimate costs. Graphing the data is an excellent way to gain intuition regarding
the relation between activity levels and costs. Graphs also alert the user to outliers and
potential non-linearity in the relation between activity levels and costs. Advanced users
also check the data to ensure that the cost and the activity are recorded in the same time
interval. For example, some of the costs associated with one months activity may be
recorded in another month. In this case, we must adjust the data so that the activity and
the associated cost line up in the same observation.
4.52 a. The cost of employees is a step cost. Specifically, Carlton needs to hire one
person until the number of cars detailed reaches 900 per year (900 = 3 cars per day 300
days a year). Beyond 900 cars, Carlton needs to hire two people, until the volume reaches
1,800 cars, at which point he needs to hire three people, and so on. Thus, the step size is
900 cars detailed and every 900 cars per year triggers a step-increase in the employee
costs. In other words, employee costs are fixed from 0 to 900 cars, from 901 to 1,800
cars, from 1,801 to 2,700 cars, and so on.
Realistically, Carlton may need to hire more than one person even if demand were fewer
than 900 cars per year because of seasonal and/or daily variations in demand for
example, it is likely that many more people will want their car detailed in June than in
January. In addition, if Carlton can hire part-time employees (say, on a daily basis), the
step-size becomes much smaller. For every 3 cars demanded, he needs to pay for an
additional day. The step is now an hour instead of a full-time employee. With a sufficient
reduction in the granularity of a resource (e.g., the minimum size for purchase), one can
turn a fixed cost into a variable cost. While such reduction appears feasible in this
business, it may not be technologically or economically feasible in other businesses.
b. First, we write out Carltons annual cost equation:
Total Costs = fixed costs + (# of employees cost per employee) + (variable cost per car
detailed # of cars detailed).
Using the data for years 1 and 2, we can estimate the variable cost per car detailed. Such
estimation is feasible because both the fixed costs and the employee costs are the same
for both years.
(Year 1): $129,000 = fixed costs + (2 cost per employee) + (1,200 VC per car)
(Year 2): $137,000 = fixed costs + (2 cost per employee) + (1,600 VC per car)
Because the employee costs are the same for these two years, we can solve for the UVC,
or detailing cost per car, as we have in the past, and find:
UVC = $137,000 - $129,000 = $8,000 = $20.00 per car detailed
1,600 1,200
400

4-28
We can now use our variable cost estimate in the cost equations for years 2 and 3, where
we do have variation in the number of employees (which is necessary so that the
employee costs do not, excuse the pun, wash in our estimation). We also could use years
1 and 3 in our estimation.
(Year 2): $137,000 = fixed costs + (2 cost per employee) + (1,600 $20)
(Year 3): $183,000 = fixed costs + (3 cost per employee) + (2,400 $20).
First we simplify these equations:
(Year 2): $137,000 = fixed costs + (2 cost per employee) + ($32,000)
(Year 3): $183,000 = fixed costs + (3 cost per employee) + (48,000).
Subtracting $32,000 and $48,000 from both sides of the respective equations leads us to
the following set of equations.
(Year 2): $105,000 = fixed costs + (2 cost per employee)
(Year 3): $135,000 = fixed costs + (3 cost per employee)
We now can solve for the UVC, which in this case is the annual cost per employee.
UVC = $135,000 - $105,000 = $30,000 = $30,000 per employee
32
1
We can now plug in the cost per employee and the variable cost per car detailed into any
of the years to estimate Carltons annual fixed costs. Using, for example, year 1 we have:
(Year 1): $129,000 = fixed costs + (2 $30,000) + (1,200 $20).
Solving, we find fixed costs = $45,000. Thus, Carltons annual cost equation is:
Total Costs = $45,000 + (# of employees $30,000) + ($20 # of cars detailed).
Please note that we need at least three data points to solve this problem. This occurs
because there are three unknowns in the cost model: (1) fixed costs, (2) the cost per
employee, and (3) the variable cost per car detailed. In general, we need at least as many
data points as unknowns in cost estimation.

4-29

4.53 a. Based on the data provided, we have:

HIGH (September)
LOW (March)

$560,000 = FC + (15,000 variable cost per pillow)

$420,000 = FC + (10,000 variable cost per pillow)

Solving for the UVC, or variable cost per pillow, we find

UVC = $560,000 - $420,000 = $140,000 = $28.00 per pillow
15,000 10,000
5,000
Substituting our estimate of UVC into either equation, we find that FC = $140,000. Thus,
Comfort Pillows monthly total cost equation is:
Total costs per month = $140,000 + ($28.00 number of pillows sold)
b. For a short-term order like the one from the store, fixed costs generally are noncontrollable as Comfort would incur theses costs whether the order is accepted or not.
The variable cost is the estimate of the additional cash outflow from making one more
pillow and, thus, would be the controllable amount.
With a 25% markup and using the estimate of the variable cost, the price per pillow
would be $28.00 (1 + 0.25) = $35.00.
Notice that this price is $4.00 less than the $39.00 price in part [a] of the previous
problem and is independent of the volume of pillows ordered.
c. The difference stems from variations in the detail considered. The account
classification method considered details such as changes in batch size and, as a result, is
likely to be more accurate. For instance, the method yielded different cost estimates at
differing volume levels (as expected with any batch processes). The high-low method, in
contrast, classifies all costs as fixed or variable. Consequently, it misclassifies some costs
and does not represent their behavior well. This method may yield a good and easy to
compute first approximation but is not as reliable. Moreover, it is likely that, under the
high-low method, some of the costs that were classified as batch- or product-level under
the account classification method would be classified as fixed. The estimates between the
high-low method and the account classification method will be close when the
magnitudes of the batch- and product-level costs are small relative to the magnitudes of
the fixed and variable costs.

4-30

4.54 a. The following graph depicts the relation between the total costs of making course
packets and class size:

The relation between the number of students and the total cost of making course packets
indeed appears to be linear. The plot indicates that the observed data points deviate only
slightly from a straight line this deviation could arise from measurement error or from
other factors such as the number of pages in a course packet that determine the cost of a
course packet.
b. Using Excel, we obtain the following regression equation and output:
Regression Statistics
R-Square
98.85%
Adjusted R-Square
98.57%
Observations
6

Intercept
Class size

Coefficient
s
143.133
3.877

Standar
d Error
8.121
0.208

t statistic
17.624
18.591

p-value
0.00
0.00

We estimate the fixed costs of preparing a course packet at $143.133 per class and
the variable cost at $3.877 per student. (Note: the high fixed costs relate to
obtaining copyright permission, assembling the master packet, and charges for the
copy machine and machine operator).
Thus, the cost equation is:
Cost of making packets for a class = $143.133 + $3.877 Class size.

4-31
c. The reported regression results indicate an excellent fit. The R-square is 98.8%,
consistent with a high association between the number of students and the cost of course
packets. Economically, the story is plausible as a greater number of students increases the
number of copies made and, in turn, cost.
We might be able to improve the accuracy of the estimate by adding the size of the course
packet (in number of pages), although the high association for Watson could be because
the size of the course packet does not vary much across classes. More data might help
shed light on the costs and benefits associated with adding other explanatory variables to
the regression equation.
4.55 a. Using Excel, we obtain the following regression equation and output:
Regression Statistics
R Square
1.1%
Adjusted R Square
0.0%
Observations
9

Intercept
Machine
hours

Coefficient
s
787.933

Standar
d Error t statistic p-value
379.463 2.076442 0.076486

0.007847

0.02771 0.283192 0.785222

Thus, the cost equation is:

Maintenance hours = 787.933 + (0.007847 Machine hours)
This equation indicates a lack of relation between machine hours and maintenance hours.
The R-square is extremely low (1%) and the coefficient on machine hours is not
significant.
b. As discussed in part [a], the equation indicates a poor fit between machine hours
and maintenance hours. The R-Square is low (1%) and the p-value for machine
hours is 0.78, meaning that it is statistically indistinguishable from zero. The result
is surprising because we expect a greater number of machine hours to lead to more
maintenance.
Franks practice alerts us to one potentially source of error. It is possible that maintenance
hours lag machine hours. That is, if there is high machine usage in quarter 1, the
associated maintenance may occur in quarter 2. If we regress (as we did in part [a]) the
maintenance hours in quarter 1 with the machine hours in quarter 1, we will not capture
this association because of the lag effect.

4-32
c. In this specification, we lag the machine hours by one quarter to match up machine
hours and maintenance hours. That is, we will treat the machine hours for quarter 1, 2007
as the predictor for the maintenance done in quarter 2 of 2007, the machine hours in Q2,
2007 as the predictors for maintenance in Q3, 2007 and so on.
Estimating the equation after such aligning of data yields:
Regression Statistics
R Square
86.95%
Adjusted R Square
84.78%
Observations
8

Intercept
Machine hours (in
prior quarter)

Coefficient Standard
s
Error
t statistic p-value
-39.6145 151.3295 -0.26178 0.802249
0.069039 0.010915

6.32514

0.00073

Maintenance hours = 787.933 + (0.007847 Prior quarter Machine hours)

This equation indicates an excellent fit, as shown by the high value for the R-square and
the low p-value for the independent variable (prior quarter machine hours). Notice,
however, that we lose one observation because we employ lagged data.
In essence, this problem highlights the importance of understanding the data and their
economic relations before employing statistical methodologies.
4.56 a. The following graph depicts the relation between advertising costs (y-axis) and
sales revenue (x-axis).

4-33
The graph indicates that the relation between advertising expenditures and sales
revenue is reasonably linear.
b. Using Excel, we obtain the following regression equation and output:
Regression Statistics
R-Square
75.6%
Adjusted R-Square
71.5%
Observations
8

Intercept
Sales Revenue

Coefficient Standard
s
Error
t statistic
-94,515.1 73659.78 -1.28313
0.2446 0.056707 4.315095

p-value
0.24
0.00

This equation indicates a good fit between the two variables. The R-square is at a high
level and the coefficient for the independent variable has a low p-value.
c. Using the equation from part [b], we have:
Advertising cost = - $94,515 + (0.2446 $1,750,000) = $333,535.
We urge caution when using this estimate. First, we are using the equation to predict costs
for a value that could be outside of the relevant range for the model. Second, the direction
of the economic linkage between sales and advertising is ambiguous. One can plausibly
argue that advertising expenses trigger sales and not vice versa. Moreover, there could be
a lag between the time of advertising and the sales realization. Thus, while the cost
equation may be a good fit statistically, the economic underpinnings of this model are
debatable.
4.57 a. The key is to realize that the service department currently is incurring the
variable costs associated with all of the repairs, regardless of whether the repairs are
internal or external. However, revenue is only recognized on sales made to external
customers (no revenue is recorded for repairs to cars purchased for inventory or
courtesy repairs to used cars sold). If the service department could charge the used car
department for these repairs (i.e., as if it were a separate stand-alone service station), then
its revenues would double (since half of their time is spent on such repairs). Meanwhile,
its variable costs would stay at the same level. In addition, the used car costs would
increase by $200,000, reflecting the value of the services received. The revised
contribution margin statement below reflects these changes:

4-34

Revenue
Revenue used cars
Variable costs
Service costs
Contribution Margin
Traceable fixed costs
Segment Margin
Common fixed costs
Profit before Taxes

Used Cars
$2,500,000
----------1,200,000
200,000
$1,100,000
750,000
$350,000

Service
$200,000
200,000
200,000
----------$200,000
250,000
($50,000)

Total
$2,700,000
200,000
1,400,000
200,000
$1,300,000
1,000,000
$300,000
200,000
$100,000

Notice that Carousels overall profit has not changed it remains at $100,000. The
revised income statement simply paints a truer picture regarding the stand-alone
revenues and costs associated with each of Carousels departments. Moreover, the service
department is not performing as poorly as previously thought.
b. Based on the nature of the common fixed costs, it is unlikely that these costs will
decrease if the service department is closed. All other revenues and costs associated with
the service department, however, likely will go away. As calculated in part [a], the service
department is losing $50,000 before considering common fixed costs thus, all other
things being the same, Carousels profit is expected to increase by $50,000 if the
service department were closed. This effect also can be seen (and verified) by
constructing an income statement with used car sales only. We present such an income
statement below (again, this income statement assumes that the used car department will
pay for minor repairs on the cars it buys and still provide courtesy repairs and
maintenance on used car purchases all of this will be done via an independent service
station at market price, or $200,000 as calculated earlier):

Revenue
Variable costs*
Contribution margin
Traceable fixed costs
Common fixed costs
Profit before Taxes

Used Cars
$2,500,000
$1,400,000
$1,100,000
$750,000
$200,000
$150,000

* = $1,200,000 + $200,000

Again, we see that Carousels overall income is expected to increase by $50,000 to

$150,000.
There are, of course, other factors that should be considered, perhaps the most important
of which relates to the effect on used car sales. For example, it is quite possible that
closing the service department will decrease used car sales. That is, the service
department likely entices customers to look at and purchase a car (e.g., someone who is

4-35
waiting on a repair might roam the used car lot). Other considerations relate to whether
the entire service departments traceable fixed costs will go away (e.g., those related to
equipment or space) and whether some of the common fixed costs will go away (e.g., the
general managers salary may decrease since his/her responsibilities have decreased).
c. A 10% decrease in used car sales implies that used auto revenues, variable costs, and
contribution margin will all decrease by 10%. However, it is unlikely that, at least in the
short term, either traceable fixed costs or common fixed costs will decrease. With this,
our revised income statement for used cars looks as follows:
Item
Revenue
Variable costs
Contribution margin
Traceable fixed costs
Common fixed costs
Profit before Taxes

Used Cars
$2,250,000
$1,260,000
$990,000
$750,000
$200,000
$40,000

Detail
$2,500,000 .90
$1,400,000 .90
$1,100,000 .90

Here, we see that Carousels overall income decreases by $60,000 to $40,000.

Assuming the accuracy of the various estimates underlying the revised income statement,
Carousel should not close the service department. This problem underscores the
importance of considering interdependencies among departments and/or products
oftentimes it is difficult to evaluate products or departments on a stand alone basis.
Moreover, the contribution margin statement helps us assess these interdependencies.
4.58 a. The total variable costs are comprised of materials, labor, and variable overhead.
Because materials and variable overhead are expected to remain the same for each of the
32 guidance systems, we calculate the sum of these costs as:
Total expected materials and variable overhead costs = 32 ($400,000 + $200,000) =
$19,200,000.

4-36

We need to factor in the 90% learning curve to estimate the total labor costs of producing
the 32 guidance systems. The following table shows the average labor cost per guidance
system as well as the total labor cost, assuming a 90% learning curve.
Number of
Guidance Systems
1
2
4
8
16
32

Average Labor Cost

per system
$600,000
(given)
$540,000
(600,000 .90)
$486,000
(540,000 .90)
$437,400
(486,000 .90)
$393,660
(437,400 .90)
$354,294
(393,660 .90)

Total Labor Cost*

$600,000
$1,080,000
$1,944,000
$3,499,200
$6,298,560
$11,337,408

Thus, the total expected variable costs = $19,200,000 + $11,337,408 = $30,537,408.

b. Bid = 1.50 total variable costs = 1.50 30,537,408 = $45,806,112.
In turn, the expected contribution margin = bid total variable costs = $45,806,112
$30,537,408 = $15,268,704.
c. The revenue that FlyWell will receive from the contract = .50 $45,806,112 =
$22,903,056.
To determine the contribution margin, we need to determine the total variable costs of
producing the 16 systems. For materials and variable overhead, we have: 16 ($400,000
+ $200,000) = $9,600,000. For labor costs, we have (from the table in part [a])
$6,298,560. Thus, FlyWells total costs = $9,600,000 + $6,298,560 = $15,898,560 and the
actual contribution margin = $22,903,056 $15,898,560 = $7,004,496, less than the
50% of the anticipated contribution margin of $15,268,704.
Furthermore, the actual markup percentage = 7,004,496/15,898,560 = 44%.
The actual markup is lower than the 50% target. This is because the cost of producing the
first 16 systems is higher than the cost of producing the next 16 systems. If Flywell had
known that the order was for 16 systems only, it should have priced the 16 systems at a
total of $23,847,840 (= $15,898,560 1.50) to achieve a 50% markup. If the government

4-37
scales back the order volume, FlyWell should attempt to renegotiate the price because
of learning effects, expected total costs (and profit) depend crucially on volume.
4.59 a. To arrive at the unit selling price, we first need to determine the learning rate.
Next, we need to calculate the total labor hours required to complete batches 1 through 16
and batches 1 through 32. Third, we need to calculate the average time to complete a
batch for batches 17 through 32. Finally, we use the average time to arrive at the unit
selling price. Each of these steps is detailed below.
Step 1: Determine the learning rate
The problem provides the actual time to complete batches 1 and 2. To determine the
learning rate, we need the average time for batches 1 and 2.
Total time to complete batches 1 and 2:
Average time to complete batches 1 and 2:
Average time to complete batch 1:
Learning rate

32,000 + 22,400 = 54,400

54,400/2 = 27,200
32,000 (given)
27,200/32, 000 = 0.85 or 85%

Step 2: Determine the total time to complete batches 1-16 and batches 1-32
The following table shows the cumulative average labor hours per batch as well as the
cumulative total labor hours, assuming an 85% learning curve.

Number of Batches
1
2
4
8
16
32

Cumulative
Average Labor
Hours
32,000
(given)
27,200
(32,000 .85)
23,120
(27,200 .85)
19,652
(23,120 .85)
16,704.20
(19,652 .85)
14,198.57
(16,704.20 .85)

Cumulative Total
Labor Hours*
32,000
54,400
92,480
157,216
267,267.20
454,354.24

* = cumulative average labor hours number of batches

4-38

Step 3: Determine the average time to complete batches 17-32

Total time for batches 1-32
Total time for batches 1-16
Total time for batches 17-32
Average time for batches 17-32

454,354.24 hours
267,267.20 hours
187,087.04 hours (454,354.24 267,267.20)
11,692.94 hours (187,087.04/16 batches)

Step 4: Determine the unit selling price

Materials cost
Variable overhead cost
Labor cost
Total variable cost
Markup
Price for batch
Price per unit

$150,000.00
$ 50,000.00
$292,323.50
$492,323.50
$369,242.63
$861,566.13
$8,615.66

(given)
(given)
(11,692.94 labor hours $25 per labor hour)
($442,323.50 .75)
($861,566/100 units per batch)

b. We can calculate Zerons expected profit in year 1 as follows:

Revenue

$861,566 16

$13,785,058

Materials costs
Variable overhead costs
Labor costs
Fixed costs
Profit in year 1

$150,000 16
$50,000 16
$267,267.20 $25

($2,400,000)
($800,000)
($6,681,680)
($3,000,000)
$903,378

c. We can calculate Zerons expected profit in year 2 as follows:

Revenue

$861,566.13 16

$13,785,058

Materials costs
Variable overhead costs
Labor costs
Fixed costs
Profit in year 2

$150,000 16
$50,000 16
$187,087.04 $25

($2,400,000)
($800,000)
($4,677,176)
($3,000,000)
$2,907,882

Notice the sharp increase in profit from year 1 to year 2 even though the firm has sold the
same number of units and for the same unit price. The increase is attributable to the
decrease in labor costs. Generally, the profit per unit will steadily increase for products
subject to a learning effect.

4-39
Note: Some instructors may wish to discuss the financial accounting implications of costs
subject to learning. Oftentimes, firms will smooth reported profit by estimating the total
profit over the product life and then using a reserve account (called deferred learning
costs) to recognize the difference between the average profit and the actual profit for the
period. This asset account will accumulate balances in the early years (less cost than
actually incurred will be recognized in the income statement). The balances decline in
later years and will be zero at the end of the project (more cost than actually incurred will
be recognized in the income statement).
Mini Cases
4.60 a. The following graph depicts the relation between Yin-Yangs total costs and cups
of yogurt sold.

Dec
Feb

Aug

Jan

b. We want to estimate the following cost equation:

Total monthly costs = Fixed costs + (Variable cost per cup of
yogurt cups of yogurt).
For convenience, write the variable cost per cup of yogurt = UVC or unit variable cost.
Using the data from January and February, we have:
January: $5,500 = FC + (UVC 1,000)
February: $6,200 = FC + (UVC 1,200).
Solving for UVC, we have:
UVC = $6,200 - $5,500 = $700 = $3.50 per cup
1,200 1,000
200
Substituting the value for UVC into the January cost equation yields

4-40
FC = $5,500 (1,000 cups $3.50 per cup) = $2,000.
Thus, we would model Yin-Yangs cost function as:
Total monthly costs = $2,000 + ($3.50 cups of yogurt).
The following graph shows this estimate vis--vis the actual data:

Dec
Feb
Jan

Note: The first data points for January and February are hidden behind the estimated
line.
c. Again, we want to estimate the following cost equation:
Total monthly costs = Fixed costs + (Variable cost per cup of yogurt cups of yogurt).
The months with the highest and lowest total costs are December and January,
respectively. Accordingly, we have:
December: $8,500 = FC + (UVC 1,100)
January: $5,500 = FC + (UVC 1,000).
Solving for UVC, we have:
UVC = $8,500 - $5,500 = $3,000 = $30.00 per cup
1,100 1,000
100
Substituting the value for UVC into the January equation yields
FC = $5,500 (1,000 cups $30.00 per cup) = $24,500.

4-41
Thus, Yin-Yangs cost function would be modeled as:
Total monthly costs = $24,500 + ($30.00 cups of yogurt).
The following graph shows this estimate vis--vis the actual data:

Dec
Jan

Aug

Note: The first two actual data points (for December and January) are hidden behind
the first two points of the estimated line.
d. The months with the lowest and highest activity levels are January and August,
respectively. Accordingly, we have:
January: $5,500 = FC + (UVC 1,000)
August: $8,125 = FC + (UVC 2,500).
Performing procedures analogous to those in parts [b] and [c] we find UVC = $1.75 and
FC = $3,750. Thus, Yin-Yangs cost function would be modeled as:
Total monthly costs = $3,750 + ($1.75 cups of yogurt).
The following graph shows this estimate vis--vis the actual data:

4-42

Aug
n
Jan

e. Using Excel, we obtain the following regression equation and output when we
include the data for December:
Regression Statistics
R-Square
34.5%
Adjusted R-Square
28.0%
Observations
12

Intercept
Cups sold

Coefficient Standard
s
Error
t statistic
5223.91
796.46
6.55
1.03
0.44
2.29

p-value
0.00
0.04

This equation indicates a questionable fit between the two variables. The R-square
is somewhat low and the p-value for the independent variable is only marginally
significant.
The picture changes dramatically if we exclude the outlier (the observation
for December). We obtain the following:
Regression Statistics
R-Square
96.3%
Adjusted R-Square
95.95%
Observations
11

4-43

Intercept
Cups sold

Coefficient Standard
s
Error
t statistic
4074.47 186.190
21.883
1.578
0.102
15.424

p-value
0.00
0.00

This equation indicates an excellent fit between the two variables. The R-square is at a
high level and the coefficient for the independent variable has a low p-value.
f. Using the highest and lowest activity levels (i.e., the cost equation estimated in part
[d]) appears to lead to the best estimate of Yin-Yangs cost structure. The differences
between the actual and predicted costs using this estimate are rather small, indicating a
very good (exceptional) fit. This estimate clearly leads to a better specification of costs
than the estimates arrived at in parts [b] and [c] even though the month of January was
used in all of our specifications. Notice that we get markedly different specifications
depending on the other month chosen.
The estimate in part [b] is biased because there is little difference in the January and
February activity levels only 200 cups of yogurt. Small deviations in cost vis--vis the
true underlying cost structure can lead to a biased estimate of variable costs (because the
denominator is small) and, in turn, fixed costs. For example, assume one of Yin-Yangs
employees was sick for a week in January with the flu and that other employees had to
cover for his/her absence. Assume the sick employee was scheduled to work for 30
hours and would have made $200 for the week. This relatively small change would
have resulted in a variable cost estimate of $2.50 rather than $3.50 and a fixed cost
estimate of $3,200 rather than $2,000.
The estimate in part [c] is biased because the December cost data appears to be an outlier
(an extreme observation). For example, Ying-Yang could have paid its employees a
Christmas bonus and/or paid its annual property taxes in December. While these costs
would be incurred and recorded in December, they do not relate to cups of yogurt sold in
December. Including data tainted by such features might lead to inaccurate measures of
fixed and variable costs indeed, we see that our estimate of fixed costs is negative
$24,500.
By itself, a negative fixed cost estimate is not enough to conclude that cost estimates are
incorrect. However, it is suggestive of errors, particularly when the relevant range is close
to zero. Moreover, this aspect of the problem illustrates that there is often more bias, or
measurement error, in total costs than in activity levels. Costs can be erratic and lumpy;
accounting systems can fail to capture the relation between spending and consumption.
This reinforces why activity levels, rather than costs, typically are the basis for selecting
data points.
More generally, instructors may wish to note that accounting conventions (e.g., cash
accounting) may result in costs for one month being recorded in another month. Because

4-44
the high-low method uses only two observations, it is particularly susceptible to this kind
of error. Using the two activity levels rather than the two cost levels reduces such
concerns. These kinds of classification error have smaller effects on analyses that use all
available data, such as the regression method.
However, the exercise on the regression, part [e], shows the effect of an outlier even on
methods such as regression. This one observation skews the data considerably,
underscoring the importance of plotting data before analyzing it using regressions.
4.61 a. The high and the low observations correspond to year 3 and year 2, respectively.
Writing out the cost equation for these two data points, we have:
$1,475,000 = Fixed costs + (Variable cost per participant 5,000 participants)
$1,122,500 = Fixed costs + (Variable cost per participant 3,500 participants)
Solving for the UVC, or variable cost per participant, we find
UVC = $1,475,000 - $1,122,500 = $352,500 = $235 per participant
5,000 3,500
1,500
Variable cost per seminar participant = $235.00
Plugging this estimate into the high or the low value equation, we have:
Fixed costs = $300,000
Thus, we estimate Brads total annual cost equation as:
Total costs = $300,000 + ($235.00 number of seminar participants)
b. If Brad offers 20 seminars under the new format, then he will have 20 seminars 230
participants per seminar = 4,600 participants for the year. Let us plug this number into the
cost equation to estimate total costs:
Total costs = $300,000 + ($235 4,600) = $1,381,000.
In turn, total revenues are:
Total revenues = $350 per participant 4,600 participants = $1,610,000.
Subtracting total costs from total revenues, we find:
Profit before taxes = $1,610,000 $1,381,000 = $229,000.
Comparing this profit estimate to Brads profit with offering 35 seminars under the
current format, it appears that Brad would make substantially less money ($229,000

4-45
versus $421,875) if he were to switch his seminar format.
c. Our classification of each cost is as follows: We note that the central office and
administration costs of $250,000 could be classified as either product-level or facilitylevel costs, depending on how they are viewed. If the costs relate solely to running
seminars, then they would rightfully be classified as product-level costs. If the costs
relate to Brads entire business, which not only includes seminars but also includes
selling books and tapes, then they would be facility-level costs.
Cost Hierarchy
Classification
Unit level

Cost Item
Variable costs
The cost for each
seminar
Cost of seminar
coordinator
Central office and
administration

Batch level
Product level
Product
level/Facility level

Explanation
Varies with the
number of
participants
Varies with the
number of seminars
Required for
offering seminars.
Required to sustain
the business.

d. This question helps us see that the high-low method does not account well for batchand product-level costs. Let us re-estimate Brads costs and profit using account
classification:
Item

Detail

Total number of
participants

# of seminars 125
persons per seminar; # of
seminars 230 persons
per seminar.
Number of participants
$400; Number of
participants $350.
$75 total number of
participants
$20,000 number of
seminars; $25,000
number of seminars.
$50,000 given

Revenue
Variable costs
Costs for setting up
the seminars
Cost of seminar
coordinator
Annual fixed
operating costs
Profit before Taxes

35 Seminars
(125 per
seminar)

20 Seminars
(230 per
seminar)

4,375

4,600

$1,750,000

$1,610,000

328,175

345,000

700,000

500,000

50,000

50,000

250,000
$421,875

250,000
$465,000

$250,000 given

The above detailed analysis suggests that Brads profit actually will be $465,000 if he
switches to the new seminar format. Moreover, Brads profit will increase by $465,000
$421,875 = $43,125 if he switched to the new format.

4-46

e. The methods do lead to dramatically different answers. Based on our analysis in part
[b], it appeared that Brad would forego roughly $200,000 in profit if he were to switch
his seminar format. In part [d], however, we find that Brads profit would actually
increase if he were to switch formats.
Why do the two methods yield such different answers? The answer is that the high-low
method implicitly classifies batch-level and product-level costs as being variable (unit
level) or fixed (facility level).Thus, any cost estimates using the high-low method
implicitly assume no change in the production technology that is, the batch size will
stay the same and the cost per batch or product will not change. For Brad, as long as the
batch size stays at 125 participants per seminar, our cost and profit estimates will be the
same under the two methods notice that our profit estimates under the high-low method
and the account classification method are equivalent for 35 seminars with 125
participants per seminar.
The proposed seminar format changes the batch size from 125 to 230. Thus, Brad can
accommodate the same (or more) participants with fewer seminars that is, the number
of batches decreases. In turn, the batch-level costs will decrease. (Equivalently, the batch
cost per participant decreases.) While the account classification method includes the
consequent decrease in cost, the high-low method, however, is still estimating costs as if
there were only 125 participants per seminar (or, approximately 4,600/125 = 36.8
seminars). Consequently, this method over-estimated costs by approximately $320,000 =
(16 phantom seminars $20,000 per seminar).
Note: The instructor can use this exercise to note that methods such as the high-low
method estimate parameters of the cost function from historical data. Using these
estimates to project future costs implicitly assumes that the underlying cost structure is
stable. (An additional assumption, not covered in this case, is that we are operating within
the relevant range.) If the assumption is not valid, poor decision making can occur. The
account classification method is less subject to this error because it examines each cost
item individually.
4.62 a. Mollys response indicates that she believes all of her costs are variable. That is,
she appears to believe that it costs $16.50 per CD regardless of the number of CDs sold.
Molly does not appear to realize that some of her costs are fixed, and therefore invariant
to sales volume (CDs sold), while some of her costs are variable and, indeed, increase
proportionally with sales volume. Many of Mollys costs are likely to be fixed, including
costs associated with leasing the land and building, having full-time employees, a
computer network, etc.
For this particular decision, Mollys fixed costs are not controllable since she is operating
within the relevant range of activity. Thus, only variable costs will differ between the
decision to keep the selling price at $16.95 per CD or lower it to $14.95 per CD.

4-47
Going a step further, we would suggest that Mollys decision should be made on the basis
of whether the increase in revenue associated with reducing the selling price is more than
the increase in variable costs associated with reducing the selling price.
b. The following graph depicts the relation between Mollys total costs and CDs sold.

The graph appears to confirm our intuition from part [a]. Indeed, a portion of Mollys
costs appear to vary directly with the number of CDs sold and a portion appears to be
fixed. Based on the plotted data, it appears that we can reasonably represent Mollys costs
by a straight line with a positive slope and a positive intercept. That is, Mollys total costs
can reasonably be represented as:
Total Costs = Fixed costs + (variable cost per CD # of CDs sold).
c. The high-low method stipulates choosing the highest and lowest levels of activity. For
Molly, this corresponds to December and August, respectively. Accordingly, we have:
HIGH (December):
LOW (August):

$170,000 = fixed costs + 12,000 CDs sold Variable cost per CD

$125,000 = fixed costs + 6,000 CDs sold variable cost per CD.

Solving for the UVC, or variable cost per pillow, we find

UVC = $170,000 - $125,000 = $45,000 = $7.50 per CD sold
12,000 6,000
6,000
Plugging this estimate into either equation yields fixed costs = $80,000. Thus, Mollys
monthly cost equation is:
Total Monthly Costs = $80,000 + (# of CDs sold $7.50).

4-48

The following graph shows this estimate in terms of the actual data:

$200,00
0
$160,00
0
$120,00
0
$80,00
0
$40,00
0

Total
Cost
s

$
0

2,50
0

5,00
0

7,50
0

CDs Sold

10,00
0

12,50
0

15,00
0

The estimated cost equation appears to fit the data extremely well as the differences
between actual and predicted costs are very small. This good fit indicates a strong
relation between the number of CDs sold and total costs.
d. As a first step, it probably is useful to restate Mollys model in terms of annual costs.
This requires us to multiply monthly fixed costs by 12. The variable cost per CD,
however, remains unchanged. Thus, we have:
Total Annual Costs = ($80,000 12) + (# of CDs sold $7.50).
Total Annual Costs = $960,000 + (# of CDs sold $7.50).
If reducing the selling price to $14.95 increases volume by 30%, then annual CD sales
are expected to be: 1.30 106,900 = 138,970. In turn, our estimate of Mollys total
annual costs = $960,000 + (138,970 7.50) = $2,002,275.
At this new level of volume, revenue is expected to be 138,970 $14.95 =
$2,077,601.50. Thus, expected profit = $2,077,601.50 $2,002, 275.00 = $75,326.50.
Compared to last years profit, Mollys profit would increase by $75,326.50 $48,105.00
= $27,221.50.

4-49

The astute student can well ask if last years profit is the right benchmark for computing
the change in expected profit. This question arises because last years data is the actual
cost. That is, it includes any random factors that might have affected costs last year (e.g.,
an unanticipated increase in utility rates because of a cold winter.) Thus, we also need to
use the model to estimate profit if volume in the coming year were to remain the same as
the previous year. Assuming Molly sold the same number of CDs this year as last year,
we would estimate Mollys profit as $1,811,955 [$960,000 + (7.50 106,900)] =
$50,205. Thus, Mollys expected increase in profit is $75,326.50 $50,205.00 =
$25,121.50.
Based on these calculations, Molly should follow your advice as her profit is
expected to increase by 50%.
e. Here, we can compare the controllable revenues associated with hiring the new
employee to the controllable costs associated with hiring the new employee.
The controllable costs associated with hiring the new employee equal the employees
salary plus the variable costs associated with selling another 750 CDs a month, or 750
12 = 9,000 CDs per year. Specifically, we have:
Annual cost of hiring new employee = $52,150 + (9,000 $7.50) = $119,650.
The annual revenues associated with hiring the new employee = $14.95 9,000 =
$134,550.
Thus, the new employee is expected to increase Mollys profit by $134,550 $119,650
= $14,900. Molly should therefore hire the new employee. Notice that knowledge of
Mollys cost structure, i.e., that the variable cost per CD = $7.50, is extremely helpful in
making this decision without this piece of information, we would not be able to
calculate the controllable costs associated with hiring the new employee and, in turn,
whether the new employee should be hired.
f. The amount paid for the CDs is long-gone (sunk) and is not relevant to the decision at
hand. In holding on to the CDs, Molly needs to consider the likelihood that she will sell
the CDs in the future and the amount that she will receive from selling the CDs. The
expected revenue from future sales is Mollys opportunity cost of declining the offer.
Thus, if Molly does not expect to make more than $15 in the future, then she should sell
them now. Since Molly has not sold a single CD in the past 7 years, it is unlikely that a
better offer will come along. Overall, Molly would be hard-pressed not to accept the
offer.
Note: As we will learn in Chapter 5, Mollys opportunity cost also depends on whether
her shelf space is constrained. If yes, then the opportunity cost of selling the CD would
include the amount lost from not being able to use the space to sell other CDs.

4-50

4.63 a. Denzels annual customer contribution statement is presented below:

Denzel Adams
Annual Customer Contribution Statement
Item
Fee per engagement
Engagements per week
Revenue per week
Variable Costs per week
Supplies1
Cost of labor2
Weekly contribution margin
# of weeks
Annual Contribution Margin
Traceable fixed costs
Advertising cost
Direct equipment
Hired help for 2 weeks3
Segment Margin
Common fixed costs
Common equipment4
Office Expenses
Profit before Taxes

Commercial Residential
$150
$80
6
6
$900
$480
180
450
$270
50
$13,500

$1,500
300
$11,700

Total
$1,380

120
180
$180
50
$9,000

300
630
$450
50
$22,500

$5,000

$5,000
1,500
300
$15,700

$4,000

$5,500
$1,500
$8,700

$180 = $30 6; $120 = $20 6

$450 = 10 hours per day $15 per hour 3 days per week; $180 = 6 hours per day
$15 per hour 2 days per week;
3
= 6 motels per week 2 weeks ($175 cost $150 fee). Note: We classify this as a
traceable fixed cost as it is a constant amount per year and it is purely associated with
Denzels motel business.
4
= $7,000 $1,500 in equipment attributable solely to motel cleaning jobs.
2

Thus, we see that Denzel earns a total of $8,700 in profit + ($630 50 weeks per year) =
$40,200 in proceeds from his cleaning business. We also see the source of Denzels
concern he earns $300/10 = $30 per hour in revenue from the motels and $240/6 = $40
per hour in revenue from his residential business. This, however, does not take into
consideration the differential costs incurred to serve the residences and motels. Indeed,
the segment margins seem to indicate that the motel business is more profitable than the
residential business we explore this further below.
b. Denzel should not drop his motel business. His profit from doubling his residential
business is:

4-51
Twice the current contribution margin
Less: Advertising

$18,000
10,000

Less: Common equipment

5,500

Less: Office expenses

1,500

Profit before Taxes

$1,000

Adding his wages, Denzel receives $1,000 + (30 hours per week $15 per hour 50
weeks per year) = $23,500 in proceeds from his business. Thus, Denzel receives $40,200
$23,500 = $16,700 less in annual proceeds if he drops the motel business.
However, Denzel would be putting in fewer hours if he drops the motel business (i.e.,
comparing proceeds is not an apples to apples comparison). Denzel saves (10 6) 3
days per week 50 weeks per year = 600 hours per year, and if he values this time at $15
per hour, this amounts to $9,000 = (600 hours $15 per hour). This savings, however,
does not make up for the $16,700.
We do note the importance of being careful when using estimates for the opportunity cost
of time. We are implicitly assuming that Denzel values his time at $15 per hour,
regardless of the number of hours of leisure. This may not be a reasonable assumption as
there is decreasing marginal utility for any normal good. This problem underscores the
value of contribution margin statements and their ability to aid decision making.