W. TERRY DANCER
PROFESSOR OF ACCOUNTING
ARKANSAS STATE UNIVERSITY
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W. TERRY DANCER
PROFESSOR OF ACCOUNTING ARKANSAS STATE UNIVERSITY
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P 1–1: Solution to MBA Students (10 minutes) [Using accounting information for decision making and control]
Together the two observations highlight the extremes in the trade-offs of using accounting information for decision and control. In the first case, there is more analysis of opportunity costs that are hard to capture with typical accounting information. In the second case, there is less intended interest in opportunity cost and greater emphasis on control. P 1-4: Solution to Managers Need Accounting Information (15 minutes) [Alternative uses of accounting information]
Use of the word “need” in the quoted passage is pejorative. It implies an unlimited level of demand for information. However, rational managers apply a cost-benefit criterion to information and will only want accounting information if its benefits exceeds its cost. Accounting information provides benefits by improving decision making and controlling behavior in organizations. In most organizations, accounting information is very prevalent which implies that its benefits exceed its costs. Hence, successful managers will find it in their self-interest to learn how to use accounting information in these organizations. Clearly, this statement is incorrect in those firms where accounting information has very limited usefulness (e.g., if the accounting information is often wrong or is not produced in a timely fashion). In these organizations, managers do not find the accounting information to have benefits in excess of its costs, will not use it, do not need to know how to use it, and definitely do not need it.
P 1–7: Solution to Budgeting (15 minutes) [Trade-off between decision making and control]
In this firm, the bonus is based on meeting the budget. Two incentives exist: sales people will under-forecast future sales and they have little incentive to sell more than the budget. This firm tries to use the budget for two functions: decision making and control. In deciding on next year’s production plans, sales peoples’ forecasts of future sales are important. However, these same forecasts (after revision by supervisors) are used as part of the compensation scheme to motivate the sales people to achieve their goals. By using the budget (forecasts) as part of the control system, the firm gives up some of the budget’s usefulness as a decision making tool to set production plans. While senior managers might recognize that the sales people’s forecasts are low, they don’t know exactly how low. This introduces more uncertainty into planning for next year’s production.
P 1–9: Solution to Parkview Hospital (25 minutes) [Changes in the environment cause accounting system changes]
a. Parkview’s accounting system was probably adequate 10 years ago. It faced little competition and had little incentive to have detailed cost and revenue data at the clinical levels.
b. With increased pressure to reduce costs, Parkview management wants detailed cost and revenue data at the clinic level to help identify units with excess revenues or deficits. This would help guide their decisions as to how to respond to the $3.2 million shortfall. The accounting system doesn’t provide as much help as management would like.
c. The question of changing the accounting system should be approached as a cost-benefit decision. What will such changes cost, how long will they take to implement, and what benefits are derived? While it is tempting to say more accurate tracking of costs and benefits allows better decision making, changing the accounting system, including all the data processing changes that are likely necessary, usually is a very costly and time consuming process. Often special studies based on approximations of clinical department costs and revenues might prove to be faster and cheaper than waiting to revamp the accounting system. Notice the change in competition in the health insurance market caused by Trans Insurance’s entry prompted a series of changes in Parkview, including a re-examination of its accounting system.
P 1–10: Solution to Montana Pen (25 minutes) [Incremental cost of outsourcing]
a. The average cost information given in the problem does not tell us what 400 clips cost. Like in the Vortec example from the chapter, the incremental cost of the 400 clips must be estimated from the following:
At the current volume of 1,200 clips, the total cost is B222,000 (B185 × 1,200). If 400 clips are outsourced, reducing in-house volume to 800, the total cost falls to B170,000 (B212.5 × 800). Hence, total cost falls B52,000 (B222,000 - B170,000), or B130 per clip (B52,000 ÷ 400). Therefore, if 400 clips are outsourced to the Chinese company, Montana saves B130 per clip, but must pay the Chinese firm 136 per clip. Therefore, based solely on the cost data presented in the problem, do not outsource the gold clips.
b. There are a number of additional factors that must be considered besides just the costs:
i. How does the quality of the Chinese clips compare to Montana’s quality? If it is significantly higher, then it might be worth paying six Baht more per clip (approximately $0.10). What about delivery reliability? Is the Chinese firm more or less reliable than producing the clips in-house?
ii. What alternative use can be made of the manufacturing capacity of the 400 clips freed up if they are outsourced? Is the Bangkok plant’s manufacturing capacity constrained because there are not enough skilled goldsmiths or because of space or equipment? If so, by outsourcing the 400 clips to the Chinese, what other pen parts can these goldsmiths manufacture?
iii. What long-term benefits are created by developing a business relation with this Chinese firm? For example, might this Chinese firm become a possible business partner or useful in opening a Chinese pen factory? Will Montana’s management learn anything new about business dealings with Chinese firms from outsourcing these clips? Will purchasing these clips in China help Montana sell more pens in China?
P 2-17: Solution to Home Auto Parts (20 minutes) [Opportunity cost of retail display space]
a. The question involves computing the opportunity cost of the special promotions being considered. If the car wax is substituted, what is the forgone profit from the dropped promotion? And which special promotion is dropped? Answering this question involves calculating the contribution of each planned promotion. The opportunity cost of dropping a planned promotion is its forgone contribution: (retail price less unit cost) × volume. The table below calculates the expected contribution of each of the three planned promotions.
Texcan oil is the promotion yielding the lowest contribution and therefore is the one Armadillo must beat out. The contribution of Armadillo car wax is:
Selling price $2.90 less: Unit cost $2.50 Contribution margin $0.40 × expected volume 800 Contribution $ 320 P 2–28: Solution to Eastern University Parking (25 minutes) [Opportunity cost of land] The University's analysis of parking ignores the opportunity cost of the land on which the surface space or parking building sits. The $12,000 cost of an enclosed parking space is the cost of the structure only. The $900 cost of the surface space is the cost of the paving only. These two numbers do not include the opportunity cost of the land which is being consumed by the parking. The land is assumed to be free. Surface spaces appear cheaper because they consume a lot more “free” land. A parking garage allows cars to be stacked on top of each other, thereby allowing less land to be consumed. The correct analysis would impute an opportunity cost to each potential parcel of land on campus, and then build this cost into both the analysis and parking fees. The differential cost of each parcel would take into account the additional walking time to the center of campus. Remote lots would have a lower opportunity cost of land and would provide less expensive parking spaces. Another major problem with the University's analysis is that parking prices should be set to allocate a scarce resource to those who value it the highest. If there is an excess demand for parking (i.e., queues exist), then prices should be raised to manage the queue and thereby allocate the scarce resource. Basing prices solely on costs does not guarantee that any excess supply or demand is eliminated. Other relevant considerations in the decision to build a parking garage include: 1. The analysis ignores the effect of poor/inconvenient parking on tuition revenues. 2. Snow removal costs are likely lower, but other maintenance costs are likely to be higher with a parking garage. The most interesting aspect of this question is "Why have University officials systematically overlooked the opportunity cost of the land in their decision-making process?" One implication of past University officials’ failure to correctly analyze the parking situation is the "dumb-administrator" hypothesis. Under this scenario, one concludes that all past University presidents were ignorant of the concept of opportunity cost and therefore failed to assign the "right" cost to the land. The way to understand why administrators will not build a parking garage is to ask what will happen if a garage is built and priced to recover cost. The cost of the covered space will be in excess of $1,200 per year. Those students, faculty, and staff with a high opportunity cost of their time (who tend to be those with higher incomes) will opt to pay the significantly higher parking fee for the garage. Lower-paid faculty will argue the inequity of allowing the "rich" the convenience of covered parking while the “poor” are relegated to surface lots. Arguments will undoubtedly be made by some constituents that parking spots should not be allocated using a price system which discriminates against the poor but rather parking should be allocated based on "merit" to be determined by a faculty committee. Presidents of universities have risen to their positions by developing a keen sense of how faculty, students, and staff will react to various proposals. An alternative to the "dumb-administrator" hypothesis is the "rational self-interested administrator" hypothesis. Under this hypothesis, the parking garage is not built because the administrators are unwilling to bear the internal political ramifications of such a decision. Finally, taxes play an important role in the University's decision not to build a parking garage. If faculty are to pay the full cost of the garage, equilibrium wage rates will have to rise to make the faculty member as well off at Eastern University paying for parking than at another university where parking is cheaper. Because employees are unable to deduct parking fees from their taxes, the University will have to increase salaries by the amount of the parking fees plus the taxes on the fees to keep the faculty indifferent about staying or leaving the University. Therefore, a parking garage paid for by the faculty (which means paid by the University) causes the government to raise more in taxes. The question then comes down to: is the parking garage the best use of the University's resources?
P 2–33: Solution to News.com (25 minutes)
Solution to News.com (25 minutes) [Breakeven and operating leverage increases risk]
a. and b. Breakeven number of hits:
c. The choice among ISPs depends on the expected number of hits. The two ISP’s have the same cost at 100,000 hits per month:
$3,000 + $0.01Q = $2,000 + $0.02Q
Q = 100,000
If the number of hits exceeds 100,000 per month, NetCom is cheaper. If the number of hits is less than 100,000, Globalink is cheaper.
d. If demand fluctuates with general economy-wide factors, then the risk of News.com is not diversifiable and the variance (and covariance) of the two ISP’s will affect News.com’s risk. For example, the table below calculates News.com’s profits if they use NetCom or Globalink and demand is either high or low. Notice that News.com has the same expected profits ($1,000 per month) from using either ISP. However, the variance of profits (and hence risk) is higher under Net.Com than under Globalink. Therefore, News.com should hire Globalink. Basically, with lower fixed costs, but higher variable costs per hit, News.com’s profits don’t fluctuate as much with Globalink as they do with Net.Com.
P 2-46: Solution to Amy’s Boards (35 minutes) [Break-even analysis — short-run versus long-run]
The major goals of this problem are to demonstrate how fixed costs first become fixed and second to illustrate the relation between fixed costs and capacity. Before the snow boards are purchased in part (a), they are a variable cost. (In the long run, all costs are variable.) However, once purchased, the boards are a fixed cost. The number of boards purchased determines the shop’s total capacity, which is fixed, until she either buys more boards or sells used boards.
a. Number of boards to break-even:
b. Expected profit with 50 boards:
c. Break-even number of rentals with 50 boards:
d. In the long run, all costs are variable. However, once purchased, the boards are a fixed cost. The reason for the difference is Amy has about ten more boards than the break-even number calculated in part (a). In part (a), before the boards are purchased, they are a variable cost. She can buy any number of boards she wants and pay a proportionately higher cost for them and rent them all 80 percent of the time. Therefore the cost of the boards is a variable cost with respect to the number of rentals. It is subtracted from the revenue in calculating the contribution margin per board. Once you buy the boards, their cost becomes fixed. Instead of being included in calculating contribution margin, it is included in the fixed cost (numerator of the breakeven volume).
P 3–11: Solution to NPV vs. Payback (15 minutes) [NPV and payback]
The investment generates cash flows of $1,200 in its first five years. The worst NPV would be generated when the entire $1,200 is received at the end of the fifth year. In that case the NPV is:
NPV = –1,200 +
= –1,200 + 482
= –$718
P 3–13: Solution to Demand for DVD Players (15 minutes) [Competitive Pricing]
Let the price be p. In a competitive industry the NPV of a new plant will tend to be zero.
NPV =
so p – $20 = $40 p = $60
The price is $60.
P 3–18: Solution to South American Mining (20 minutes) [IRR of an additional investment]
a. The IRR is calculated by looking at the incremental differences (000s).
Let X = 1 ÷ (1 + IRR). Using the equation,
0 = –$1 + $10X – $10X2
IRR can be calculated using the quadratic formula.
x = EQ \f(-b ± \r(,b2 - 4ac),2a)
where: a = -$10 b = $10 c = -$1
x = EQ \f(-$10 ± $7.746,-$20)
Or, x1 = .8873 and
x2 = .1127
Since, x = EQ \f(1,1+irr)
then irr = EQ \f(1,x) - 1
And, irr1 = EQ \f(1,.8873) - 1 = .127
irr2 = EQ \f(1,.1127) - 1 = 7.87
The IRRs are 12.7 percent and 787 percent.
b. The bond rate of 15 percent lies between the two IRRs, making the additional outlay a positive NPV project. The company should invest the extra $1 million.
P 3–20: Solution to Flower City Grocery (20 minutes) [Replacement problem without taxes]
Old Machine Outflow Repair ($ 1,000) Inflow PV of Profits @ $5,000 per year for 5 years, r = .09 (3.890) $19,450 Net Present Value of keeping old machine $18,450
New Machine Outflow Purchase ($ 5,000) Inflow Sale of old machine $25,285 $500 Why or why not? r for 5 years, r =.09 (3.890) Net Present Value of purchasing new machine $20,785
NPVnew – NPVold $ 2,335
Purchasing the new machine is the better choice.
P 3–27: Solution to Housing Markets (20 minutes) [Valuing real estate]
a. The question is, how much is the assumable mortgage on your house worth?
PV of annuity at 8% = 11.258 PV of annuity at 15% = 6.566
= $69,987 PV of payments
Gain on loan: $120,000 – 69,987 $ 50,013 + sale price of identical house 150,000
Price of house $200,013
b. Difference in property taxes is $1,000/year for perpetuity.
PV =
Third home should sell for $156,667.
P 4-5: Solution to Voluntary Financial Disclosure (15 minutes) [Monitoring role of external financial reports]
The advantage of issuing financial statements voluntarily is reducing the monitoring costs of potential investors. If investors have more information about a company, they will bear less risk and be more willing to invest in the company. The disadvantage of issuing financial statements is revealing proprietary information that may be of benefit to competitors. Firms may be reluctant to issue financial statements if they are performing poorly. Investors, however, will infer they are doing poorly if only the successful companies are issuing financial statements to distinguish themselves from poorly performing companies.
P 4-17: Solution to Private Country Clubs (20 minutes)
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