Solutions Chap 8 Suggested Exercises

Solutions Chap 8 Suggested Exercises 2. Howard Bowen’s cotton farm analysis appears below. a.

Accounting profits: Revenues$5,000,000 Less: Variable operating costs4,500,000 Less: Depreciation40,000 Less: Wages50,000 Equals: Operating Income$410,000 Less: Interest expense400,000 Accounting income before tax+$10,000 b. Economic profits: Revenues$5,000,000 Less: Variable operating costs4,500,000 Less: Opportunity value of Bowen's income potential30,000 Less: Economic depreciation60,000 Equals: Economic profit before financial costs$410,000Less: Interest expense400,000 Less: Opportunity cost of net $1 million equity @10%100,000 Equals: Economic profit, or (loss)($90,000) If these calculations are representative of Bowen's regular performance, he would be better off financially by selling the farm and working for someone else. This analysis ignores many intangible factors that may affect Bowen's decision. 3.

Mary Graham’s work at Piedmont Properties. a. Pro forma Accounting pre-tax profits for the first year: Revenues $2,000,000Less: Salaries 1,500,000 Operating expenses 250,000 Depreciation 5,000 Total 1,775,000 Operating income 245,000 Less: Interest expense 75,000 Accounting profit before tax $170,000 b. Pro forma Economic pre-tax profits for the first year: Revenues $2,000,000Less: Salaries 1,500,000 Operating expenses 250,000 Depreciation 20,000 Graham's foregone income 100,000 Total 1,870,000 Economic profit before financial costs 130,000 Less: Interest expense 75,000 Economic profit before tax $55,000 c. Explicit costssalaries, operating expenses, depreciation for tax purposes ($5,000), and interest expenses.Implicit costsGraham's foregone income and additional depreciation ($15,000 = $20,000 $5,000).

Note that Mary Graham would decide to start the new real estate agency using accounting data, because it produces more than her current $100,000 income. But, she would more likely decide to continue to work for Piedmont Properties using the economic data. 6. The Blair Company has multiple plant locations. a. One centralized plant in Missouri: TC = $900,000 + (6,000 + 4,500 + 3,000) $250 = $4,275,000 Three subassembly plants:TC = ($475,000 + $425,000 + $400,000) + (6000 + 4500 + 3000) $225 = $4,337,500 One centralized plant would be cheaper.

b. One centralized plant at full capacity: TC = $900,000 + (18,000)$250 = $5,400,000 Three plants: TC = ($475,000 + $425,000 + $400,000) + (8,000 + 6,000 + 4,000)$225 = $5,350,000. Three plants should be built. c. It would be helpful to have a credible forecast of the future demand for subassemblies.

Solution to Case Exercise: Cost Analysis 1. Incremental costs per chair for Leisure Products are equal to the variable costs, consisting of direct labor ($2. 5) and materials ($2. 30), for a total of $4.

55 per chair in incremental costs. 2. It was assumed that all of plant overhead and administrative and selling expense were fixed costs. One would like to know what portion of these costs (if any) represents variable costs. For example, part of plant overhead, such as power and supplies, may vary with the output level. Likewise, part of the selling costs (e.

g. , billing) may constitute variable costs. 3. Based on incremental economic reasoning, the Southeast order should be accepted since the price ($5.

0) exceeds the calculated variable costs ($4. 55). The order will contribute approximately $28,500 (($5. 50 $4.

55) 30,000) to the profits of the firm. 4. One would have to consider the long-run impact on the firm of accepting the order. For example, if other customers find out the LP is selling chairs considerably below the standard quoted price of $7. 15, these other customers may begin demanding lower prices on their orders.

The net effect could be lower prices for all customers and lower profits for LP.