Catawba: Variable Cost and Differential Cost Approach
Is the company correct in its decision of not manufacturing standard model compressors on Sundays? Why? Show your calculations. Decision making should be based on change of RELEVANT items ONLY. The company’s calculation is WRONG, as it takes into concern of irrelevant fixed cost. By double-counting depreciation, other Mfg. overheads, SG&A in Sunday’s cost; it distorts the P&L sheet. To correctly show cost structure for decision making, there are two different approaches, yet each should reach same conclusion. Approach 1: Differential Cost Approach
As suggested in case, by producing 4 unites on Sunday, total depreciation, total Mfg. overhead and SG&A will not change. Thus, we should only look into accounts that will change out of producing activities on Sunday. Table below shows the result of Contribution Margin computation. As illustrated in the table, producing on Sunday will bring $ 2,600 contribution margin per unit and thus company should manufacture. Approach 2: Comprehensive Income Approach. Based on P&L sheet we can calculate total fixed cost for one week manufacturing Depreciation=$ 497? 4= $11,928 Mfg. Then we construct weekly income statement of two scenarios As suggested in table, by producing in Sunday, company can realize $ 10,400 profit every week, same as by using Differential Cost Approach. Total Increasing Profit=Contribution Margin? unit=$ 2,600? 4=$ 10,400 Suppose Marge McPhee decides to manufacture 10 light weight compressors each week during weekdays for 8 weeks only and sell them at a price of $8,000.
Compared to only producing standard compressors, do you support this decision? Why? Show your calculations to support your argument. We use differential cost approach to make decision. Since factory is producing at full-capacity and company cannot force the 3rd shift, nor recruit more labor, the direct labor hour is the constrain factor. Light compressor requires 62. 5 DLH and standard compressor requires 100 DLH, in other words, produce 1 light compressor can produce 62. 5/100=0. 25 standard compressor and 10 light compressors => 6. 25 standard compressors. Based on information, we can construct the comparison table between two scenarios. As illustrated by table, producing 10 light compressors instead of 6. 25 standard compressors for ONLT 8 weeks will generate $ 182,000 more contribution margin. However, to realize this amount of margin Catawba need to invest $ 218,000 on additional jigs, sensors and soft wares. Thus, company should NOT produce light compressor.
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