14-29, Plant Closing Decision [LO1, LO2]

QualSupport Corporation manufactures seats for automobiles, vans, trucks, and various recreational vehicles. The
company has a number of plants around the world, including the Denver Cover Plant, which makes seat covers.
Ted Vosilo is the plant manager of the Denver Cover Plant but also serves as the regional production manager for the
company. His budget as the regional manager is charged to the Denver Cover Plant.
Vosilo has just heard that QualSupport has received a bid from an outside vendor to supply the equivalent of the entire
annual output of the Denver Cover Plant for $35 million. Vosilo was astonished at the low outside bid because the
budget for the Denver Cover Plant’s operating costs for the upcoming year was set at $52 million. If this bid is
accepted, the Denver Cover Plant will be closed down. The budget for Denver Cover’s operating costs for the coming
year is presented below. Additional facts regarding the plant’s operations are as follows:
a. Due to Denver Cover’s commitment to use high-quality fabrics in all of its products, the Purchasing
Department was instructed to place blanket purchase orders with major suppliers to ensure the receipt of
sufficient materials for the coming year. If these orders are cancelled as a consequence of the plant closing,
termination charges would amount to 20% of the cost of direct materials.
b. Approximately 400 plant employees will lose their jobs if the plant is closed. This includes all of the
direct laborers and supervisors as well as the plumbers, electricians, and other skilled workers classified as
indirect plant workers. Some would be able to find new jobs while many others would have difficulty. All
employees would have difficulty matching Denver Cover’s base pay of $18.80 per hour, which is the highest
in the area. A clause in Denver Cover’s contract with the union may help some employees; the company
must provide employment assistance to its former employees for 12 months after a plant closing. The
estimated cost to administer this service would be $1.5 million for the year.
c. Some employees would probably choose early retirement because QualSupport has an excellent pension
plan. In fact, $3 million of the annual pension expense would continue whether Denver Cover is open or not.
d. Vosilo and his staff would not be affected by the closing of Denver Cover. They would still be responsible
for administering three other area plants.
e. If the Denver Cover Plant were closed, the company would realize about $3.2 million salvage value for
the equipment and building. If the plant remains open, there are no plans to make any significant investments
in new equipment or buildings. The old equipment is adequate and should last indefinitely.

Required:
1. Without regard to costs, identify the advantages to QualSupport Corporation of continuing to obtain covers from its
own Denver Cover Plant.
2. QualSupport Corporation plans to prepare a financial analysis that will be used in deciding whether or not to close
the Denver Cover Plant. Management has asked you to identify:
a. The annual budgeted costs that are relevant to the decision regarding closing the plant (show the dollar
amounts).
b. The annual budgeted costs that are not relevant to the decision regarding closing the plant and explain
why they are not relevant (again show the dollar amounts).
c. Any nonrecurring costs that would arise due to the closing of the plant, and explain how they would affect
the decision (again show any dollar amounts).
3. Looking at the data you have prepared in (2) above, should the plant be closed? Show computations and explain
your answer.
4. Identify any revenues or costs not specifically mentioned in the problem that QualSupport should consider before
making a decision.

1. Continuing to obtain covers from its own Denver Cover Plant would
allow QualSupport to maintain its current level of control over the quality
of the covers and the timing of their delivery. Keeping the Denver Cover
Plant open also allows QualSupport more flexibility than purchasing the
coverings from outside suppliers. QualSupport could more easily alter
the coverings’ design and change the quantities produced, especially if
long-term contracts are required with outside suppliers. QualSupport
should also consider the economic impact that closing Denver Cover will
have on the community and how this might affect QualSupport’s other
operations in the region.
2. a. The following costs can be avoided by closing the plant, and
therefore, are relevant to the decision:
Materials ........................................ $14,000,000
Labor:
Direct ..................................... $13,100,000
Supervision ............................. 900,000
Indirect plant .......................... 4,000,000 18,000,000
Differential pension cost
($5,000,000 – $3,000,000) ............... 2,000,000
Total annual relevant costs ............... $34,000,000

2. b. The following costs can’t be avoided by closing the plant, and

therefore, are not relevant to the decision:
Depreciation—equipment ....................................... $ 3,200,000
Depreciation—building ........................................... 7,000,000
Continuing pension cost ($5,000,000 – $2,000,000). 3,000,000
Plant manager and staff ......................................... 800,000
Corporate expenses ............................................... 4,000,000
Total annual continuing costs .................................. $18,000,000

Depreciation is not relevant because it is a sunk cost. Three-fifths of the

annual pension expense ($3,000,000) is not relevant because it would
continue whether or not the plant is closed. The amount for plant
manager and staff is not relevant because Vosilo and his staff would
continue with QualSupport and administer the three remaining plants.
The corporate allocation is not relevant because this represents costs
incurred outside Denver Cover and assigned to the plant.
2. c. The following nonrecurring costs would arise in the year that the
plant is closed, but would not be incurred in any other year:
Termination charges on canceled material orders
($14,000,000 × 20%) ............................................. $2,800,000
Employment assistance ........................................... 1,500,000
Total recurring costs ............................................... $4,300,000
These two costs are relevant to the decision because they will be
incurred only if the plant is closed.

3. No, the plant should not be closed. The computations are:

First Year Other Years
Cost of purchasing the covers outside ..... $(35,000,000) $(35,000,000)
Costs avoided by closing the plant
(Part 2a) .......................................... 34,000,000 34,000,000
Cost of closing the plant (first year only) . (4,300,000)
Salvage value of equipment and building . 3,200,000 ____________
Net advantage (disadvantage) of closing
the plant ............................................. $ (2,100,000) $ (1,000,000)

4. Factors that should be considered by QualSupport before making a

decision include:
a. Alternative uses of the building and equipment.
b. Any tax implications.
c. The outside supplier’s prices in future years.
d. The cost to manufacture coverings at the Denver Cover Plant in
future years.
e. The value of the time Vosilo and his staff would have spent
managing
the Denver Cover Plant. This time may be spent on other
important matters.
f. The morale of QualSupport employees at remaining plants.
14-31, Sell or Process Further Decision [LO6]
The Scottie Sweater Company produces sweaters under the “Scottie” label. The company buys raw wool and
processes it into wool yarn from which the sweaters are woven. One spindle of wool yarn is required to produce one
sweater. The costs and revenues associated with the sweaters are given below:

Originally, all of the wool yarn was used to produce sweaters, but in recent years a market has developed for the wool
yarn itself. The yarn is purchased by other companies for use in production of wool blankets and other wool products.
Since the development of the market for the wool yarn, a continuing dispute has existed in the Scottie Sweater
Company as to whether the yarn should be sold simply as yarn or processed into sweaters. Current cost and revenue
data on the yarn are given below:

The market for sweaters is temporarily depressed, due to unusually warm weather in the western states where the
sweaters are sold. This has made it necessary for the company to discount the selling price of the sweaters to $30 from
the normal $40 price. Since the market for wool yarn has remained strong, the dispute has again surfaced over
whether the yarn should be sold outright rather than processed into sweaters. The sales manager thinks that the
production of sweaters should be discontinued; she is upset about having to sell sweaters at a $2.50 loss when the yarn
could be sold for a $4.00 profit. However, the production superintendent does not want to close down a large portion
of the factory. He argues that the company is in the sweater business, not the yarn business, and that the company
should focus on its core strength. All of the manufacturing overhead costs are fixed and would not be affected even if
sweaters were discontinued. Manufacturing overhead is assigned to products on the basis of 150% of direct labor cost.
Materials and direct labor costs are variable.

Required:
1. Would you recommend that the wool yarn be sold outright or processed into sweaters? Support your answer with
appropriate computations and explain your reasoning.
2. What is the lowest price that the company should accept for a sweater? Support your answer with appropriate
computations and explain your reasoning.

1. As much yarn as possible should be processed into sweaters.

Products should be processed further so long as the added revenues
from further processing are greater than the added costs. In this case,
the added revenues and costs are:
 Per Sweater
Added revenue ($30.00 – $20.00) ....... $10.00
Added costs:
Buttons, thread, lining ...................... $2.00
Direct labor ..................................... 5.80 7.80
Added contribution margin .................. $ 2.20

Thus, the company will gain $2.20 in contribution margin for each
spindle of yarn that is further processed into a sweater. The fixed
manufacturing overhead costs are not relevant to the decision because
they will be the same regardless of whether the yarn is sold or
processed further. In addition, we must omit the $16.00 cost of
manufacturing the yarn because this cost will be incurred whether the
yarn is sold as is or is used in sweaters.

2. The lowest price the company should accept is $27.80 per sweater.
The simplest approach to this answer is:

Present selling price per sweater ......... $30.00

Less added contribution margin being
realized on each sweater sold ........... 2.20
Minimum selling price per sweater ....... $27.80

A more involved approach to the same answer is to reason as follows:

If the wool yarn is sold outright, then the company will realize a
contribution margin of $9.40 per spindle:
Per Spindle
Selling price .......................... $20.00
Variable expenses:
Raw wool ........................... $7.00
Direct labor ........................ 3.60 10.60
Contribution margin ............... $ 9.40

This $9.40 is an opportunity cost. The price of the sweaters must be

high enough to cover this opportunity cost. In addition, the company
must be able to cover all of its variable costs from the time the raw wool
is purchased until the sweater is completed. Therefore, the minimum
price is:
Variable costs of producing a spindle of yarn:
Raw wool ................................................... $7.00
Direct labor ................................................ 3.60 $10.60
Added variable costs of producing a sweater:
Buttons, etc. ............................................... 2.00
Direct labor ................................................ 5.80 7.80
Total variable costs ........................................ 18.40
Opportunity cost—contribution margin if the
yarn is sold outright .................................... 9.40
Minimum selling price per sweater .................. $27.80

15-31, Ethics and the Manager

The Fore Corporation is an integrated food processing company that has operations in over two dozen countries.
Fore’s corporate headquarters is in Chicago, and the company’s executives frequently travel to visit Fore’s foreign
and domestic facilities. Fore has a fleet of aircraft that consists of two business jets with international range and six
smaller turboprop aircraft that are used on shorter flights. Company policy is to assign aircraft to trips on the basis of
minimizing cost, but the practice is to assign the aircraft based on the organizational rank of the traveller. Fore offers
its aircraft for short-term lease or for charter by other organizations whenever Fore itself does not plan to use the
aircraft. Fore surveys the market often in order to keep its lease and charter rates competitive. William Earle, Fore’s
vice president of finance, has claimed that a third business jet can be justified financially. However, some people in
the controller’s office have surmised that the real reason for a third business jet was to upgrade the aircraft used by
Earle. Presently, the people outranking Earle keep the two business jets busy with the result that Earle usually flies in
smaller turboprop aircraft. The third business jet would cost $11 million. A capital expenditure of this magnitude
requires a formal proposal with projected cash flows and net present value computations using Fore’s minimum
required rate of return. If Fore’s president and the finance committee of the board of directors approve the proposal, it
will be submitted to the full board of directors. The board has final approval on capital expenditures exceeding $5
million and has established a fi rm policy of rejecting any discretionary proposal that has a negative net present value.
Earle asked Rachel Arnett, assistant corporate controller, to prepare a proposal on a third business jet. Arnett gathered
the following data:
• Acquisition cost of the aircraft, including instrumentation and interior furnishing.
• Operating cost of the aircraft for company use.
• Projected avoidable commercial airfare and other avoidable costs from company use of the plane.
• Projected value of executive time saved by using the third business jet.
• Projected contribution margin from incremental lease and charter activity.
• Estimated resale value of the aircraft.
When Earle reviewed Arnett’s completed proposal and saw the large negative net present value figure, he returned the
proposal to Arnett. With a glare, Earle commented, “You must have made an error. The proposal should look better
than that.” Feeling some pressure, Arnett went back and checked her computations; she found no errors. However,
Earle’s message was clear. Arnett discarded her projections that she believed were reasonable and replaced them with
figures that had a remote chance of actually occurring but were more favorable to the proposal. For example, she used
first-class airfares to refigure the avoidable commercial airfare costs, even though company policy was to fl y coach.
She found revising the proposal to be distressing. The revised proposal still had a negative net present value. Earle’s
anger was evident as he told Arnett to revise the proposal again, and to start with a $100,000 positive net present value
and work backwards to compute supporting projections.

Required:
1. Explain whether Rachel Arnett’s revision of the proposal was in violation of the IMA’s Statement of Ethical
Professional Practice.
2. Was William Earle in violation of the IMA’s Statement of Ethical Professional Practice by telling Arnett
specifically how to revise the proposal? Explain your answer.
3. Identify specific internal controls that Fore Corporation could implement to prevent unethical behaviour on the part
of the vice president of finance.

1. Rachel Arnett’s revision of her first proposal can be considered a

violation of the IMA’s Statement of Ethical Professional Practice. She
discarded her reasonable projections and estimates after she was
questioned by William Earle. She used figures that had a remote chance
of occurring. By doing this, she violated the requirements to
Communicate information fairly and objectively and disclose all
relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, analyses, or
recommendations. By altering her analysis, she also violated the
Integrity standard. She engaged in an activity that would prejudice her
ability to carry out her duties ethically. In addition, she violated the
Competence standard—―Provide decision support information and
recommendations that are accurate, clear, concise, and timely.
2. Earle was clearly in violation of the Standards of Ethical Conduct for
Management Accountants because he tried to persuade a subordinate to
prepare a proposal with data that was false and misleading. Earle has
violated the standards of Competence (Provide decision support
information and recommendations that are accurate, clear, concise, and
timely.), Integrity (Mitigate actual conflicts of interest. Regularly
communicate with business associates to avoid apparent conflicts of
interest.), and Credibility (Communicate information fairly and
objectively. Disclose all relevant information that could reasonably be
expected to influence an intended user’s understanding of the reports,
analyses, or recommendations.).
3. The internal controls Fore Corporation could implement to prevent
unethical behaviour include:
 approval of all formal capital expenditure proposals by the
Controller and/or the Board of Directors.
 designating a non-accounting/finance manager to coordinate
capital expenditure requests and/or segregating duties during the
preparation and approval of capital expenditure requests.
 requiring that all capital expenditure proposals be reviewed by
senior operating management, which includes the Controller, before the
proposals are submitted for approval.
 requiring the internal audit staff to review all capital expenditure
proposals or contracting external auditors to review the proposal if the
corporation lacks manpower.

15-32, Net Present Value Analysis of a New Product [LO1]

Matheson Electronics has just developed a new electronic device which, when mounted on an automobile, will tell the
driver how many miles the automobile is traveling per gallon of gasoline. The company is anxious to begin production
of the new device. To this end, marketing and cost studies have been made to determine probable costs and market
potential. These studies have provided the following information:
a. New equipment would have to be acquired to produce the device. The equipment would cost $315,000
and have a (six years) useful life. After (six years), it would have a salvage value of about $15,000.
 b. Sales in units over the next (6 years) are projected to be as follows:

Year Sales in Units

1 9,000
2 15,000
3 18,000
4-6 22,000
c. Production and sales of the device would require working capital of $60,000 to finance accounts
receivable, inventories, and day-to-day cash needs. This working capital would be released at the end of the
project’s life.
d. The devices would sell for $35 each; variable costs for production, administration, and sales would be $15
per unit.
e. Fixed costs for salaries, maintenance, property taxes, insurance, and straight-line depreciation on the
equipment would total $135,000 per year. (Depreciation is based on cost less salvage value.)
f. To gain rapid entry into the market, the company would have to advertise heavily. The advertising
program would be:
Year Amount of Yearly
Advertising
1-2 $180,000
3 $150,000
4-6 $120,000

g. The company’s required rate of return is 14%.

Required:
(Ignore income taxes.)
1. Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from sale of the device
for each year over the next (6 years).
2. Using the data computed in (1) above and other data provided in the problem, determine the net present value of the
proposed investment. Would you recommend that Matheson accept the device as a new product?
1. The net cash inflow from sales of the device for each year would be:
Year_________________
1 2 3 4-6_
Sales in units ........................ 9,000 15,000 18,000 22,000
Sales in dollars
(@ $35 each) .................$ 315,000 $525,000 $630,000 $770,000
Variable expenses
(@ $15 each) ....................135,000 225,000 270,000 330,000
Contribution margin ............180,000 300,000 360,000 440,000
Fixed expenses:
Salaries and other* ............135,000 135,000 135,000 135,000
Advertising ........................180,000 180,000 150,000 120,000
Total fixed expenses ...........315,000 315,000 285,000 255,000
Net cash inflow (outflow) .$(135,000) $(15,000) $ 75,000 $185,000
* Depreciation is not a cash expense and therefore must be eliminated
from this computation. The analysis is:
($315,000 – $15,000 = $300,000) ÷ 6 years = $50,000 depreciation;
$135,000 total expense – $50,000 depreciation = $135,000.
2. The net present value of the proposed investment would be:
 Amount of 14% Present Value
Item Yr Cash Flow Factor of Cash Flow
Investment in equipment ........ Now $(315,000) 1.000 $(315,000)
Working capital needed ........... Now $(60,000) 1.000 (60,000)
Yearly cash flows (see above) .. 1 $(135,000) 0.877 (118,395)
Yearly cash flows (see above) .. 2 $(15,000) 0.769 (11,535)
Yearly cash flows (see above) .. 3 $75,000 0.675 50,625
Yearly cash flows (see above) .. 4-6 $185,000 1.567 * 289,895
Salvage value of equipment ..... 6 $15,000 0.456 6,840
Release of working capital ....... 6 $60,000 0.456 27,360
Net present value ................... $ (130,210)
* Present value factor for 6 periods ....................................... 3.889
Present value factor for 3 periods ......................................... 2.322
Present value factor for 9 periods, starting 4 periods in the
future .............................................................................. 1.567
Since the net present value is negative, the company should not accept the device
as a new product.