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CHAPTER 2
THE NATURE OF COSTS
P 2-1: Solution to Darien Industries (10 minutes)
[Relevant costs and benefits]
Current cafeteria income
Sales $12,000
Variable costs (40% × 12,000) (4,800)
Fixed costs (4,700)
Operating income $2,500
Vending machine income
Sales (12,000 × 1.4) $16,800
Darien’s share of sales
(.16 × $16,800) 2,688
Increase in operating income $ 188
P 2-2: Negative Opportunity Costs (10 minutes)
[Opportunity cost]
Yes, when the most valuable alternative to a decision is a net cash outflow that
would have occurred is now eliminated. The opportunity cost of that decision is negative
(an opportunity benefit). For example, suppose you own a house with an in-ground
swimming pool you no longer use or want. To dig up the pool and fill in the hole costs
$3,000. You sell the house instead and the new owner wants the pool. By selling the
house, you avoid removing the pool and you save $3,000. The decision to sell the house
includes an opportunity benefit (a negative opportunity cost) of $3,000.
P 2-3: Solution to NPR (10 minutes)
[Opportunity cost of radio listeners]
The quoted passage ignores the opportunity cost of listeners’ having to forego
normal programming for on-air pledges. While such fundraising campaigns may have a
low out-of-pocket cost to NPR, if they were to consider the listeners’ opportunity cost,
such campaigns may be quite costly.
P 2-4: Solution to Silky Smooth Lotions (15 minutes)
[Break even with multiple products]
Given that current production and sales are: 2,000, 4,000, and 1,000 cases of 4, 8,
and 12 ounce bottles, construct of lotion bundle to consist of 2 cases of 4 ounce bottles, 4
cases of 8 ounce bottles, and 1 case of 12 ounce bottles. The following table calculates
the break-even number of lotion bundles to break even and hence the number of cases of
each of the three products required to break even.
Per Case 4 ounce 8 ounce 12 ounce Bundle
Price $36.00 $66.00 $72.00
Variable cost $13.00 $24.50 $27.00
Contribution margin $23.00 $41.50 $45.00
Current production 2000 4000 1000
Cases per bundle 2 4 1
Contribution margin per bundle $46.00 $166.00 $45.00 $257.00
Fixed costs $771,000
Number of bundles to break even 3000
Number of cases to break even 6000 12000 3000
P 2-5: Solution to J. P. Max Department Stores (15 minutes)
[Opportunity cost of retail space]
Home Appliances Televisions
Profits after fixed cost allocations $64,000 $82,000
Allocated fixed costs 7,000 8,400
Profits before fixed cost allocations 71,000 90,400
Lease Payments 72,000 86,400
Forgone Profits – $1,000 $ 4,000
We would rent out the Home Appliance department, as lease rental receipts are
more than the profits in the Home Appliance Department. On the other hand, profits
generated by the Television Department are more than the lease rentals if leased out, so
we continue running the TV Department. However, neither is being charged inventory
holding costs, which could easily change the decision.
Also, one should examine externalities. What kind of merchandise is being sold
in the leased store and will this increase or decrease overall traffic and hence sales in the
other departments?
P 2-6: Solution to Vintage Cellars (15 minutes)
[Average versus marginal cost]
a. The following tabulates total, marginal and average cost.
Quantity
Average
Cost
Total
Cost
Marginal
Cost
1 $12,000 $12,000
2 10,000 20,000 $8,000
3 8,600 25,800 5,800
4 7,700 30,800 5,000
5 7,100 35,500 4,700
6 7,100 42,600 7,100
7 7,350 51,450 8,850
8 7,850 62,800 11,350
9 8,600 77,400 14,600
10 9,600 96,000 18,600
b. Marginal cost intersects average cost at minimum average cost
(MC=AC=$7,100). Or, at between 5 and 6 units AC = MC = $7,100.
c. At four units, the opportunity cost of producing and selling one more unit is
$4,700. At four units, total cost is $30,800. At five units, total cost rises to
$35,500. The incremental cost (i.e., the opportunity cost) of producing the fifth
unit is $4,700.
d. Vintage Cellars maximizes profits ($) by producing and selling seven units.
Quantity
Average
Cost
Total
Cost
Total
Revenue Profit
1 $12,000 $12,000 $9,000 -$3,000
2 10,000 20,000 18,000 -2,000
3 8,600 25,800 27,000 1,200
4 7,700 30,800 36,000 5,200
5 7,100 35,500 45,000 9,500
6 7,100 42,600 54,000 11,400
7 7,350 51,450 63,000 11,550
8 7,850 62,800 72,000 9,200
9 8,600 77,400 81,000 3,600
10 9,600 96,000 90,000 -6,000
P 2-7: Solution to ETB (15 minutes)
[Minimizing average cost does not maximize profits]
a. The following table calculates that the average cost of the iPad bamboo case is
minimized by producing 4,500 cases per month.
Monthly Production and Sales
Production (units) 3,000 3,500 4,500 5,000
Total cost $162,100 $163,000 $167,500 $195,000
Average cost $54.03 $46.57 $37.22 $39.00
b. The following table calculates net income of the four production (sales) levels.
Monthly Production and Sales
Production (units) 3,000 3,500 4,500 5,000
Revenue $195,000 $227,500 $292,500 $325,000
Total cost 162,100 163,000 167,500 195,000
Net income $32,900 $64,500 $125,000 $130,000
Based on the above analysis, the profit maximizing production (sales) level is to
manufacture and sell 5,000 iPad cases a month. Selecting the output level that minimizes
average cost (4,500 cases) does not maximize profits.
P 2-8: Solution to Taylor Chemicals (15 minutes)
[Relation between average, marginal, and total cost]
a. Marginal cost is the cost of the next unit. So, producing two cases costs an
additional $400, whereas to go from producing two cases to producing three cases
costs an additional $325, and so forth. So, to compute the total cost of producing
say five cases you sum the marginal costs of 1, 2, …, 5 cases and add the fixed
costs ($500 + $400 + $325 + $275 + $325 + $1000 = $2825). The following table
computes average and total cost given fixed cost and marginal cost.
Quantity
Marginal
Cost
Fixed
Cost
Total
Cost
Average
Cost
1 $500 $1000 $1500 $1500.00
2 400 1000 1900 950.00
3 325 1000 2225 741.67
4 275 1000 2500 625.00
5 325 1000 2825 565.00
6 400 1000 3225 537.50
7 500 1000 3725 532.14
8 625 1000 4350 543.75
9 775 1000 5125 569.44
10 950 1000 6075 607.50
b. Average cost is minimized when seven cases are produced. At seven cases,
average cost is $532.14.
c. Marginal cost always intersects average cost at minimum average cost. If
marginal cost is above average cost, average cost is increasing. Likewise, when
marginal cost is below average cost, average cost is falling. When marginal cost
equals average cost, average cost is neither rising nor falling. This only occurs
when average cost is at its lowest level (or at its maximum).
P 2-9: Solution to Emrich Processing (15 minutes)
[Negative opportunity costs]
Opportunity costs are usually positive. In this case, opportunity costs are negative
(opportunity benefits) because the firm can avoid disposal costs if they accept the rush
job.
The original $1,000 price paid for GX-100 is a sunk cost. The opportunity cost of
GX-100 is -$400. That is, Emrich will increase its cash flows by $400 by accepting the
rush order because it will avoid having to dispose of the remaining GX-100 by paying
Environ the $400 disposal fee.
How to price the special order is another question. Just because the $400 disposal
fee was built into the previous job does not mean it is irrelevant in pricing this job.
Clearly, one factor to consider in pricing this job is the reservation price of the customer
proposing the rush order. The $400 disposal fee enters the pricing decision in the
following way: Emrich should be prepared to pay up to $399 less any out-of-pocket
costs to get this contract.
P 2-10: Solution to Verdi Opera or Madonna? (15 minutes)
[Opportunity cost of attending a Madonna concert]
If you attend the Verdi opera, you forego the $200 in benefits (i.e., your willingness
to pay) you would have received from going to see Madonna. You also save the $160
(the costs) you would have paid to see Madonna. Since an avoided benefit is a cost and
an avoided cost is a benefit, the opportunity cost of attending the opera (the value you
forego by not attending the Madonna concert) is $40 – i.e., the net benefit foregone. Your
willingness to pay $30 for the Verdi opera is unrelated to the costs and benefits of
foregoing the Madonna concert.
P 2-11: Solution to Dod Electronics (15 minutes)
[Estimating marginal cost from average cost]
a. Dod should accept Xtron’s offer. The marginal cost to produce the 10,000 chips is
unknown. But since management is convinced that average cost is falling, this means
that marginal cost is less than average cost. The only way that average cost of $35
can fall is if marginal cost is less than $35. Since Xtron is willing to pay $38 per
chip, Dod should make at least $30,000 on this special order (10,000 x $3). This
assumes (i) that average cost continues to fall for the next 10,000 units (i.e., it
assumes that at, say 61,000 units, average cost does not start to increase), and (ii)
there are no other costs of taking this special order.
b. Dod can’t make a decision based on the information. Since average cost is
increasing, we know that marginal cost is greater than $35 per unit. But we don’t
know how much larger. If marginal cost at the 60,001th unit is $35.01, average cost
is increasing and if marginal cost of the 70,000th unit is less than $38, then DOD
should accept the special order. But if marginal cost at the 60,001th unit is $38.01,
the special order should be rejected.
P 2-12: Solution to Napoli Pizzeria (15 minutes)
[Break-even analysis]
a. The break-even number of servings per month is:
($300 – $75) ÷ ($3 – $1)
= ($225) ÷ ($2)
= 112.5 servings
b. To generate $1,000 after taxes Gino needs to sell 881.73 servings of
espresso/cappuccino.
Profits after tax = [Revenues – Expenses] x (1– 0.35)
$1,000 = [$3N + $75 – $1N – $300] x (1– 0.35)
$1,000 = [$2N – $225] x .65
$1,000 ÷ .65 = $2N – $225
$1,538.46 = $2N – $225
$2N = $1,763.46
N = 881.73
P 2-13: Solution to JLT Systems (20 minutes)
[Cost-volume-profit analysis]
a. Since we know that average cost is $2,700 at 200 unit sales, then Total Cost (TC)
divided by 200 is $2,700. Also, since JLT has a linear cost curve, we can write,
TC=FC+VxQ where FC is fixed cost, V is variable cost per unit, and Q is quantity
sold and installed. Given FC = $400,000, then:
TC/Q = (FC+VxQ)/Q = AC
($400,000 + 200 V) / 200 = $2,700
$400,000 + 200 V = $540,000
200 V = $140,000
V = $700
b. Given the total cost curve from part a, a tax rate of 40%, and a $2,000 selling
price, and an after-tax profit target of $18,000, we can write:
($2000 Q – $400,000 – $700 Q) x (1- 40%) = $18,000
1300 Q -400,000 = 18,000 / .60 = 30,000
1300 Q = 430,000
Q = 330.8
In other words, to make an after-tax profit of $18,000, JLT must have 330.8 sales
and installs per month.
c. The simplest (and fastest way) to solve for the profit maximizing quantity given
the demand curve is to write the profit equation, take the first derivative, set it to
zero, and solve for Q.
Total Profit = (2600 – 2Q) Q -400,000 -700 Q
First derivative: 2600 – 4Q -700 = 0
4Q = 1900
Q = 475
The same solution is obtained if you set marginal revenue (where MR is 2600 –
4Q) equal to marginal cost (700), and again solve for Q, or
2600 – 4Q = 700
Q = 475
The more laborious solution technique is to use a spreadsheet and identify the
profit maximizing price quantity combination.
As before, we again observe that 475 sales and installs maximize profits.
P 2-14: Solution to Volume and Profits (15 minutes)
[Cost-volume-profit]
a. False.
b. Write the equation for firm profits:
Profits = P × Q – (FC – VC × Q) = Q(P – VC) – FC
= Q(P – VC) – (FC ÷ Q)Q
Notice that average fixed costs per unit (FC÷Q) falls as Q increases, but with
more volume, you have more fixed cost per unit such that (FC÷Q) × Q = FC.
That is, the decline in average fixed cost per unit is exactly offset by having more
units.
Profits will increase with volume even if the firm has no fixed costs, as
long as price is greater than variable costs. Suppose price is $3 and variable cost
is $1. If there are no fixed costs, profits increase $2 for every unit produced.
Now suppose fixed cost is $50. Volume increases from 100 units to 101 units.
Profits increase from $150 ($2 ×100 – $50) to $152 ($2 × 101 – $50). The change
in profits ($2) is the contribution margin. It is true that average unit cost declines
from $1.50 ([100 × $1 + $50]÷100) to $1.495 ([101 × $1 + $50]÷101). However,
this has nothing to do with the increase in profits. The increase in profits is due
solely to the fact that the contribution margin is positive.
Alternatively, suppose price is $3, variable cost is $3, and fixed cost is
$50. Contribution margin in this case is zero. Doubling output from 100 to 200
Quantity Price Revenue Total Cost Profit
250 $2,100 $525,000 $575,000 ($50,000)
275 2,050 563,750 592,500 (28,750)
300 2,000 600,000 610,000 (10,000)
325 1,950 633,750 627,500 6,250
350 1,900 665,000 645,000 20,000
375 1,850 693,750 662,500 31,250
400 1,800 720,000 680,000 40,000
425 1,750 743,750 697,500 46,250
450 1,700 765,000 715,000 50,000
475 1,650 783,750 732,500 51,250
500 1,600 800,000 750,000 50,000
525 1,550 813,750 767,500 46,250
550 1,500 825,000 785,000 40,000
causes average cost to fall from $3.50 ([100 × $3 + $50]÷100) to $3.25 ([200 × $3
+ $50]÷200), but profits are still zero.
P 2-15: Solution to American Cinema (20 minutes)
[Break-even analysis for an operating decision]
a. Both movies are expected to have the same ticket sales in weeks one and two, and
lower sales in weeks three and four.
Let Q1 be the number of tickets sold in the first two weeks, and Q2 be the number
of tickets sold in weeks three and four. Then, profits in the first two weeks, 1,
and in weeks three and four, 2, are:
1 = .1(6.5Q1) – $2,000
2 = .2(6.5Q2) – $2,000
―I Do‖ should replace ―Paris‖ if
1 > 2, or
.65Q1 – 2,000 > 1.3Q2 – 2,000, or
Q1 > 2Q2.
In other words, they should keep ―Paris‖ for four weeks unless they expect ticket
sales in weeks one and two of ―I Do‖ to be twice the expected ticket sales in
weeks three and four of ―Paris.‖
b. Taxes of 30 percent do not affect the answer in part (a).
c. With average concession profits of $2 per ticket sold,
1 = .65Q1 + 2Q1 – 2,000
2 = 1.30Q2 + 2Q2 – 2,000
1 > 2 if
2.65Q1 > 3.3Q2
Q1 > 1.245Q2
Now, ticket sales in the first two weeks need only be about 25 percent higher than
in weeks three and four to replace ―Paris‖ with ―I Do.‖
P 2-16: 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.
Planned Promotion Displays
For Next Week
End-of-
Aisle
Front
Door
Cash
Register
Item Texcan Oil Wiper blades Floor mats
Projected volume (week) 5,000 200 70
Sales price 69¢/can $9.99 $22.99
Unit cost 62¢ $7.99 $17.49
Contribution margin 7¢ $2.00 $5.50
Contribution
(margin × volume)
$350 $400 $385
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
Clearly, since the Armadillo car wax yields a lower contribution margin than all
three of the existing planned promotions, management should not change their
planned promotions and should reject the Armadillo offer.
b. With 50 free units of car wax, Armadillo’s contribution is:
Contribution from 50 free units (50 × $2.90) $145
Contribution from remaining 750 units:
Selling price $2.90
less: Unit cost $2.50
Contribution margin $0.40
× expected volume 750 300
Contribution $445
With 50 free units of car wax, it is now profitable to replace the oil display area
with the car wax. The opportunity cost of replacing the oil display is its forgone
contribution ($350), whereas the benefits provided by the car wax are $445.
Additional discussion points raised
(i) This problem introduces the concept of the opportunity cost of retail shelf
space. With the proliferation of consumer products, supermarkets’
valuable scarce commodity is shelf space. Consumers often learn about a
product for the first time by seeing it on the grocery shelf. To induce the
store to stock an item, food companies often give the store a number of
free cases. Such a giveaway compensates the store for allocating scarce
shelf space to the item.
(ii) This problem also illustrates that retail stores track contribution margins
and volumes very closely in deciding which items to stock and where to
display them.
(iii) One of the simplifying assumptions made early in the problem was that
the sale of the special display items did not affect the unit sales of
competitive items in the store. Suppose that some of the Texcan oil sales
came at the expense of other oil sales in the store. Discuss how this would
alter the analysis.
P 2-17: Solution to Stahl Inc. (25 minutes)
[Finding unknown quantities in cost-volume-profit analysis]
The formula for the break-even quantity is
Break-even Q = Fixed Costs / (P – V)
where: P = price per unit
V = variable cost per unit
Substituting the data into this equation yields
24,000 = F / (P – 12)
F = 24,000 P – 288,000 (1)
From the after tax data we can write down the following equation:
Profits after tax = (1-T) (P Q – V Q – Fixed Cost)
Where T = tax rate = 0.30
33,600 = (1 – 0.30) (30,000 P – 30,000 V – F)
33,600 = 0.70 (30,000 P – 30,000 x 12 – F)
48,000 =30,000 P – 360,000 – F
Substituting in eq. (1) from above yields:
48,000 =30,000 P – 360,000 – (24,000 P – 288,000)
408,000 =30,000 P – 24,000 P + 288,000
P = $20
Substituting P = $20 back into eq. (1) from above yields:
F = 24,000 x 20 – 288,000
F = $192,000
P 2-18: Solution to Affording a Hybrid (20 minutes)
[Break-even analysis]
a. The $1,500 upfront payment is irrelevant since it applies to both alternatives. To
find the break-even mileage, M, set the monthly cost of both vehicles equal:
25
$3.00 $399
50
$3.00 $499 M M
$100 = M(.12 – .06)
M = $100/.06 = 1,666.66 miles per month
Miles per year = 1,666.66 × 12 = 20,000
b.
25
$4.00 399
50
$4.00 $499 M M
$100 = M(.16 – .08)
M = $100/.08 = 1,250 miles per month
Miles per year = 1,250 × 12 = 15,000 miles per year
P 2-19: Solution to Easton Diagnostics (20 minutes)
[Break-even and operating leverage]
a. As computed in the following table, if the proposal is accepted, the break-even
point falls from 7,000 blood samples to 6,538 samples as computed in the
following table:
Current
Equipment
Proposed
equipment
Price $750 $750
Variable costs:
Direct labor 175 175
Direct material 125 135
Royalty fee 150 180
Total variable costs $450 $490
Fixed costs:
Lease $1,600,000 $1,200,000
Supervision 400,000 400,000
Occupancy costs 100,000 100,000
Fixed costs $2,100,000 $1,700,000
Contribution margin $300 $260
Break-even 7,000 6,538
b. The table below shows that at an annual volume of 10,300 blood samples, Easton
makes $12,000 more by staying with its existing equipment than by accepting the
competing vendor’s proposal. However, such a recommendation ignores the fact
that staying with the existing lease adds $400,000 of operating leverage to Easton
compared to the vendor’s proposal, thereby increasing the chance of financial
distress. If Easton has sufficient net cash flow that the chance of financial distress
is very remote, then there is no reason to worry about the higher operating
leverage of the existing lease and management should reject the proposal.
However, if Easton’s net cash flow has significant variation such that financial
distress is a concern, then the proposed equipment lease that lowers operating
leverage by $400,000 should be accepted if the expected costs of financial distress
fall by more than $12,000 per year.
Current
Equipment
Proposed
equipment
Price $750 $750
Total variable costs 450 490
Contribution margin $300 $260
Fixed costs $2,100,000 $1,700,000
Annual volume 10,300 10,300
Total profit $990,000 $978,000
P2-20: Solution to Spa Salon (20 minutes)
[Break-even analysis with two products]
The problem states that the Spa performed 90 massages and 30 manicures last
month. From these data and the revenue numbers we can compute the price of a massage
is $90 ($8,100 / 90) and the price of a manicure is $50 ($1,500 /30). Similarly, the
variable cost of a massage is $40 ($3,600/90) and a manicure is $20 ($600/30),
respectively.
Since one out of every three massage clients also purchases a manicure, a bundle
of products consists of 3 massages and one manicure (with revenues of $320 = 3 × $90 +
$50 and variable cost of $140 = 3 × $40 + 20).
We can now compute the break-even number of bundles as
Break-even bundles = FC/(P-VC) = $7,020/($320-$140)
= 39 bundles
39 bundles consists of 39 × 3 massages = 117 massages
39 bundles consists of 39 × 1 manicures = 39 manicures
To check these computations, prepare an income statement using 117
massages and 39 manicures
Massage revenue (117 × $90) $10,530
Manicure revenue (39 × $50) 1,950
Total revenue $12,480
Massage variable cost (117 × $40) 4680
Manicure variable cost (39 × $20) 780
Fixed cost 7,020
Total costs $12,480
Profit $0
P 2-21: Solution to Manufacturing Cost Classification (20 minutes)
[Period versus product costs]
Period
Cost
Product
Cost
Direct
Labor
Direct
Material
Over-
head
Advertising expenses for DVD x
Depreciation on PCs in marketing dept. x
Fire insurance on corporate headquarters x
Fire insurance on plant x x
Leather carrying case for the DVD x x
Motor drive (externally sourced) x x
Overtime premium paid assembly workers x x
Plant building maintenance department x x
Plant security guards x x
Plastic case for the DVD x x
Property taxes paid on corporate office x
Salaries of public relations staff x
Salary of corporate controller x
Wages of engineers in quality control dept. x x
Wages paid assembly line employees x x
Wages paid employees in finished goods
warehouse
x
P 2-22: Solution to Australian Shipping (20 minutes)
[Negative transportation costs]
a. Recommendation: The ship captain should be indifferent (at least financially)
between using stone or wrought iron as ballast. The total cost (£550) is the same.
Stone as ballast
Cost of purchasing and loading stone £40
Cost of unloading and disposing of stone 15
£55
Ton required × 10
Total cost £550
Wrought iron as ballast
Number of bars required:
10 tons of ballast × 2,000 pounds/ton 20,000 pounds
Weight of bar ÷ 20 pounds/bar
1,000 bars
Loss per bar (£1.20 – £0.90) £0.30
× number of bars 1,000
£300
Cost of loading bars (£15 ×10) 150
Cost of unloading bars (£10 ×10) 100
Total cost £550
b. The price is lower in Sydney because the supply of wrought iron relative to
demand is greater in Sydney because of wrought iron’s use as ballast. In fact, in
equilibrium, ships will continue to import wrought iron as ballast as long as the
relative price of wrought iron in London and Sydney make it cheaper (net of
loading and unloading costs) than stone.
P 2-23: Solution to iGen3 (20 minutes)
[Cost-volume-profit and break-even on a lease contract]
a and b. Break-even number of impressions under Options A and B:
Option A Option B
Monthly fixed lease cost $10,000 $0
Labor/month 5,000 5,000
Total fixed cost/month $15,000 $5,000
Variable lease cost/impression $0.01 $0.03
Ink/impression 0.02 0.02
Total variable cost $0.03 $0.05
Price/impression $0.08 $0.08
Contribution margin/impression $0.05 $0.03
Break-even number of impressions 300,000 166,667
c. The choice of Option A or B depends on the expected print volume ColorGrafix
forecasts. Choosing among different cost structures should not be based on
break-even but rather which one results in lower total cost. Notice the two options
result in equal cost at 500,000 impressions:
$15,000 + $0.03 Q = $5,000 + $0.05 Q
$10,000 = $0.02
Q = 500,000
Therefore, if ColorGrafix expects to produce more than 500,000 impressions it
should choose Option A and if fewer than 500,000 impressions are expected
ColorGrafix should choose Option B.
d. At 520,000 expected impressions, Option A costs $30,600 ($15,000 + .03 ×
520,000), whereas Option B costs $31,000 ($5,000 + .05 × 520,000). Therefore,
Option A costs $400 less than Option B. However, Option A generates much
more operating leverage ($10,000/month), thereby increasing the expected costs
of financial distress (and bankruptcy). Since ColorGrafix has substantial financial
leverage, they should at least consider if it is worth spending an additional $400
per month and choose Option B to reduce the total amount of leverage (operating
and financial) in the firm. Without knowing precisely the magnitude of the costs
of financial distress, one can not say definitively if the $400 additional cost
