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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