Solution Manual of Cost Accounting A Managerial Emphasis by Horngren, Datar & Rajan 14th Edition

Solutions Manual

COST ACCOUNTING

© 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren


Solutions Manual

COST ACCOUNTING Fourteenth Edition

Charles T. Horngren Srikant M. Datar Madhav Rajan

Upper Saddle River, NJ 07458

© 2012 Pearson Education, Inc. Publishing as Prentice Hall


This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials.

Acquisition Editor: Stephanie Wall Editorial Project Manager: Christina Rumbaugh Editorial Assistant: Brian Reilly Project Manager, Production: Lynne Breitfeller Operations Specialist: Natacha Moore Printer/Binder: OPM Digital Print Services Cover Printer: OPM Digital Print Services

Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text. ______________________________________________________________________________________ Copyright © 2012 by Pearson Education, Inc., Upper Saddle River, New Jersey, 07458. Pearson Prentice Hall. All rights reserved. Printed in the United States of America. This publication is protected by Copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission(s), write to: Rights and Permissions Department. Pearson Prentice Hall™ is a trademark of Pearson Education, Inc. Pearson® is a registered trademark of Pearson plc Prentice Hall® is a registered trademark of Pearson Education, Inc. Pearson Education Ltd., London Pearson Education Singapore, Pte. Ltd Pearson Education, Canada, Inc. Pearson Education–Japan Pearson Education Australia PTY, Limited

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ISBN-13: 978-0-13-210921-5 ISBN 10: 0-13-210921-2


TABLE OF CONTENTS Preface

v

Supplements Available for Fourteenth Edition

ix

Alternative Suggested Chapter Sequences

xiii

Categorization of Assignment Material

xvii

Presentation of Solutions

xxxi

Major Changes in Text for the Fourteenth Edition

xxxiii

Changes in Assignment Material for the Fourteenth Edition

xxxvii

Chapter Solutions 1

The Manager and Management Accounting

1-1

2

An Introduction to Cost Terms and Purposes

2-1

3

Cost-Volume-Profit Analysis

3-1

4

Job Costing

4-1

5

Activity-Based Costing and Activity-Based Management

5-1

6

Master Budget and Responsibility Accounting

6-1

7

Flexible Budgets, Direct-Cost Variances, and Management Control

7-1

8

Flexible Budgets, Overhead Cost Variances, and Management Control

8-1

9

Inventory Costing and Capacity Analysis

9-1

10

Determining How Costs Behave

10-1

11

Decision Making and Relevant Information

11-1

12

Pricing Decisions and Cost Management

12-1

13

Strategy, Balanced Scorecard, and Strategic Profitability Analysis

13-1

14

Cost Allocation, Customer-Profitability Analysis, and Sales-Variance Analysis

14-1

15

Allocation of Support-Department Costs, Common Costs, and Revenues

15-1

16

Cost Allocation: Joint Products and Byproducts

16-1

17

Process Costing

17-1

18

Spoilage, Rework, and Scrap

18-1

19

Balanced Scorecard: Quality, Time, and the Theory of Constraints

19-1

20

Inventory Management, Just-in-Time, and Simplified Costing Methods

20-1

21

Capital Budgeting and Cost Analysis

21-1

22

Management Control Systems, Transfer Pricing, and Multinational Considerations

22-1

v © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

23

Performance Measurement, Compensation, and Multinational Considerations

23-1

vi © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

PREFACE The keys to the success of a course in cost accounting are the assignment and discussion of provocative problem material. The gathering of high-quality assignment material has been a crucial phase of this book‘s preparation – not a painful afterthought. Please review the preface in the text in conjunction with examining the suggestions in this Solutions Manual. Please also read all the front matter of this manual. Anna Jensen, Barbara Durham, Anna Jensen and Shalin Shah assisted us greatly with contributing, critiquing, and checking of the problems and their solutions. We thank them for their many wonderful contributions. We deeply appreciate the tremendous support of Caroline Roop, Aimée Hamel, and Shalin Shah. Their ability to cheerfully respond to the many challenges made our tasks much more manageable. We further appreciate the technical support for data analysis provided by DeYett Law. We are thankful to Stephanie Wall and Christina Rumbaugh at Prentice-Hall for providing continual support in preparing this Solutions Manual. CHARLES T. HORNGREN SRIKANT M. DATAR MADHAV V. RAJAN

vii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

viii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

SUPPLEMENTS AVAILABLE FOR THE FOURTEENTH EDITION A complete package of supplements is available to assist students and instructors in using Cost Accounting: A Managerial Emphasis

MyAccountingLab: for Horngren Cost Accounting 14e MyAccountingLab is an online homework and assessment tool, designed to help students practice cost accounting problems and concepts, and give their instructors feedback on their performance. It lets cost accounting professors assign a homework deliverable that is automatically graded, but that also serves as a tutorial experience for students. Based on Pearson‘s MathXL platform that has graded over millions of assignments, MyAccountingLab provides a strong, reliable platform with a rock solid performance history. To learn more visit www.myaccountinglab.com.

For Instructors Instructor Resource Center (IRC) These password-protected resources are accessible from www.pearsonhighered.com for Cost Accounting, 14th ed. Resources Include: Instructor‘s Manual Test Item File Test Gen EQ—A computerized test item file. Solutions Manual Image Library—Access to most of the images and illustrations featured in the text. Excel Labs and their solutions. Also included are the Excel files of the figures and tables in the text. Complete PowerPoint Presentations NEW PowerPoint slides of fully-worked-out solutions for selected problems. Support for Blackboard and WebCT courses Instructor’s Manual By Sheila Handy © 2012 | 0-13-210924-7 | Online Chapter by chapter manual offers helpful classroom suggestions and teaching tips Test Item File © 2012 | 0-13-210922-0 | Online This collection of tests for each chapter offers an array of questions ranging from easy to difficult. An electronic version of these questions is also available. The Test Item File now supports Association to Advance Collegiate Schools of Business (AACSB) International Accreditation.

ix © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Solutions Manual © 2012 | 0-13-210921-2 | Paper This manual contains the fully worked-out and accuracy-checked solutions for every question, exercise and problem in the text. Power Point Presentations © 2012 | 0-13-210997-2 | Online Chapter by chapter presentations that provide you with a slide show ready for classroom use. Use the slides as they are, or edit them to meet your classroom needs.

For Students Student Study Guide by John K. Harris © 2012 | 0-13-210920-4 | Paper This chapter-by-chapter learning aid effectively helps students learn cost accounting and get the maximum benefit from their study time. Each chapter provides a Chapter Overview and Review, a Featured Exercise that covers all of the most important chapter material, and Review Questions and Exercises with Solutions that best test the students‘ understanding of the material. Student Solutions Manual © 2012 | 0-13-210919-0 | Paper This manual contains the fully worked-out and accuracy-checked solutions for selected end-ofchapter problems in the text. Excel Manual for Cost Accounting By Laurie Burney and Michelle Matherly © 2012 | 0-13-2109182 | Paper This brief supplement is aligned to bring students up to speed with using Excel in this course. Student Download Page --- Horngren URL: www.pearsonhighered.com/horngren Our Companion Website provides students with chapter learning objectives and chapter by chapter self-study quizzes. --- For Students: Excel templates for selected and –of-chapter exercises and problems (marked with an icon) are available online. These templates allow students to complete selected exercises and problems using Excel. The Focus is on having students use Excel to understand and apply chapter content. This Excel-based learning is completely optional; therefore, students may choose to solve these exercises and problems manually. The Excel Labs can be found on the Instructor‘s Resource Center (IRC).

x © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

ALTERNATIVE SUGGESTED CHAPTER SEQUENCES The Preface to Cost Accounting noted that our aim in organizing the material was to present a modular, flexible organization that permits a course to be custom tailored. This section presents six possible sequences for a first course in cost accounting. For each of these six sequences, we also present the sequence of a second course that would result in coverage of many or all of the topics in Cost Accounting. Outlines I–V all include Chapters 1 to 9 in varying orders of sequence. Outline VI has a strong (almost exclusive) focus on the decision making role of cost accounting. We analyzed the sequences of chapters assigned by many users of the 13th edition. Although many instructors tended to follow the sequence in the text, other instructors tailored sequences to fit their particular desires. These tailored sequences varied considerably. By far the most popular departure was to assign the chapter on process costing (Chapter 17) immediately after the coverage of job costing (Chapter 4) and activity-based costing (Chapter 5). The next most popular departure was to assign Chapter 10 after Chapter 2 or 3. All the accompanying alternative assignment schedules have an optional provision to facilitate tailoring a course. Obviously, instructors should alter any suggested sequence to suit their preferences. OUTLINE I: This basic course provides a balance of topics between the major purposes of cost accounting: 1. Calculating the cost of products, services, and other cost objects. 2. Obtaining information for planning and control and performance evaluation. 3. Analyzing relevant information for making decisions. Finishing the first course with Chapters 11 and 12 means that topics with less procedural emphasis are highlighted in the last weeks of the course; these two chapters also introduce topics covered in more detail in a second course. Some instructors may assign Chapter 10 without using the Appendix on ―Regression Analysis,‖ preferring to delay use of the Appendix until the second course (especially if many students have not been exposed to regression analysis at the time of the basic course). OUTLINE II: This basic course covers the same chapters as Outline I, but assigns Chapter 10 (Determining How Costs Behaves) immediately after Chapter 3 (Cost Volume-Profit Analysis). It also assigns the new Chapter 13 on Strategy, Balanced Scorecard, and Strategic Profitability Analysis. This first part of the Second Course emphasizes cost management and performance evaluation before covering the six chapters (14–20) on cost allocation and other aspects of costing systems. OUTLINE III: After covering Chapters 1 to 9 and 11 in the basic course, this sequence finishes with a chapter on strategic issues (Chapter 13) and two chapters on cost allocation topics (Chapters 14 and 15). Some instructors view it as important that students taking only one cost accounting course become aware of how pervasive cost allocation issues are in practice. OUTLINE IV: This basic course is similar to Outline II with one key exception; Chapter 17 (Process Costing) is covered immediately after Chapter 5. Many instructors prefer to cover job costing and process costing in sequence so that their differences are highlighted. xi © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

OUTLINE V: This basic course emphasizes technical cost accounting topics more than the other five outlines. Chapters 17 and 18, extend Chapters 4 and 5; covering 4, 5, 17, and 18, as a single section of the course provides students with a solid understanding of product costing alternatives. OUTLINE VI: This basic course is adopted by instructors who wish to put most emphasis on the decision making and performance evaluation aspects of cost accounting. Finishing the basic course with Chapters 22 and 23 means that behavioral issues are highlighted in the final weeks of the course.

xii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

BASIC COURSE

OUTLINE I Number of Chapter Sessions 1 (1) 2 (2) 3 (2) 4 (3) 5 (3) 6 (2) 7 (2) 8 (2) 9 (2) 10 (2) 11 (2) 12 (2) Tests Optional

SECOND COURSE

Chapter 13 14 15 16 17 18 19 20 21 22 23 Tests Optional

(3) (4) 32

Number of Sessions (3) (2) (2) (2) (2) (2) (2) (2) (2) (2) (2) (3) (6) 32

OUTLINE II Number of Chapter Sessions 1 (1) 2 (2) 3 (2) 10 (2) 4 (3) 5 (3) 6 (2) 7 (2) 8 (2) 9 (2) 11 (2) 12 (2) 13 (2) Tests (3) Optional (2) 32

Chapter 21 22 23 14 15 16 17 18 19 20 Tests Optional

Number of Sessions (3) (2) (2) (3) (2) (2) (3) (2) (2) (2) (3) (6) 32

OUTLINE III Number of Chapter Sessions 1 (1) 2 (2) 3 (2) 4 (3) 5 (3) 6 (2) 7 (2) 8 (2) 9 (2) 11 (2) 13 (2) 14 (2) 15 (2) Tests (3) Optional (2) 32

Chapter 10 12 21 15 17 18 19 20 22 23 Tests Optional

Number of Sessions (2) (2) (3) (2) (3) (2) (2) (3) (2) (2) (3) (6) 32

xiii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

BASIC COURSE

SECOND COURSE

OUTLINE IV Number of Chapter Sessions 1 (1) 2 (2) 3 (2) 10 (2) 4 (2) 5 (2) 17 (2) 6 (2) 7 (2) 8 (2) 9 (2) 11 (2) 12 (2) Tests (3) Optional (4) 32

Chapter 13 21 22 23 14 15 16 18 19 20

Tests Optional

Number of Sessions (3) (3) (2) (2) (3) (2) (2) (2) (2) (2)

(3) (6) 32

OUTLINE V Number of Chapter Sessions 1 (1) 2 (2) 3 (2) 4 (3) 5 (3) 17 (3) 18 (2) 6 (3) 7 (2) 8 (2) 9 (2)

OUTLINE VI Number of Chapter Sessions 1 (1) 2 (2) 3 (2) 10 (2) 4 (2) 5 (2) 6 (2) 11 (2) 12 (2) 13 (3) 22 (2) 23 (2)

Tests Optional

Tests Optional

Chapter 10 11 12 13 21 14 15 16 19 20 22 23 Tests Optional

(3) (4) 32

Number of Sessions (2) (2) (2) (3) (3) (2) (2) (2) (2) (2) (2) (2) (3) (3) 32

Chapter 7 8 9 17 18 19 20 21 14 15 16 Tests Optional

(3) (5) 32

Number of Sessions (2) (2) (2) (3) (2) (2) (2) (3) (2) (2) (2) (3) (5) 32

xiv © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

CATEGORIZATION OF ASSIGNMENT MATERIAL The assignment material in the fourteenth edition has been developed to offer instructors a broad range of options in developing a challenging and interesting course. The following exhibits assist instructors in selecting assignment material. Exhibits P-l and P-2 show assignment material that is based on service/nonprofit, merchandising (retail, wholesale or distribution) sectors of the economy. While much assignment in the fourteenth edition is based in the manufacturing sector, Exhibits P-l and P-2 provide many examples for instructors to either select assignment material from a broad range of sectors or indeed to concentrate on sectors outside manufacturing. 1.

SERVICE AND NONPROFIT SECTORS: Includes such settings as accounting firms, law firms, advertising agencies, bank and finance companies, lodging companies, transportation companies, and government agencies.

2.

MERCHANDISING SECTORS: Includes such settings as distributors, wholesalers, and retailers.

There is growing demand from instructors for assignment material in three specific areas— ethics, global or international, and modern cost management. Exhibits P-3 to P-5 show assignment material in the fourteenth edition on these three topics. 3.

ETHICS. The second-last problem of many chapters incorporates an ethical issue facing a management accountant or a manager. Examples include pressure for cooking the books, concealing of unfavorable information, and conflicts of interest between management incentives and company value. Many of these problems require students to consider the "Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management" on p.16 of the text.

4.

GLOBAL/INTERNATIONAL DIMENSIONS. Included assignment material based outside the United States or problems pertaining to companies with operations in more than one country.

5.

MODERN COST MANAGEMENT FRONTIER IDEAS. Includes assignment material that an instructor can use to highlight areas such as customer focus, key success factors, balanced scorecard, total value-chain analysis, strategic analysis of operating income, JIT, and continuous improvement. Assignment material related to activity-based costing (ABC), activity-based management (ABM), and cost drivers is found in many chapters.

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EXHIBIT P-1 ASSIGNMENT MATERIAL FROM SERVICE AND NOT-FOR-PROFIT SECTORS Chapter Number Context 1 1-22 House-painting service; five-step decision-making process 1-24 Internet company; planning and control 1-30 Publishing company; ethics; end-of-year actions 1-31 Shipping company; ethical challenges 2

2-18 2-21 2-24 2-26

Classification of costs, marketing research Phone contract; fixed and variable costs Publishing company; value chain, cost drivers Total costs and unit costs of student entertainment

3

3-18 3-22 3-29 3-33 3-34 3-40

Travel agency; CVP analysis Restaurant; CVP analysis Music Society; CVP analysis Tourism; CVP analysis Daycare; CVP analysis, target operating income Printing company; breakeven; alternative cost structures, uncertainty, sensitivity Computer retailer; CVP, alternative cost structures Museum of art; gross margin, contribution margin

3-41 3-47 4

4-18 4-21 4-24 4-28 4-29 4-32 4-33 4-39 4-41

5

5-17 5-18 5-22 5-27 5-28 5-29 5-30 5-31 5-33 5-34 5-37

Residential construction; job costing, normal, actual Consulting firm, job costing University press; job costing, journal entries Canadian accounting firm; actual, normal and variation from normal costing Architecture firm; actual, normal, and variation from normal costing Law firm; job costing Law firm; job costing Printing; allocation and proration of overhead Book signing agency; job costing Testing labs; activity-based costing, cost hierarchy Professional services firm; alternative allocation bases Printing company; activity-based costing Custom framing; activity-based costing Banking; activity-based costing, product costing, cross-subsidization Law firm; job costing, single direct- and indirect-cost categories Law firm; job costing, multiple direct- and single indirect-cost categories Law firm; job costing, multiple direct- and indirect-cost categories Radiology center; department, activity-cost rates Dance studio, childcare, fitness; activity-based costing and management Health care; activity-based costing system xvi


EXHIBIT P-1 (Continued) Chapter Number Context 6 6-16 Environmental testing; sales budget 6-40 Hair salon; human aspects of budgeting 7

7-31

Car detailing; variance analysis

8

8-24 8-36 8-40

Food delivery service; overhead variances Publishing company; activity-based costing Pet food inspection; non-financial variances

9

9-31 9-39 9-40

University press; metrics to minimize inventory buildups Hospital chain; cost allocation, downward demand spiral Hospital chain; cost allocation, responsibility accounting, ethics

10

10-17 10-20 10-21 10-23 10-24 10-25 10-27 10-32 10-33

Car rental contracts; variable-, fixed- and mixed-cost functions Car wash; account analysis method Restaurant; account analysis method Travel services; estimating a cost function, high-low method Customer-service costs; estimating a cost function, high-low method Consulting services; linear cost approximation Catering company; regression analysis Produce club; high-low method, regression analysis Restaurant; sales and advertising, high-low method, regression analysis

11

11-24 11-26 11-27

Hospital; relevant costs, decision on closing surgery centers Printing press; choosing customers Auto wash company; relevance of equipment costs

12

12-19 12-20 12-23 12-27 12-31 12-32 12-33 12-33 12-35 12-36

Tool repair shop; value-added, nonvalue-added costs Architects; target operating income, value-added costs Hotel management; cost-plus target return on investment pricing Hotel; price discrimination Repair services; cost-plus, time and materials, ethics Temp labor agency; cost-plus and market-based pricing Testing labs; cost-plus and market-based pricing Testing labs; cost-plus and market-based pricing Airline; price discrimination Art framing; preparing a bid, pricing, ethics

13

13-26 13-27 13-28

Consulting firm; strategy, balanced scorecard Consulting firm; strategic analysis of operating income Consulting firm; analysis of growth, price-recovery, and productivity components Consulting firm; identifying and managing unused capacity

13-29

xvii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

EXHIBIT P-1 (Continued) Chapter Number Context 14 14-16 Hospitals; cost allocation 14-18 Hotel; cost allocation to divisions 14-21 Repair service; customer profitability 14-23 Sports team; variance analysis, multiple products 14-38 Interior design; customer-cost hierarchy and profitability analysis 15

15-19

15-23 15-24 15-29 15-35

Management consulting; direct and step-down support department cost allocation Management consulting; reciprocal method support department cost allocation Allocation of common living costs Consulting services; allocation of common travel costs University; fixed cost allocation Hotel; revenue allocation, bundled products

17

17-38 17-39

Publishing company; transferred-in costs, weighted-average method Publishing company; transferred-in costs, FIFO method

19

19-21 19-22 19-23 19-30 19-37

Conference center; quality improvement, relevant costs and revenues University; waiting time University; waiting time, relevant costs, student satisfaction Healthcare group; patient satisfaction, waiting time, compensation Pizza delivery; quality improvement, Pareto diagram, cause-and-effect diagram

21

21-18 21-19 21-22 21-24 21-34

Hospital; capital budgeting methods, no income taxes Hospital; capital budgeting methods, income taxes Construction company; payback and NPV methods, no income taxes Bakery; new equipment purchase, income taxes Fitness center; recognizing cash flows for capital investment projects, NPV, income taxes

22

22-16

Theme parks; management control systems, balanced scorecard

23

23-17 23-29 23-32

Educational services; DuPont method Restaurants; ROI, measurement alternatives for performance measures Media group; ROI, RI, DuPont method, investment decisions, balanced scorecard Media group; division managers' compensation, levers of control Bank; compensation, balanced scorecard, compensation Health spas; RI, EVA, measurement alternatives, goal congruence

15-20

23-33 23-34 23-37

xviii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

EXHIBIT P-2 ASSIGNMENT MATERIAL FROM MERCHANDISING SECTORS Chapter Number Context 2 2-19 Classification of costs, merchandising sector 2-29 Department store; cost of goods purchased, cost of goods sold, and income statement 2-30 Retail outlet store; cost of goods sold and income statement 3

3-19 3-21 3-23 3-25 3-28 3-30 3-32 3-38 3-39 3-46

Doughnut retailing; CVP Car dealer; CVP analysis Book publisher; CVP and sensitivity analysis Rug dealer; space rental terms, operating leverage Bagel shop; sales mix; CVP Men's clothing retailer; contribution margin, decision making Retail; uncertainty, expected costs Shoe store; sales commissions, CVP analysis Shoe store; sales commissions, CVP analysis Luggage carrier retailer; sales mix, CVP

5

5-24 5-25 5-35 5-41

Supermarket; ABC, product-line profitability Furniture wholesaler; ABC, customer profitability Pharmaceuticals distributor; ABC Bookstore; activity-based costing and management

6

6-24 6-25 6-27 6-37

Supermarket chain; activity-based budgeting Supermarket chain; activity-based budgeting, kaizen budgeting Video game distributor; cash flow analysis Wholesaler; cash budgeting

10

10-40 10-41 10-42

Department store chain; cost drivers, ABC, simple regression analysis Department store chain; cost drivers, ABC, multiple regression analysis Clothing store; matching time periods, regression, ethics

11

11-22 11-25

Food store; relevant costs, contribution margin, product emphasis Convenience stores; relevant costs, closing and opening stores

12

12-21

Distributor; target prices, target costs, ABC

13

13-18 13-19 13-20

T-shirts distributor; strategy, balanced scorecard T-shirts distributor; strategic analysis of operating income T-shirts distributor; analysis of growth, price-recovery, and productivity components T-shirts distributor; identifying and managing unused capacity Clothing retailer; strategic analysis of operating income

13-21 13-39

xix © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

EXHIBIT P-2 (Continued) Chapter Number Context 14 14-20 Electronics distributor; customer profitability, customer-cost hierarchy 14-22 Pharmaceutical distributor; customer profitability 14-24 Wine glass retailer; variance analysis, multiple products 14-30 Bottled water distributor; customer profitability 14-34 Gelato stores; variance analysis, multiple products 15

15-21

15-25 15-26 15-27 15-33

Online book retailer; direct and step-down support department cost allocation Online book retailer; reciprocal method support department cost allocation Fragrance retailer; revenue allocation Auto sales; allocation of common costs Department store; single-rate, dual-rate and practical capacity allocation Computer hardware sales; revenue allocation

20

20-16 20-17 20-18 20-26 20-29

Sporting goods retailer; EOQ Sporting goods retailer; EOQ, effect of parameter changes Textile retailer; EOQ Linen retailer; effect of different order quantities, EOQ, Online computer retailer; EOQ, performance evaluation

21

21-17 21-36 21-37

Hardware stores; capital budgeting methods, no income taxes Food retailer; NPV, inflation, income taxes Food franchise; NPV, internal rate of return, sensitivity analysis

23

23-22 23-26

Automobile retailer; ROI, RI, EVA Car battery sales; risk sharing, incentives, benchmarking, multiple tasks

15-22

xx © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

EXHIBIT P-3 ASSIGNMENT MATERIAL ON ETHICS Chapter Number Context 1 1-23 Division performance 1-28 Pharmaceutical company, budgeting 1-29 End-of-year actions 1-30 End-of-year actions 1-31 Global company, end-of-year actions 2

2-41

Cost classification

3

3-48

Environmental costs, CVP analysis

4

4-40

Job costing, contracting, cost reimbursement

5

5-40

Electronics; ABC, implementation, ethics

6

6-39

Manufacturer; slack, ethics

7

7-41

Drum manufacturer; variances, standard-setting, benchmarking, ethics

8

8-42

Overhead variances, ethics

9

9-40

Hospital chain; cost allocation, responsibility accounting, ethics

10

10-42

Clothing store; matching time periods, regression, ethics

11

11-41

Dropping a customer, activity-based costing, ethics

12

12-31 12-36

Repair services; cost-plus, time and materials, ethics Art framing; preparing a bid, pricing, ethics

13

13-33

Electronic component manufacturer; ethics

14

14-39

Writing smaller orders; customer profitability and ethics

19

19-18 19-38

Car seats; costs of quality, ethics Auto parts manufacturer; ethics and quality

20

20-36

Container manufacturer; JIT production, relevant benefits, relevant costs, ethics

22

22-35

Luggage manufacturer; transfer pricing, goal congruence, ethics

23

23-35 23-36

Semiconductors; manager's performance evaluation, ethics Picture frame molding; levers of control, ethics xxv


EXHIBIT P-4 ASSIGNMENT MATERIAL WITH GLOBALOR INTERNATIONAL SETTING Chapter Number Context 1 1-31 Contract bidding, ethical and cultural issues 3

3-18 3-26

Travel agency, CVP analysis International cost structure differences, CVP analysis

4

4-28

Canadian accounting firm; actual, normal and variation from normal costing

6

6-22

Japanese motorcycle manufacturer; revenues, production and purchases budgets

8

8-23

Telecommunications company; manufacturing overhead, standardcosting system

11

11-30

International outsourcing; relevant costs, exchange rates

21

21-26 21-29

Clothing manufacturer; selling a plant, income taxes Fragrance manufacturer; DCF, sensitivity analysis, no income taxes

22

22-19

Multinational computer company; transfer pricing, global income-tax minimization Canadian lumber company; transfer-pricing methods, goal congruence Telecommunications equipment, global marketing; multinational transfer pricing, global tax minimization Telecommunications equipment, global marketing; multinational transfer pricing, goal congruence Industrial diamonds; multinational transfer pricing, global tax minimization Component manufacturer; multinational transfer pricing, taxation, goal congruence

22-20 22-23 22-24 22-32 22-33

23

23-24 22-30 23-31

Manufacturing, U.S. and Norway; multinational performance measurement, ROI, RI Manufacturing, U.S. and France; multinational performance measurement, ROI, RI Multinational firm, U.S., Germany, and New Zealand; performance measurement, ROI, RI, cost of capital, taxes

xxvi © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

EXHIBIT P-5 ASSIGNMENT MATERIAL USING MODERN COST MANAGEMENT FRONTIER IDEAS Chapter 1

Number 1-16 1-17 1-18 1-19 1-25

2

2-24

Publishing company; value chain, cost drivers

5

5-16 5-17 5-19 5-20

5-39 5-40 5-41

Cost hierarchy at manufacturer Testing labs; ABC, cost hierarchy Automotive products; plantwide, department, ABC costing Trophies and plaques manufacturer; plantwide, department, ABC costing Calculator manufacturer; ABC, process costing Printing company; activity-based costing Door manufacturer; activity-based costing Supermarket; ABC, product-line profitability Furniture wholesaler; ABC, customer profitability Food processing; ABC, area cost-driver rates, product crosssubsidization Custom framing; activity-based costing Banking; ABC, product costing, cross-subsidization Law firm; job costing, multiple direct- and single indirect-cost categories Law firm; job costing, multiple direct- and indirect-cost categories Trophy manufacturing; plantwide, department, activity-cost rates Radiology center; department, activity-cost rates Dance studio, childcare, fitness; activity-based costing and management Pharmaceuticals distributor; ABC Bag manufacturer; activity-based costing and management Health care; ABC system Sports manufacturer; unused capacity, activity-based costing and management Machining shop; ABC Electronics; ABC, implementation, ethics Bookstore; activity-based costing and management

6-24 6-25 6-29 6-32 6-33 6-38 6-41

Supermarket chain; activity-based budgeting Supermarket chain; activity-based budgeting, kaizen budgeting T-shirt manufacturer; kaizen approach Purchasing agent; responsibility accounting Luggage manufacturer; activity-based budgeting Plastic accessories manufacturer; activity-based budgeting Footwear manufacturer; activity-based budgeting

5-21 5-22 5-23 5-24 5-25 5-26 5-27 5-28 5-30 5-31 5-32 5-33 5-34 5-35 5-36 5-37 5-38

6

Context Computer company; value chain, cost classification Pharmaceutical company; value chain, cost classification Fast food restaurant; value chain, cost classification Key success factors Making strategic decisions

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EXHIBIT P-5 (Continued) Chapter Number Context 7 7-25 Lamp manufacturer; continuous improvement 7-32 Sunglass frame/lens manufacturer; responsibility issues 7-38 Eyeglass lens manufacturer; use of variances for benchmarking 7-41 Drum manufacturer; variances, standard-setting, benchmarking, ethics 7-42 Electronics manufacturer; variances, standards, negotiations 8

8-35 8-36 8-37 8-41

9

9-17 9-19 9-25 9-26 9-31 9-34

Shoe manufacturer; activity-based costing, batch-level variance analysis Publishing company; activity-based costing, batch-level variance analysis Jewelry maker; relationship between production-volume and salesvolume variance analysis Cloth shopping bag maker; relationship between production-volume and sales-volume variance analysis

9-36 9-39 9-40

Auto company; throughput costing Electronics manufacturer; throughput costing Capacity management, denominator-level capacity concepts Motorcycle manufacturer; alternative denominator-level capacities Textbook publisher; metrics to minimize inventory buildups Denominator-level choices, changes in inventory levels, effect on operating income Electronics manufacturer; downward demand spiral Hospital meal service; cost allocation, downward demand spiral Hospital meal service; cost allocation, responsibility accounting, ethics

10

10-34 10-38 10-39 10-40 10-41

Manufacturing; cost drivers, ABC, simple regression analysis Manufacturing; cost drivers, ABC, simple regression analysis Manufacturing; cost drivers, ABC, multiple regression analysis Department store chain; cost drivers, ABC, simple regression analysis Department store chain; cost drivers, ABC, multiple regression analysis

11

11-19 11-20 11-26 11-36 11-41

Special order, activity-based costing Make versus buy, activity-based costing Printers; customer profitability analysis Manufacturing; ABC, make versus buy Customer profitability, activity-based costing, ethics

12

12-19 12-20 12-21 12-22

Tool repair shop; value-added, nonvalue-added costs Architects; target operating income, value-added costs Distributor; target prices, target costs, ABC Medical instruments; target costs, effect of product-design changes on product costs Hotel management; cost-plus target return on investment pricing Manufacturer; cost-plus, target pricing Toy manufacturer; life-cycle product costing Hotel; price discrimination

12-23 12-24 12-25 12-27

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EXHIBIT P-5 (Continued) Chapter Number Context 12-28 Manufacturer; target pricing 12-29 Electronics; target prices, target costs, value engineering, cost incurrence, locked-in costs, ABC 12-30 Candy manufacturer; target return on investment pricing 12-32 Temp labor agency; cost-plus and market-based pricing 12-33 Testing labs; cost-plus, activity-based costing, market-based pricing 12-34 Industrial site cleanup; life-cycle costing 12-35 Airline; price discrimination 12-37 Manufacturing; target prices, target costs, locked-in costs, value engineering 13

13-16 13-17 13-18 13-19 13-20

13-33 13-34 13-35 13-36 13-37 13-38 13-39

Balanced scorecard Analysis of growth, price-recovery and productivity components Merchandising; strategy, balanced scorecard Merchandising; strategic analysis of operating income Merchandising; analysis of growth, price-recovery, and productivity components Merchandising; identifying and managing unused capacity Manufacturing; strategy, balanced scorecard Manufacturing; strategic analysis of operating income Manufacturing; analysis of growth, price-recovery and productivity components Manufacturing; identifying and managing unused capacity Consulting firm; strategy, balanced scorecard Consulting firm; strategic analysis of operating income Consulting firm; analysis of growth, price-recovery, and productivity components Consulting firm; identifying and managing unused capacity Manufacturing; strategy, balanced scorecard Manufacturing; strategic analysis of operating income Manufacturing; analysis of growth, price-recovery, and productivity components Manufacturing; identifying and managing unused capacity Balanced scorecard Petroleum company; balanced scorecard Laser printers; balanced scorecard Manufacturing; partial productivity measurement Manufacturing; total factor productivity Clothing retailer; strategic analysis of operating income

14-20 14-21 14-22 14-29 14-30 14-31

Electronics distribution; customer profitability, customer-cost hierarchy Repair service; customer profitability Pharmaceutical distributor; customer profitability Jewelry manufacturer; customer profitability Bottled water distributor; customer profitability Manufacturing company; customer profitability analysis

13-21 13-22 13-23 13-24 13-25 13-26 13-27 13-28 13-29 13-30 13-31 13-32

14

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EXHIBIT P-5 (Continued) Chapter Number Context 14-38 Interior design; customer-cost hierarchy, customer profitability 14-39 Writing smaller orders; customer-cost hierarchy, profitability and ethics 19

19-16 19-17 19-18 19-19 19-20 19-21 19-22 19-23 19-24 19-25 19-26 19-27 19-28 19-29 19-30 19-31 19-32 19-33 19-34 19-35 19-36 19-37 19-38 19-39

20

20-21 20-22 20-23 20-24 20-25 20-28 20-30

Cell phone equipment; costs of quality Car seats; costs of quality Car seats; costs-of-quality, ethics Cell phones; nonfinancial measures of quality and time Printing presses; quality improvements, relevant costs and relevant revenues Conference center, quality improvement, relevant costs and relevant revenues University; waiting time University; waiting time, relevant costs, student satisfaction Manufacturer; nonfinancial measures of quality, manufacturing cycle efficiency Filing cabinets; theory of constraints, throughput margin, relevant costs Filing cabinets; theory of constraints, throughput margin, quality Valve manufacturing; quality improvement, relevant costs, and relevant revenues Plastic products; quality improvement, relevant costs, and relevant revenues Cereal manufacturer; statistical quality control Healthcare group; waiting time, patient satisfaction, compensation Plastic products; waiting times, manufacturing lead times Plastic products; waiting times, relevant revenues, and relevant costs Wire harnesses; manufacturing cycle times, relevant revenues, and relevant costs Electronic testing equipment; theory of constraints, throughput margin, relevant costs Pharmaceutical manufacturer; theory of constraints, throughput margin, quality, relevant costs Toy manufacturer; theory of constraints, sensitivity analysis Pizza delivery; quality improvement, Pareto diagram, cause-and-effect diagram Auto parts manufacturer; quality and ethics Textile printing; quality improvement; theory of constraints Car manufacturer; JIT, balanced scorecard Hardware company; JIT production, relevant benefits, relevant costs Computer assembly; backflush costing and JIT production Computer assembly; backflush costing, two trigger points, materials purchase and sale Computer assembly; backflush costing, two trigger points, completion of production and sale Music players; EOQ, JIT production Automotive supplier, JIT purchasing, relevant benefits, relevant cost xxx


EXHIBIT P-5 (Continued) Chapter Number Context 20-31 Computer manufacturer; supplier evaluation, costs of quality, timely deliveries 20-32 Electrical goods; backflush costing and JIT production 20-33 Electrical goods; backflush, two trigger points, materials purchase and sale 20-34 Electrical goods; backflush, two trigger points, completion of production and sale 20-35 Security devices; lean accounting 20-36 Container manufacturer; JIT production, relevant benefits, relevant costs, ethics. 22

22-16 22-18

Theme parks; management control systems, balanced scorecard Supermarket chain; decentralization, goal congruence, responsibility centers

23

23-22 23-24

Automotive retailer; ROI, RI, EVA Manufacturing, U.S. and Norway; multinational performance measurement, ROI, RI Fashion product manufacturer; ROI, RI, EVA, performance evaluation Automotive; risk sharing, incentives, benchmarking, multiple tasks Doorbell manufacturing; RI, EVA, adjusted operating income Manufacturing, U.S. and France; multinational performance measurement, ROI, RI Multinational firm, U.S., Germany, and New Zealand; multinational performance measurement, ROI, RI, cost of capital, taxes Media group; ROI, RI, DuPont method, investment decisions, balanced scorecard Media group; division managers' compensation, levers of control Bank; business unit compensation, balanced scorecard Picture frame molding; levers of control, ethics Health spas; RI, EVA, measurement alternatives, goal congruence

23-25 23-26 23-27 23-30 23-31 23-32 23-33 23-34 23-36 23-37

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xxxii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

PRESENTATION OF SOLUTIONS This edition is accompanied by a Student Solutions Manual, which is available for sale to students. The Manual provides worked-out solutions to all of the even numbered assignment material. Instructors have a variety of views regarding the use of classroom time for homework solutions. Most instructors put solutions on a blackboard or an overhead projector. In turn, their students frantically copy the materials in their notes. Our practice is to reproduce the printed homework solutions for distribution either before, during, or after the discussion for a particular solution. The members of the class are glad to pay a modest fee to the school to cover the reproduction costs. In this way, students can spend more of their classroom time in thinking rather than writing. Further, they have a complete set of notes. Some instructors object to this procedure because it provides students with a "file" that can be passed along to subsequent classes. Students in subsequent classes will then use the "file" to avoid conscientious preparation of homework. We used to worry about such practices, but long ago we decided that there would always be some students who hurt themselves by not doing homework in an appropriate way. Why should the vast majority of students be penalized by withholding the printed solutions? The benefits of using printed solutions clearly outweigh the costs. We no longer fret about the few students who beat the system (and themselves). Similarly, we distribute printed solutions to tests and examinations along with a summary of overall class performance. We do not devote class time to discussing these solutions. The students deserve feedback, but they have sufficient motivation to scrutinize the printed solutions and check their errors on an individual basis. In this way more class time is available for new material. If students have complaints about grades, we usually ask them to cool off for 24 hours and to then submit a written analysis of how they were unjustly treated. We then take these complaints in batches, regrade the papers, and return the papers. If the student then wants to have a person-to-person discussion of the matter, he or she is welcome at our office. This procedure may seem too impersonal, but we recommend it to those teachers who have been through some painful debates that have been inefficient and frustrating for both student and teacher.

xxxiii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

xxxiv © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

MAJOR CHANGES IN TEXT OF THE FOURTEENTH EDITION Greater Emphasis on Strategy This edition deepens the book‘s emphasis on strategy development and execution. Several chapters build on the strategy theme introduced in Chapter 1. Chapter 13 has a greater discussion of strategy maps as a useful tool to implement the balanced scorecard and a simplified presentation of how income statements of companies can be analyzed from the strategic perspective of product differentiation or cost leadership. We also discuss strategy considerations in the design of activity-based costing systems in Chapter 5, the preparation of budgets in Chapter 6, and decision making in Chapters 11 and 12. Deeper Consideration of Global Issues Business is increasingly becoming more global. Even small and medium-sized companies across the manufacturing, merchandising, and service sectors are being forced to deal with the effects of globalization. Global considerations permeate many chapters. For example, Chapter 11 discusses the benefits and the challenges that arise when outsourcing products or services outside the United States. Chapter 22 examines the importance of transfer pricing in minimizing the tax burden faced by multinational companies. Several new examples of management accounting applications in companies are drawn from international settings. Increased Focus on the Service Sector In keeping with the shifts in the U.S. and world economy this edition makes greater use of service sector examples. For example, Chapter 2 discusses the concepts around the measurement of costs in a software development rather than a manufacturing setting. Chapter 6 provides several examples of the use of budgets and targets in service companies. Several concepts in action boxes focus on the service sector such as activity-based costing at Charles Schwab (Chapter 5) and managing wireless data bottlenecks (Chapter 19). New Cutting-Edge Topics The pace of change in organizations continues to be rapid. The fourteenth edition of Cost Accounting reflects changes occurring in the role of cost accounting in organizations. We have introduced foreign currency and forward contract issues in the context of outsourcing decisions. We have added ideas based on Six Sigma to the discussion of quality. We have rewritten the chapter on strategy and the balanced scorecard and simplified the presentation to connect strategy development, strategy maps, balanced scorecard, and analysis of operating income. We discuss current trends towards Beyond Budgeting and the use of rolling forecasts. We develop the link between traditional forms of cost allocation and the nascent movement in Europe towards Resource Consumption Accounting. We focus more sharply on how companies are simplifying their costing systems with the presentation of value streams and lean accounting. Opening Vignettes Each chapter opens with a vignette on a real company situation. The vignettes engage the reader in a business situation, or dilemma, illustrating why and how the concepts in the chapter are relevant in business. For example, Chapter 1 describes how Apple uses cost accounting information to make decisions relating to how they price the most popular songs on iTunes. xxxv © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Chapter 3 explains how the band U2 paid for their extensive new stage by lowering ticket prices. Chapter 7 describes how even the NBA was forced to cut costs after over half of the league‘s franchises declared losses. Chapter 11 shows how JetBlue uses Twitter and e-mail to help their customers make better pricing decisions. Chapter 12 discusses how Tata Motors designed a car for the Indian masses, priced at only $2,500. Chapter 14 shows how Best Buy boosts profits by analyzing its customers and their buying habits. Chapter 18 describes how Boeing incurred great losses as it reworked its much-anticipated Dreamliner airplane. Concepts in Action Boxes Found in every chapter, these boxes cover real-world cost accounting issues across a variety of industries including automobile racing, defense contracting, entertainment, manufacturing, and retailing. New examples include How Zipcar Helps Reduce Business Transportation Costs Job Costing at Cowboys Stadium The ―Death Spiral‖ and the End of Landline Telephone Service Transfer Pricing Dispute Temporarily Stops the Flow of Fiji Water Streamlined Presentation We continue to try to simplify and streamline our presentation of various topics to make it as easy as possible for a student to learn the concepts, tools, and frameworks introduced in different chapters. Examples of more streamlined presentations can be found in Chapter 3, on the discussion of target net income Chapter 5, on the core issues in activity-based costing (ABC) Chapter 8, which uses a single comprehensive example to illustrate the use of variance analysis in ABC systems Chapter 13, which contains a much simpler presentation of the strategic analysis of operating income Chapter 15, which uses a simpler, unified framework to discuss various cost-allocation methods Chapters 17 and 18, where the material on standard costing has been moved to the appendix, allowing for smoother transitions through the sections in the body of the chapter Highlights of New Chapter-by-Chapter Changes Chapter 1: Chapter 1 has been rewritten to focus on strategy, decision-making, and learning emphasizing the managerial issues that animate modern management accounting. It now emphasizes decision making instead of problem solving, performance evaluation instead of scorekeeping and learning instead of attention directing. Chapter 2: Chapter 2 has been rewritten to emphasize the service sector. For example, instead of a manufacturing company context, the chapter uses the software development setting at a company like Apple Inc. to discuss cost measurement. It also develops ideas related to risk when discussing fixed versus variable costs.

xxxvi © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Chapter 3: Chapter 3 has been rewritten to simplify the presentation of target net income by describing how target net income can be converted to target operating income. This allows students to use the equations already developed for target operating income when discussing target net income. We deleted the section on multiple cost drivers, because it is closely related to the multi-product example discussed in the chapter. The managerial and decision-making aspects of the chapter have also been strengthened. Chapter 4: Chapter 4 has been reorganized to first discuss normal costing and then actual costing because normal costing is much more prevalent in practice. As a result of this change the exhibits in the early part of the chapter tie in more closely to the detailed exhibits of normal job-costing systems in manufacturing later in the chapter. The presentation of actual costing has been retained to help students understand the benefits and challenges of actual costing systems. To focus on job costing, we moved the discussion of responsibility centers and departments to Chapter 6. Chapter 5: Chapter 5 has been reorganized to clearly distinguish design choices, implementation challenges, and managerial applications of ABC systems. The presentation of the ideas has been simplified and streamlined to focus on the core issues. Chapter 6: Chapter 6 now includes ideas from relevant applied research on the usefulness of budgets and the circumstances in which they add the greatest value, as well as the challenges in administering them. It incorporates new material on the Beyond Budgeting movement, and in particular the trend towards the use of rolling forecasts.. Chapters 7 and 8: Chapters 7 and 8 present a streamlined discussion of direct-cost and overhead variances, respectively. The separate sections on ABC and variance analysis in chapters 7 and 8 have now been combined into a single integrated example at the end of Chapter 8. A new appendix to Chapter 7 now addresses more detailed revenue variances using the existing Webb Company example. The use of potentially confusing terms such as 2-variance analysis and 1-variance analysis has been eliminated. Chapter 9: We have rewritten Chapter 9 as a single integrated chapter with the same running example rather than as two distinct sub-parts on inventory costing and capacity analysis. The material on the tax and financial reporting implications of various capacity concepts has also been fully revised. Chapter 10: Chapter 10 has been revised to provide a more linear progression through the ideas of cost estimation and the choice of cost drivers, culminating in the use of quantitative analysis (regression analysis, in particular) for managerial decision-making. Chapter 11: Chapter 11 now includes more discussion of global issues such as foreign currency considerations in international outsourcing decisions. There is also greater emphasis on strategy and decisionmaking. xxxvii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Chapter 12: Chapter 12 has been reorganized to more sharply delineate short-run from long-run costing and pricing and to bring together the various considerations other than costs that affect pricing decisions. This reorganization has helped streamline several sections in the chapter. Chapter 13: Chapter 13 has been substantially rewritten. Strategy maps are presented as a way to link strategic objectives and as a useful first step in developing balanced scorecard measures. The section on strategic analysis of operating income has been significantly simplified by focusing on only one indirect cost and eliminating most of the technical details. Finally, the section on engineered and discretionary costs has been considerably shortened to focus on only the key ideas. Chapter 14: Chapter 14 now discusses the use of ―whale curves‖ to depict the outcome of customer profitability analysis. The last part of the chapter has been rationalized to focus on the decomposition of sales volume variances into quantity and mix variances; and the calculation of sales mix variances has also been simplified. Chapter 15: Chapter 15 has been completely revised and uses a simple, unified conceptual framework to discuss various cost allocation methods (single-rate versus dual-rate, actual costs versus budgeted costs, etc.). Chapter 16: Chapter 16 now provides a more in-depth discussion of the rationale underlying joint cost allocation as well as the reasons why some firms do not allocate costs (along with real-world examples). Chapters 17 and 18: Chapters 17 and 18 have been reorganized, with the material on standard costing moved to the appendix in both chapters. This reorganization has made the chapters easier to navigate and fully consistent (since all sections in the body of the chapter now use actual costing). The material on multiple inspection points from the appendix to Chapter 18 has been moved into the body of the chapter, but using a variant of the existing example involving Anzio Corp. Chapter 19: Chapter 19 introduces the idea of Six Sigma quality. It also integrates design quality, conformance quality, and financial and nonfinancial measures of quality. The discussion of queues, delays, and costs of time has been significantly streamlined. Chapter 20: Chapter 20‘s discussion of EOQ has been substantially revised and the ideas of lean accounting further developed. The section on backflush costing has been completely rewritten. Chapter 21: Chapter 21 has been revised to incorporate the payback period method with discounting, and also now includes survey evidence on the use of various capital budgeting methods. The discussion of xxxviii © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

goal congruence and performance measurement has been simplified and combined, making the latter half of the chapter easier to follow. Chapter 22: Chapter 22 has been fully rewritten with a new section on the use of hybrid pricing methods. The chapter also now includes a fuller description (and a variety of examples) of the use of transfer pricing for tax minimization, and incorporates such developments as the recent tax changes proposed by the Obama administration. Chapter 23: Chapter 23 includes a more thorough description of Residual Income and EVA, as well as a more streamlined discussion of the various choices of accounting-based performance measures.

xxxix © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

CHANGES IN ASSIGNMENT MATERIAL FOR THE FOURTEENTH EDITION Over 60% of the exercises and problems in the fourteenth edition are new or revised. The remaining exercises and problems are taken from the thirteenth edition. The following exhibits indicate the source of each of the exercises and problems in the thirteenth edition. These exhibits can be read as follows: Chapter 5

Category (a) Category (b) Category (c)

14E ∙ ∙ ∙ 5-xx 5-yy 5-zz

13E ∙ ∙ ∙ New 5-yy Rev 5-zz

Category (a) shows that problem 5-xx in the fourteenth edition is new to this edition. Category (b) shows that problem 5-yy in the fourteenth edition is a revision of problem 5-yy in the thirteenth edition; the ‗Rev‘ in ‗5-yy Rev‘ indicates that the content and numbers in the thirteenth edition have been revised. Category (c) shows that problem 5-zz in the fourteenth edition is problem 5-zz in the thirteenth edition. The absence of a ‗Rev‖ after ‗5-zz‘ means that no change in the content or numbers has been made in continuing use of this problem in the fourteenth edition.

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Chapter 1 14E 13E 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

16 17 18 New 20 21 22 Rev 23 24 25 26 27 New 29 New New

Chapter 2 14E 13E 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42

16 Rev New 18 19 20 21 Rev 22 23 Rev New 25 26 27 Rev 28 30 Rev New 29 Rev 31 New 32 33 34 Rev 35 Rev New 37 Rev 38 Rev New 40

Chapter 3 14E 13E 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49

16 17 Rev 18 Rev 19 20 21 Rev 22 Rev 23 24 Rev 25 New 27 Rev New New 30 Rev 31 32 Rev 33 Rev 34 Rev New 36 New 38 39 New New New 43 44 45 46 Rev 47 Rev 48 49

Chapter 4 14E 13E 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

16 17 18 Rev 19 Rev 20 21 Rev New 23 24 25 26 27 Rev 28 Rev New 30 Rev 31 Rev 32 33 34 35 New 37 New New New New

Chapter 5 14E 13E 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

16 Rev 17 Rev 18 Rev 19 New 20 21 New 23 24 Rev 25 New 27 Rev 28 29 30 New 32 Rev 33 Rev 34 35 Rev 36 Rev 37 38 Rev 39 40

Chapter 6 14E 13E 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

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16 Rev 17 18 19 20 21 Rev 22 23 24 25 Rev New New 28 Rev New 30 31 New 33 Rev 34 Rev 35 36 37 Rev 38 Rev New New

Chapter 7 14E 13E 16 16 17 17 18 18 19 19 20 20 Rev 21 21 22 22 23 23 24 24 25 25 Rev 26 26 27 27 28 28 29 New 30 30 Rev 31 31 Rev 32 32 33 33 Rev 34 34 Rev 35 35 Rev 36 36 37 37 Rev 38 38 Rev 39 39 Rev 40 New 41 New 42 40

Chapter 8 14E 13E 16 16 17 17 18 18 19 19 20 20 21 21 Rev 22 22 23 23 Rev 24 24 25 25 Rev 26 26 27 27 Rev 28 28 Rev 29 29 30 30 31 31 Rev 32 32 Rev 33 33 34 34 Rev 35 New 36 36 Rev 37 38 38 39 39 40 40 41 Rev 41 New 42 New

Chapter 9 14E 13E 16 16 17 17 18 18 19 19 20 20 21 21 22 22 Rev 23 23 24 24 Rev 25 25 26 26 Rev 27 New 28 28 29 29 Rev 30 30 31 31 Rev 32 32 33 33 34 34 Rev 35 35 Rev 36 New 37 37 Rev 38 38 Rev 39 39 Rev 40 40 Rev 41 New

Chapter 10 14E 13E 16 16 17 17 18 18 19 19 20 20 21 New 22 22 23 23 24 24 Rev 25 25 Rev 26 26 Rev 27 27 28 28 Rev 29 29 Rev 30 30 Rev 31 31 Rev 32 32 Rev 33 33 34 34 Rev 35 35 Rev 36 36 Rev 37 37 Rev 38 38 Rev 39 39 Rev 40 40 Rev 41 41 Rev 42 New

Chapter 11 14E 13E 16 16 Rev 17 17 Rev 18 18 19 19 20 20 21 21 Rev 22 22 Rev 23 23 24 New 25 25 26 26 27 27 28 28 Rev 29 29 30 New 31 31 32 32 Rev 33 33 34 34 35 35 36 New 37 37 38 38 Rev 39 39 40 40 41 New 42 New

Chapter 12 14E 13E 16 16 17 17 18 18 Rev 19 19 20 20 Rev 21 21 22 22 23 23 Rev 24 New 25 New 26 26 Rev 27 New 28 28 Rev 29 29 30 30 31 New 32 32 Rev 33 33 34 New 35 35 Rev 36 New 37 New

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Chapter 13 14E 13E 16 16 Rev 17 17 Rev 18 18 19 19 Rev 20 20 Rev 21 21 Rev 22 22 23 23 Rev 24 24 Rev 25 25 Rev 26 26 27 27 Rev 28 28 Rev 29 29 Rev 30 New 31 New 32 New 33 New 34 34 35 35 36 36 37 37 Rev 38 38 Rev 39 39

Chapter 14 14E 13E 16 16 17 17 Rev 18 18 19 19 20 20 Rev 21 21 22 22 23 23 24 24 Rev 25 25 Rev 26 26 Rev 27 27 28 28 29 29 30 30 31 31 Rev 32 32 Rev 33 33 Rev 34 34 Rev 35 36 36 37 Rev 37 New 38 New 39 New

Chapter 15 14E 13E 16 16 17 17 18 18 19 19 20 20 21 21 22 22 23 23 Rev 24 24 Rev 25 25 Rev 26 New 27 27 Rev 28 28 Rev 29 New 30 30 31 31 32 32 Rev 33 33 Rev 34 New 35 35 Rev

Chapter 16 14E 13E 16 16 17 17 18 18 19 19 20 20 Rev 21 21 22 22 23 23 24 24 Rev 25 25 Rev 26 26 Rev 27 27 Rev 28 28 29 29 30 30 Rev 31 31 Rev 32 32 Rev 33 33 Rev 34 34 Rev 35 36 Rev 36 New 37 New

Chapter 17 14E 13E 16 16 17 17 18 18 19 19 20 20 21 21 22 22 23 New 24 24 Rev 25 25 Rev 26 26 Rev 27 27 28 28 29 New 30 30 31 31 32 32 33 33 34 34 35 35 Rev 36 36 Rev 37 37 Rev 38 38 Rev 39 39 Rev 40 40 Rev 41 41 Rev 42 29

Chapter 18 14E 13E 16 16 17 17 18 18 19 19 20 20 21 21 22 22 Rev 23 23 Rev 24 24 25 25 26 26 27 27 Rev 28 28 29 29 Rev 30 30 Rev 31 31 Rev 32 32 Rev 33 33 Rev 34 New 35 35 Rev 36 36 Rev 37 37 Rev 38 New 39 39 40 New 41 New

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Chapter 19 14E 13E 16 16 17 17 Rev 18 18 Rev 19 19 20 20 Rev 21 New 22 22 Rev 23 23 Rev 24 New 25 25 26 26 27 27 28 28 29 New 30 30 Rev 31 31 Rev 32 32 Rev 33 33 34 34 Rev 35 35 36 36 Rev 37 New 38 New 39 39

Chapter 20 14E 13E 16 16 17 17 18 18 Rev 19 19 20 New 21 21 22 22 23 23 24 24 25 25 26 26 Rev 27 New 28 28 Rev 29 29 30 31 31 32 32 33 Rev 33 34 Rev 34 35 Rev 35 New 36 New

Chapter 21 14E 13E 16 16 Rev 17 17 Rev 18 18 19 19 20 20 21 21 Rev 22 22 23 23 24 24 25 25 Rev 26 26 Rev 27 27 28 28 29 29 Rev 30 30 Rev 31 31 32 32 Rev 33 33 Rev 34 34 35 35 Rev 36 36 Rev 37 38 Rev 38 New

Chapter 22 14E 13E 16 New 17 17 18 New 19 19 Rev 20 20 21 21 22 22 23 23 Rev 24 24 Rev 25 25 26 26 27 27 Rev 28 28 29 29 30 30 31 31 32 32 Rev 33 33 Rev 34 34 Rev 35 New 36 36 Rev

Chapter 23 14E 13E 16 16 17 17 Rev 18 18 19 19 20 20 21 21 22 22 23 23 24 24 Rev 25 25 26 26 27 27 Rev 28 28 Rev 29 New 30 30 Rev 31 31 Rev 32 32 Rev 33 33 34 34 Rev 35 35 Rev 36 36 Rev 37 New

xliv © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

CHAPTER 1 THE MANAGER AND MANAGEMENT ACCOUNTING See the front matter of this Solutions Manual for suggestions regarding your choices of assignment material for each chapter. 1-1 Management accounting measures, analyzes and reports financial and nonfinancial information that helps managers make decisions to fulfill the goals of an organization. It focuses on internal reporting and is not restricted by generally accepted accounting principles (GAAP). Financial accounting focuses on reporting to external parties such as investors, government agencies, and banks. It measures and records business transactions and provides financial statements that are based on generally accepted accounting principles (GAAP). Other differences include (1) management accounting emphasizes the future (not the past), and (2) management accounting influences the behavior of managers and other employees (rather than primarily reporting economic events). 1-2 Financial accounting is constrained by generally accepted accounting principles. Management accounting is not restricted to these principles. The result is that management accounting allows managers to charge interest on owners’ capital to help judge a division’s performance, even though such a charge is not allowed under GAAP, management accounting can include assets or liabilities (such as ―brand names‖ developed internally) not recognized under GAAP, and management accounting can use asset or liability measurement rules (such as present values or resale prices) not permitted under GAAP. 1-3 Management accountants can help to formulate strategy by providing information about the sources of competitive advantage—for example, the cost, productivity, or efficiency advantage of their company relative to competitors or the premium prices a company can charge relative to the costs of adding features that make its products or services distinctive. 1-4

The business functions in the value chain are Research and development—generating and experimenting with ideas related to new products, services, or processes. Design of products and processes—the detailed planning, engineering, and testing of products and processes. Production—procuring, transporting, storing and assembling resources to produce a product or deliver a service. Marketing—promoting and selling products or services to customers or prospective customers. Distribution—processing orders and shipping products or services to customers. Customer service—providing after-sales service to customers.

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1-5 Supply chain describes the flow of goods, services, and information from the initial sources of materials and services to the delivery of products to consumers, regardless of whether those activities occur in the same organization or in other organizations. Cost management is most effective when it integrates and coordinates activities across all companies in the supply chain as well as across each business function in an individual company’s value chain. Attempts are made to restructure all cost areas to be more cost-effective. 1-6 ―Management accounting deals only with costs.‖ This statement is misleading at best, and wrong at worst. Management accounting measures, analyzes, and reports financial and nonfinancial information that helps managers define the organization’s goals, and make decisions to fulfill them. Management accounting also analyzes revenues from products and customers in order to assess product and customer profitability. Therefore, while management accounting does use cost information, it is only a part of the organization’s information recorded and analyzed by management accountants. 1-7 Management accountants can help improve quality and achieve timely product deliveries by recording and reporting an organization’s current quality and timeliness levels and by analyzing and evaluating the costs and benefits—both financial and non-financial—of new quality initiatives such as TQM, relieving bottleneck constraints or providing faster customer service. 1-8 The five-step decision-making process is (1) identify the problem and uncertainties (2) obtain information (3) make predictions about the future (4) make decisions by choosing among alternatives and (5) implement the decision, evaluate performance and learn. 1-9 Planning decisions focus on selecting organization goals and strategies, predicting results under various alternative ways of achieving those goals, deciding how to attain the desired goals, and communicating the goals and how to attain them to the entire organization. Control decisions focus on taking actions that implement the planning decisions, deciding how to evaluate performance, and providing feedback and learning to help future decision making. 1-10

The three guidelines for management accountants are 1. Employ a cost-benefit approach. 2. Recognize behavioral and technical considerations. 3. Apply the notion of ―different costs for different purposes‖.

1-11 Agree. A successful management accountant requires general business skills (such as understanding the strategy of an organization) and people skills (such as motivating other team members) as well as technical skills (such as computer knowledge, calculating costs of products, and supporting planning and control decisions).


1-12

The new controller could reply in one or more of the following ways: (a) Demonstrate to the plant manager how he or she could make better decisions if the plant controller was viewed as a resource rather than a deadweight. In a related way, the plant controller could show how the plant manager’s time and resources could be saved by viewing the new plant controller as a team member. (b) Demonstrate to the plant manager a good knowledge of the technical aspects of the plant. This approach may involve doing background reading. It certainly will involve spending much time on the plant floor speaking to plant personnel. (c) Show the plant manager examples of the new plant controller’s past successes in working with line managers in other plants. Examples could include assistance in preparing the budget, assistance in analyzing problem situations and evaluating financial and nonfinancial aspects of different alternatives, and assistance in submitting capital budget requests. (d) Seek assistance from the corporate controller to highlight to the plant manager the importance of many tasks undertaken by the new plant controller. This approach is a last resort but may be necessary in some cases.

1-13 The controller is the chief management accounting executive. The corporate controller reports to the chief financial officer, a staff function. Companies also have business unit controllers who support business unit managers or regional controllers who support regional managers in major geographic regions. 1-14 The Institute of Management Accountants (IMA) sets standards of ethical conduct for management accountants in the following four areas: Competence Confidentiality Integrity Credibility 1-15

Steps to take when established written policies provide insufficient guidance are (a) Discuss the problem with the immediate superior (except when it appears that the superior is involved). (b) Clarify relevant ethical issues by confidential discussion with an IMA Ethics Counselor or other impartial advisor. (c) Consult your own attorney as to legal obligations and rights concerning the ethical conflicts.


1-16

(15 min.) Value chain and classification of costs, computer company. Cost Item a. b. c. d. e. f. g. h.

1-17

(15 min.) Value chain and classification of costs, pharmaceutical company. Cost Item a. b. c. d. e. f. g. h.

1-18

Value Chain Business Function Design of products and processes Marketing Customer Service Research and Development Marketing Production Marketing Distribution

(15 min.) Value chain and classification of costs, fast food restaurant. Cost Item a. b. c. d. e. f. g. h.

1-19

Value Chain Business Function Production Distribution Design of products and processes Research and Development Customer Service or Marketing Design of products and processes (or Research and Development) Marketing Production

Value Chain Business Function Production Distribution Marketing Marketing Marketing Production Design of products and processes (or Research and Development) Customer service

(15 min.) Key success factors. Change in Operations/ Management Accounting a. b. c. d. e.

Key Success Factor Innovation Cost and Quality Time Time and Cost Cost


1-20

(10-15 min.) Planning and control decisions. Action a. b. c. d. e.

1-21

(15 min.) Five-step decision-making process, manufacturing. Action a. b. c. d. e. f. g.

1-22

Decision Planning Control Control Planning Planning

Step in Decision-Making Process Obtain information Make predictions about the future Identify the problem and uncertainties Implement the decision, evaluate performance, and learn Make predictions about the future Make decisions by choosing among alternatives Obtain information

(15 min.) Five-step decision-making process, service firm. Action a. b. c. d. e. f.

Step in Decision-Making Process Obtain information Identify the problem and uncertainties Obtain information and/or make predictions about the future Make predictions about the future Obtain information Make decisions by choosing among alternatives


1-23

(10–15 min.) Professional ethics and reporting division performance.

1. Miller’s ethical responsibilities are well summarized in the IMA’s ―Standards of Ethical Conduct for Management Accountants‖ (Exhibit 1-7 of text). Areas of ethical responsibility include the following: competence confidentiality integrity credibility The ethical standards related to Miller’s current dilemma are integrity, competence and credibility. Using the integrity standard, Miller should carry out duties ethically and communicate unfavorable as well as favorable information and professional judgments or opinions. Competence demands that Miller perform her professional duties in accordance with relevant laws, regulations, and technical standards and provide decision support information that is accurate. Credibility requires that Miller report information fairly and objectively and disclose deficiencies in internal controls in conformance with organizational policy and/or applicable law. Miller should refuse to book the $200,000 of sales until the goods are shipped. Both financial accounting and management accounting principles maintain that sales are not complete until the title is transferred to the buyer. 2. Miller should refuse to follow Maloney's orders. If Maloney persists, the incident should be reported to the corporate controller. Support for line management should be wholehearted, but it should not require unethical conduct. 1-24

(15 min.) Planning and control decisions, Internet company.

1.

Planning decisions a. Decision to raise monthly subscription fee c. Decision to upgrade content of online services (later decision to inform subscribers and upgrade online services is an implementation part of control) e. Decision to decrease monthly subscription fee starting in November. Control decisions b. Decision to inform existing subscribers about the rate of increase—an implementation part of control decisions d. Dismissal of VP of Marketing—performance evaluation and feedback aspect of control decisions

2. Other planning decisions that may be made at WebNews.com: decision to raise or lower advertising fees; decision to charge a fee from on-line retailers when customers click-through from WebNews.com to the retailers’ websites. Other control decisions that may be made at WebNews.com: evaluating how customers like the new format for the weather information, working with an outside vendor to redesign the website, and evaluating whether the waiting time for customers to access the website has been reduced.


1-25

(20 min.) Strategic decisions and management accounting.

1. The strategies the companies are following in each case are: a. Low price strategy b. Differentiated product strategy c. Low price strategy d. Differentiated product strategy 2. Examples of information the management accountant can provide for each strategic decision follow. a. Cost to manufacture and sell the cell phone Productivity, efficiency and cost advantages relative to competition Prices of competitive cell phones Sensitivity of target customers to price and quality The production capacity of Roger Phones and its competitors b.

1-26 1. 2. 3. 4. 5. 6. 7. 8. 9.

Cost to develop, produce and sell new software Premium price that customers would be willing to pay due to product uniqueness Price of basic software Price of closest competitive software Cash needed to develop, produce and sell new software

c.

Cost of producing the ―store-brand‖ lip gloss Productivity, efficiency and cost advantages relative to competition Prices of competitive products Sensitivity of target customers to price and quality How the market for lip gloss is growing

d.

Cost to produce and sell new line of gourmet bologna Premium price that customers would be willing to pay due to product uniqueness Price of basic meat product Price of closest competitive product

(15 min.) Management accounting guidelines.

Cost-benefit approach Behavioral and technical considerations Different costs for different purposes Cost-benefit approach Behavioral and technical considerations Cost-benefit approach Behavioral and technical considerations Different costs for different purposes Behavioral and technical considerations


1-27

(15 min.) Role of controller, role of chief financial officer.

1. Activity Managing accounts payable Communicating with investors Strategic review of different lines of businesses Budgeting funds for a plant upgrade Managing the company’s short-term investments Negotiating fees with auditors Assessing profitability of various products Evaluating the costs and benefits of a new product design

Controller X

CFO X X

X X X X X

2. As CFO, Perez will be interacting much more with the senior management of the company, the board of directors, auditors, and the external financial community. Any experience he can get with these aspects will help him in his new role as CFO. George Perez can be better positioned for his new role as CFO by participating in strategy discussions with senior management, by preparing the external investor communications and press releases under the guidance of the current CFO, by attending courses that focus on the interaction and negotiations between the various business functions and outside parties such as auditors and, either formally or on the job, getting training in issues related to investments and corporate finance.


1-28

(30 min.) Pharmaceutical company, budgeting, ethics.

1. The overarching principles of the IMA Statement of Ethical Professional Practice are Honesty, Fairness, Objectivity and Responsibility. The statement’s corresponding ―Standards for Ethical Conduct…‖ require management accountants to Perform professional duties in accordance with relevant laws, regulations, and technical standards. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 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. The idea of capitalizing some of the company’s R&D expenditures is a direct violation of the IMA’s ethical standards above. This transaction would not be ―in accordance with relevant laws, regulations, and technical standards‖. Generally Accepted Accounting Principles require research and development costs to be expensed as incurred. Even if Johnson believes his transaction is justifiable, it violates the profession’s technical standards and would be unethical. The other ―year-end‖ actions occur in many organizations and fall into the ―gray‖ to ―acceptable‖ area. Much depends on the circumstances surrounding each one, however, such as the following: a. Stop all research and development efforts on the drug Lyricon until after year-end. This change would delay the drug going to market by at least six months. It is also possible that in the meantime a PharmaCor competitor could make it to market with a similar drug. While this solution may solve the budget short-fall in this year, it could result in a significant loss of future profits for PharmaCor in the long-run, especially if a competitor is able to obtain a patent on a similar drug before PharmaCor. b. Sell off rights to the drug, Markapro. The company had not planned on doing this because, under current market conditions, it would get less than fair value. It would, however, result in a onetime gain that could offset the budget short-fall. Of course, all future profits from Markapro would be lost. Again, this solution may solve the company’s short-term budget crisis; but could result in the loss of future profits for PharmaCor in the long-run. 2. While it is not uncommon for companies to sacrifice long-term profits for short-term gains, it may not be in the best interest of the company’s shareholders. In the case of PharmaCor, the CFO is primarily concerned with ―maximizing shareholder wealth‖ in the immediate future (third quarter only), but not in the long-term. Because this executive’s incentive pay and even employment may be based on his ability to meet short-term targets, he may not be acting in the best interest of the shareholders in the long-run. Johnson definitely faces an ethical dilemma. It is not unethical on Johnson’s part to want to please his new boss, nor is it unethical that Johnson wants to make a good impression on his first days at his new job; however, Johnson must still act within the ethical standards required by


his profession. Taking illegal and/or unethical action by capitalizing R&D to satisfy the demands of his new supervisor, James Clark, is unacceptable. Although not strictly unethical, I would recommend that Johnson not agree to slow down the R&D efforts on Lyricon or sell off the rights to Markapro. Each of these appears to sacrifice the overall economic interests of PharmaCor for short-run gain. Johnson should argue against doing this but not resign if Clark insists that these actions be taken. If, however, Clark asks Johnson to capitalize R&D, he should raise this issue with the chair of the Audit Committee after informing Clark that he is doing so. If the CFO still insists on Johnson capitalizing R&D, he should resign rather than engage in unethical behavior.


1-29

(30–40 min.) Professional ethics and end-of-year actions.

1. The possible motivations for the snack foods division wanting to take end-of-year actions include: (a) Management incentives. Gourmet Foods may have a division bonus scheme based on one-year reported division earnings. Efforts to front-end revenue into the current year or transfer costs into the next year can increase this bonus. (b) Promotion opportunities and job security. Top management of Gourmet Foods likely will view those division managers that deliver high reported earnings growth rates as being the best prospects for promotion. Division managers who deliver ―unwelcome surprises‖ may be viewed as less capable. (c) Retain division autonomy. If top management of Gourmet Foods adopts a ―management by exception‖ approach, divisions that report sharp reductions in their earnings growth rates may attract a sizable increase in top management supervision. 2.

The ―Standards of Ethical Conduct . . . ‖ require management accountants to Perform professional duties in accordance with relevant laws, regulations, and technical standards. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. Communicate information fairly and objectively.

Several of the ―end-of-year actions‖ clearly are in conflict with these requirements and should be viewed as unacceptable by Taylor. (b) The fiscal year-end should be closed on midnight of December 31. ―Extending‖ the close falsely reports next year’s sales as this year’s sales. (c) Altering shipping dates is falsification of the accounting reports. (f) Advertisements run in December should be charged to the current year. The advertising agency is facilitating falsification of the accounting records. The other ―end-of-year actions‖ occur in many organizations and fall into the ―gray‖ to ―acceptable‖ area. However, much depends on the circumstances surrounding each one, such as the following: (a) If the independent contractor does not do maintenance work in December, there is no transaction regarding maintenance to record. The responsibility for ensuring that packaging equipment is well maintained is that of the plant manager. The division controller probably can do little more than observe the absence of a December maintenance charge. (d) In many organizations, sales are heavily concentrated in the final weeks of the fiscal year-end. If the double bonus is approved by the division marketing manager, the division controller can do little more than observe the extra bonus paid in December. (e) If TV spots are reduced in December, the advertising cost in December will be reduced. There is no record falsification here. (g) Much depends on the means of ―persuading‖ carriers to accept the merchandise. For example, if an under-the-table payment is involved, or if carriers are pressured to accept merchandise, it is clearly unethical. If, however, the carrier receives no extra consideration and willingly agrees to accept the assignment because it sees potential sales opportunities in December, the transaction appears ethical. 1-11 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Each of the (a), (d), (e), and (g) ―end-of-year actions‖ may well disadvantage Gourmet Foods in the long run. For example, lack of routine maintenance may lead to subsequent equipment failure. The divisional controller is well advised to raise such issues in meetings with the division president. However, if Gourmet Foods has a rigid set of line/staff distinctions, the division president is the one who bears primary responsibility for justifying division actions to senior corporate officers. 3. If Taylor believes that Ryan wants her to engage in unethical behavior, she should first directly raise her concerns with Ryan. If Ryan is unwilling to change his request, Taylor should discuss her concerns with the Corporate Controller of Gourmet Foods. She could also initiate a confidential discussion with an IMA Ethics Counselor, other impartial adviser, or her own attorney. Taylor also may well ask for a transfer from the snack foods division if she perceives Ryan is unwilling to listen to pressure brought by the Corporate Controller, CFO, or even President of Gourmet Foods. In the extreme, she may want to resign if the corporate culture of Gourmet Foods is to reward division managers who take ―end-of-year actions‖ that Taylor views as unethical and possibly illegal. It was precisely actions along the lines of (b), (c), and (f) that caused Betty Vinson, an accountant at WorldCom to be indicted for falsifying WorldCom’s books and misleading investors.


1-30 (30 min.) Professional ethics and end-of-year actions. 1. The possible motivations for Controller, Todd Allen to modify the division’s year-end earnings are: (i) Job security and promotion. The company’s CFO will likely reward him for meeting the company’s performance expectations. Alternately, the Allen may be penalized, perhaps even by losing his job if the performance expectations are not met. (ii) Management incentives. Allen’s bonus may be based on the division’s ability to meet certain profit targets. If the Consumer Products division has already met its profit target for the year, the Controller may personally benefit if new printing equipment is sold off and replaced with the discarded equipment that no longer meets current safety standards, or if operating income is manipulated by questionable revenue and/or expense recognition. 2. The overarching principles of the IMA Statement of Ethical Professional Practice are Honesty, Fairness, Objectivity and Responsibility. The statement’s corresponding ―Standards for Ethical Conduct…‖ require management accountants to Perform professional duties in accordance with relevant laws, regulations, and technical standards. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 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. Several of the ―year-end‖ actions are clearly are in conflict with the statement’s principles and required standards and should be viewed as unacceptable. (c) Subscription revenue received in December in advance for magazines that will be sent out in January is a liability. Showing it as revenue falsely reports next year’s revenue as this year’s revenue. (d) Reversing the division’s Allowance for Bad Debt Expense would violate Generally Accepted Accounting Principles unless the bad debt allowance is currently overstated. Recording this transaction would result in an overstatement of income and could potentially mislead investors. (e) Booking advertising revenues that relate to January in December falsely reports next year’s revenue as this year’s revenue. The other ―year-end‖ actions occur in many organizations and fall into the ―gray‖ to ―acceptable‖ area. Much depends on the circumstances surrounding each one, however, such as the following: (a) Cancelling two of the division’s least profitable magazines, resulting in the layoff of twenty-five employees. While employee layoffs may be necessary for the business to survive, the layoff decision could result in economic hardship for those employees who lose their jobs, as well as result in employee morale problems for the rest of the division. Most companies would prefer to avoid causing hardship for their existing employees due to layoffs unless absolutely necessary for the survival of the business as a whole.


(b) Selling the new printing equipment that was purchased in January and replacing it with discarded equipment from one of the company’s other divisions. The previously discarded equipment no longer meets current safety standards. Again, while this method may result in a short-term solution for the Controller and the Production Manager personally, this decision may actually harm the corporation financially as a whole, not to mention the potential resulting injuries to production workers from hazardous equipment. This method would be also be ethically questionable and would likely violate the IMA’s ethical standards of integrity and credibility. (f) Switching from declining balance to straight line depreciation to reduce depreciation expense in the current year. Many companies switch their depreciation policy from one method to another. Deacon Publishing could argue that straight-line depreciation better represents the decrease in the economic value of the asset compared to the declining balance method. Straight-line depreciation may also be more in line with what its competitors do. If, however, the company changes to straight-line depreciation with the sole purpose of reducing expenses to meet its profit goals, such behavior would be unacceptable. The Standards of Ethical Behavior require management accountants to communicate information fairly and objectively and to carry out duties ethically. 3. Allen should directly raise his concerns first with the CFO, especially if the pressure from the CFO is so great that the only course of action on the part of the controller is to otherwise behave unethically. If the CFO refuses to change his direction, then the controller should raise these issues with the CEO, and next to the Audit Committee and the Board of Directors, after informing the CFO that he is doing so. The Controller could also initiate a confidential discussion with an IMA Ethics Counselor, other impartial adviser, or his/her own attorney. In the extreme, the Controller may want to resign if the corporate culture of Deacon Publishing is to reward executives who take year-end actions that the Controller views as unethical and possibly illegal. It was precisely actions along the lines of (c), (d) and (e) that caused Betty Vinson, an accountant at WorldCom, to be indicted for falsifying WorldCom’s books and misleading investors.


1-31

(40 min.) Global company, ethical challenges.

1. The overarching principles of the IMA Statement of Ethical Professional Practice are Honesty, Fairness, Objectivity and Responsibility. The statement’s corresponding ―Standards for Ethical Conduct…‖ require management accountants to Perform professional duties in accordance with relevant laws, regulations, and technical standards. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 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. Several of the suggestions made by Hamsen’s staff are clearly in conflict with the statement’s principles and required standards and should be viewed as unacceptable. c. Pressure current customers to take early delivery of goods before the end of the year so that more revenue can be reported on this year’s financial statements. This tactic, commonly known as channel stuffing, merely results in shifting future period revenues into the current period. The overstatement of revenue in the current period may mislead investor’s to believe that the company’s financial well being is better than the actual results achieved. This practice would violate the IMA’s standards of credibility and integrity. Channel stuffing is frequently considered a fraudulent practice. e. Record the executive year-end bonus compensation for the current year in the next year when it is paid until after the December fiscal year-end. Generally Accepted Accounting Principles requires expenses to be recorded (accrued) when incurred, not when paid (cash basis accounting). Therefore, failure to record the executives’ yearend bonus would violate the IMA’s standards of credibility and integrity. f. Recognize sales revenues on orders received, but not shipped as of the end of the year. Generally Accepted Accounting Principles requires income to be recorded (accrued) when the four criteria of revenue recognition have been met: 1.

The company has completed a significant portion of the production and sales effort.

2.

The amount of revenue can by objectively measured.

3.

The major portion of the costs has been incurred, and the remaining costs can be reasonably estimated.

4.

The eventual collection of the cash is reasonably assured.

Because criteria 1 and 3 have not been met at the time the order is placed the revenue should not be recognized until after year-end. Therefore, recording next year’s revenue in the current year would be a violation of Generally Accepted Accounting Principles and would be falsifying revenue. This would be a violation of the IMA’s standards of credibility and integrity and may be considered fraudulent. The other ―year-end‖ actions occur in many organizations and fall into the ―gray‖ to


―acceptable‖ area. Much depends on the circumstances surrounding each one, however, such as the following: a. Stop all transatlantic shipping efforts. The start-up costs for the new operations are hurting current profit margins. While this method may result in better short-term financial results for Bredahl, it may do harm to the long-term financial condition of the corporation as a whole. b. Make deep cuts in pricing through the end of the year to generate additional revenue. Again, this is only a short-term tactic to improve this year’s financial results. Investors may be content in the short-run, but in the long run the new shipping company will see reduced margins from these actions. d. Sell-off distribution equipment prior to year-end. The sale would result in one-time gains that could offset the company’s lagging profits. The owned equipment could be replaced with leased equipment at a lower cost in the current year. While this course of action does not necessarily violate the IMA’s code of ethical standards, it may be only a short-term tactic to improve this year’s financial results. Hamsen will need to weigh his options long-term to make the most cost effective decision for his company. g. Establish corporate headquarters in Ireland before the end of the year, lowering the company’s corporate tax rate from 28% to 12.5%. Hamsen may have other legitimate reasons for relocating his company to Ireland, but doing so only to reduce his tax liability would likely be considered an evasion of taxes in the company’s home country. Hamsen should seek the advice of skilled consultants in the area of international tax before making any such move. The company could face large fines and even criminal charges for evading corporate income taxes of the home country. 2. It is possible that any of the ―year-end‖ actions that fall into the ―gray‖ area may be good for investors, depending on the credible evidence which supports the management decision. For example, replacing owned equipment with leased equipment may result in both short-term gains for the company and long-term cost reduction. If so, this decision would be in the best interest of the investors. If the decision only results in short-term gains, but higher costs in the long-run, then the decision may not be in the best long-term interest of the company’s investors and should not be implemented solely to prop up short-term earnings. Those decisions that clearly violate the IMA code of ethical standards (c, e, and f) would never be in the best interest of the investor. These options would result in misleading financial statements and could result in the demise of the company or even in criminal charges, as was the case with companies such as Enron and WorldCom. If Hamsen asks the management accountant to take any of the actions that are clearly unethical, he should raise this issue with the chair of the Audit Committee after informing Hamsen that he is doing so. If Hamsen still insists on the management accountant taking these actions, he should resign rather than engage in unethical behavior.


CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES 2-1 A cost object is anything for which a separate measurement of costs is desired. Examples include a product, a service, a project, a customer, a brand category, an activity, and a department. 2-2 Direct costs of a cost object are related to the particular cost object and can be traced to that cost object in an economically feasible (cost-effective) way. Indirect costs of a cost object are related to the particular cost object but cannot be traced to that cost object in an economically feasible (cost-effective) way. Cost assignment is a general term that encompasses the assignment of both direct costs and indirect costs to a cost object. Direct costs are traced to a cost object while indirect costs are allocated to a cost object. 2-3 Managers believe that direct costs that are traced to a particular cost object are more accurately assigned to that cost object than are indirect allocated costs. When costs are allocated, managers are less certain whether the cost allocation base accurately measures the resources demanded by a cost object. Managers prefer to use more accurate costs in their decisions. 2-4

Factors affecting the classification of a cost as direct or indirect include the materiality of the cost in question, available information-gathering technology, design of operations

2-5 A variable cost changes in total in proportion to changes in the related level of total activity or volume. An example is a sales commission that is a percentage of each sales revenue dollar. A fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume. An example is the leasing cost of a machine that is unchanged for a given time period (such as a year) regardless of the number of units of product produced on the machine. 2-6 A cost driver is a variable, such as the level of activity or volume, that causally affects total costs over a given time span. A change in the cost driver results in a change in the level of total costs. For example, the number of vehicles assembled is a driver of the costs of steering wheels on a motor-vehicle assembly line. 2-7 The relevant range is the band of normal activity level or volume in which there is a specific relationship between the level of activity or volume and the cost in question. Costs are described as variable or fixed with respect to a particular relevant range. 2-8 A unit cost is computed by dividing some amount of total costs (the numerator) by the related number of units (the denominator). In many cases, the numerator will include a fixed cost that will not change despite changes in the denominator. It is erroneous in those cases to multiply the unit cost by activity or volume change to predict changes in total costs at different activity or volume levels.


2-9 Manufacturing-sector companies purchase materials and Ashtonnents and convert them into various finished goods, for example automotive and textile companies. Merchandising-sector companies purchase and then sell tangible products without changing their basic form, for example retailing or distribution. Service-sector companies provide services or intangible products to their customers, for example, legal advice or audits. 2-10

Manufacturing companies have one or more of the following three types of inventory: 1. Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing process. 2. Work-in-process inventory. Goods partially worked on but not yet completed. Also called work in progress. 3. Finished goods inventory. Goods completed but not yet sold.

2-11 Inventoriable costs are all costs of a product that are considered as assets in the balance sheet when they are incurred and that become cost of goods sold when the product is sold. These costs are included in work-in-process and finished goods inventory (they are ―inventoried‖) to accumulate the costs of creating these assets. Period costs are all costs in the income statement other than cost of goods sold. These costs are treated as expenses of the accounting period in which they are incurred because they are expected not to benefit future periods (because there is not sufficient evidence to conclude that such benefit exists). Expensing these costs immediately best matches expenses to revenues. 2-12 Direct material costs are the acquisition costs of all materials that eventually become part of the cost object (work in process and then finished goods), and can be traced to the cost object in an economically feasible way. Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to the cost object (work in process and then finished goods) in an economically feasible way. Manufacturing overhead costs are all manufacturing costs that are related to the cost object (work in process and then finished goods), but cannot be traced to that cost object in an economically feasible way. Prime costs are all direct manufacturing costs (direct material and direct manufacturing labor). Conversion costs are all manufacturing costs other than direct material costs. 2-13 Overtime premium is the wage rate paid to workers (for both direct labor and indirect labor) in excess of their straight-time wage rates. Idle time is a subclassification of indirect labor that represents wages paid for unproductive time caused by lack of orders, machine breakdowns, material shortages, poor scheduling, and the like. 2-14 A product cost is the sum of the costs assigned to a product for a specific purpose. Purposes for computing a product cost include pricing and product mix decisions, contracting with government agencies, and preparing financial statements for external reporting under generally accepted accounting principles. 2-2 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

2-15

Three common features of cost accounting and cost management are: calculating the costs of products, services, and other cost objects obtaining information for planning and control and performance evaluation analyzing the relevant information for making decisions

2-16

(15 min.) Computing and interpreting manufacturing unit costs.

1. Direct material cost Direct manuf. labor costs Manufacturing overhead costs Total manuf. costs Fixed costs allocated at a rate of $15M $50M (direct mfg. labor) equal to $0.30 per dir. manuf. labor dollar (0.30 $16; 26; 8) Variable costs Units produced (millions) Cost per unit (Total manuf. costs ÷ units produced) Variable manuf. cost per unit (Variable manuf. costs Units produced)

2.

Based on total manuf. cost per unit ($1.2240 150; $1.0733 190; $0.6571 220) Correct total manuf. costs based on variable manuf. costs plus fixed costs equal Variable costs ($1.1856 150; $1.0213 190; $0.64 220) Fixed costs Total costs

Supreme $ 89.00 16.00 48.00 153.00

(in millions) Deluxe $ 57.00 26.00 78.00 161.00

4.80 $148.20 125

Regular $60.00 8.00 24.00 92.00

Total $206.00 50.00 150.00 406.00

7.80 $153.20 150

2.40 $89.60 140

15.00 $391.00

$1.2240

$1.0733

$0.6571

$1.1856

$1.0213

$0.6400

Supreme

(in millions) Deluxe

Regular

Total

$183.60

$203.93

$144.56

$532.09

$177.84

$194.05

$140.80

$512.69 15.00 $527.69

The total manufacturing cost per unit in requirement 1 includes $15 million of indirect manufacturing costs that are fixed irrespective of changes in the volume of output per month, while the remaining variable indirect manufacturing costs change with the production volume. Given the unit volume changes for August 2011, the use of total manufacturing cost per unit from the past month at a different unit volume level (both in aggregate and at the individual product level) will overestimate total costs of $532.09 million in August 2011 relative to the correct total manufacturing costs of $527.69 million calculated using variable manufacturing cost per unit times units produced plus the fixed costs of $15 million.


2-17 (15 min.) Direct, indirect, fixed and variable costs. 1. Yeast – direct, variable Flour- direct, variable Packaging materials –direct (or could be indirect if small and not traced to each unit), variable Depreciation on ovens –indirect, fixed (unless ―units of output‖ depreciation, which then would be variable) Depreciation on mixing machines–indirect, fixed (unless ―units of output‖ depreciation, which then would be variable) Rent on factory building – indirect, fixed Fire Insurance on factory building–indirect, fixed Factory utilities – indirect, probably some variable and some fixed (e.g. electricity may be variable but heating costs may be fixed) Finishing department hourly laborers – direct, variable (or fixed if the laborers are under a union contract) Mixing department manager – indirect, fixed Materials handlers –depends on how they are paid. If paid hourly and not under union contract, then indirect, variable. If salaried or under union contract then indirect, fixed Custodian in factory –indirect, fixed Night guard in factory –indirect, fixed Machinist (running the mixing machine) –depends on how they are paid. If paid hourly and not under union contract, then indirect, variable. If salaried or under union contract then indirect, fixed Machine maintenance personnel – indirect, probably fixed, if salaried, but may be variable if paid only for time worked and maintenance increases with increased production Maintenance supplies – indirect, variable Cleaning supplies – indirect, most likely fixed since the custodians probably do the same amount of cleaning every night 2. If the cost object is Mixing Department, then anything directly associated with the Mixing Department will be a direct cost. This will include: Depreciation on mixing machines Mixing Department manager Materials handlers (of the Mixing Department) Machinist (running the mixing machines) Machine Maintenance personnel (of the Mixing Department) Maintenance supplies (if separately identified for the Mixing Department) Of course the yeast and flour will also be a direct cost of the Mixing Department, but it is already a direct cost of each kind of bread produced.


2-18

(15–20 min.) Classification of costs, service sector.

Cost object: Each individual focus group Cost variability: With respect to the number of focus groups There may be some debate over classifications of individual items, especially with regard to cost variability. Cost Item A B C D E F G H

D or I D I I I D I D I

V or F V F Va F V F V Vb

a

Some students will note that phone call costs are variable when each call has a separate charge. It may be a fixed cost if Consumer Focus has a flat monthly charge for a line, irrespective of the amount of usage. b Gasoline costs are likely to vary with the number of focus groups. However, vehicles likely serve multiple purposes, and detailed records may be required to examine how costs vary with changes in one of the many purposes served.

2-19

(15–20 min.) Classification of costs, merchandising sector.

Cost object: Videos sold in video section of store Cost variability: With respect to changes in the number of videos sold There may be some debate over classifications of individual items, especially with regard to cost variability. Cost Item A B C D E F G H

D or I D I D D I I I D

V or F F F V F F V F V


2-20

(15–20 min.) Classification of costs, manufacturing sector.

Cost object: Type of car assembled (Corolla or Geo Prism) Cost variability: With respect to changes in the number of cars assembled There may be some debate over classifications of individual items, especially with regard to cost variability. Cost Item A B C D E F G H

2-21

D or I D I D D D I D I

V or F V F F F V V V F

(20 min.) Variable costs, fixed costs, total costs.

1. Minutes/month Plan A ($/month) Plan B ($/month) Plan C ($/month)

0 0 15 22

50 100 150 200 240 300 327.5 350 400 5 10 15 20 24 30 32.75 35 40 15 15 15 15 15 19.80 22 23.80 27.80 22 22 22 22 22 22 22 22 22

450 510 45 51 31.80 36.60 22 22

540 600 650 54 60 65 39 43.80 47.80 23.50 26.50 29

60

Total Cost

50 40 Plan A Plan B Plan C

30

20 10 0 0

100

200

300

400

500

600

Number of long-distance minutes

2. In each region, Ashton chooses the plan that has the lowest cost. From the graph (or from calculations)*, we can see that if Ashton expects to use 0–150 minutes of long-distance each month, she should buy Plan A; for 150–327.5 minutes, Plan B; and for over 327.5 minutes, Plan C. If Ashton plans to make 100 minutes of long-distance calls each month, she should choose Plan A; for 240 minutes, choose Plan B; for 540 minutes, choose Plan C. *Let x be the number of minutes when Plan A and Plan B have equal cost $0.10x = $15 x = $15 ÷ $0.10 per minute = 150 minutes. Let y be the number of minutes when Plan B and Plan C have equal cost $15 + $0.08 (y – 240) = $22 $0.08 (y – 240) = $22 – $15 = $7 $7 87.5 y – 240 = $0.08 y = 87.5 + 240 = 327.5 minutes


2-22 1.

(15–20 min.) Variable costs and fixed costs. Variable cost per ton of beach sand mined Subcontractor $ 80 per ton Government tax 50 per ton Total $130 per ton Fixed costs per month 0 to 100 tons of capacity per day 101 to 200 tons of capacity per day 201 to 300 tons of capacity per day

= = =

$150,000 $300,000 $450,000

2. $450,000

Costs $300,000

$650,000

Tota l Fixed

Tota l Va riable C osts

$975,000

$325,000

2,500

5,000

$150,000

100

7,500

Tons Mine d

200

300

Tons of Cap acity p er Day

The concept of relevant range is potentially relevant for both graphs. However, the question does not place restrictions on the unit variable costs. The relevant range for the total fixed costs is from 0 to 100 tons; 101 to 200 tons; 201 to 300 tons, and so on. Within these ranges, the total fixed costs do not change in total. 3. Tons Mined per Day (1) (a) 180 (b) 220

Tons Mined per Month (2) = (1) × 25 4,500

Fixed Unit Cost per Ton (3) = FC ÷ (2) $300,000 ÷ 4,500 = $66.67

Variable Unit Cost per Ton (4) $130

Total Unit Cost per Ton (5) = (3) + (4) $196.67

5,500

$450,000 ÷ 5,500 = $81.82

$130

$211.82

The unit cost for 220 tons mined per day is $211.82, while for 180 tons it is only $196.67. This difference is caused by the fixed cost increment from 101 to 200 tons being spread over an increment of 80 tons, while the fixed cost increment from 201 to 300 tons is spread over an increment of only 20 tons.


2-23 (20 min.) Variable costs, fixed costs, relevant range. 1. The production capacity is 4,100 jaw breakers per month. Therefore, the current annual relevant range of output is 0 to 4,100 jaw breakers × 12 months = 0 to 49,200 jaw breakers. 2. Current annual fixed manufacturing costs within the relevant range are $1,200 × 12 = $14,400 for rent and other overhead costs, plus $9,000 ÷ 10 = $900 for depreciation, totaling $15,300. The variable costs, the materials, are 30 cents per jaw breaker, or $13,680 ($0.30 per jaw breaker × 3,800 jaw breakers per month × 12 months) for the year. 3. If demand changes from 3,800 to 7,600 jaw breakers per month, or from 3,800 × 12 = 45,600 to 7,600 × 12 = 91,200 jaw breakers per year, Sweetum will need a second machine. Assuming Sweetum buys a second machine identical to the first machine, it will increase capacity from 4,100 jaw breakers per month to 8,200. The annual relevant range will be between 4,100 × 12 = 49,200 and 8,200 × 12 = 98,400 jaw breakers. Assume the second machine costs $9,000 and is depreciated using straight-line depreciation over 10 years and zero residual value, just like the first machine. This will add $900 of depreciation per year. Fixed costs for next year will increase to $16,200 from $15,300 for the current year + $900 (because rent and other fixed overhead costs will remain the same at $14,400). That is, total fixed costs for next year equal $900 (depreciation on first machine) + $900 (depreciation on second machine) + $14,400 (rent and other fixed overhead costs). The variable cost per jaw breaker next year will be 90% × $0.30 = $0.27. Total variable costs equal $0.27 per jaw breaker × 91,200 jaw breakers = $24,624. If Sweetum decides to not increase capacity and meet only that amount of demand for which it has available capacity (4,100 jaw breakers per month or 4,100 × 12 = 49,200 jaw breakers per year), the variable cost per unit will be the same at $0.30 per jaw breaker. Annual total variable manufacturing costs will increase to $0.30 × 4,100 jaw breakers per month × 12 months = $14,760. Annual total fixed manufacturing costs will remain the same, $15,300.


2-24 (20 min.) Cost drivers and value chain. 1. Identify customer needs (what do smartphone users want?) — Design of products and processes Perform market research on competing brands — Design of products and processes Design a prototype of the HCP smartphone — Design of products and processes Market the new design to cell phone companies — Marketing Manufacture the HCP smartphone — Production Process orders from cell phone companies — Distribution Package the HCP smartphones — Production Deliver the HCP smartphones to the cell phone companies — Distribution Provide online assistance to cell phone users for use of the HCP smartphone — Customer Service Make design changes to the HCP smartphone based on customer feedback — Design of products and processes 2. Value Chain Category Activity Cost driver Identify customer needs Number of surveys returned and processed Design of from competing smartphone users products and processes Perform market research on Hours spent researching competing market competing brands brands Number of surveys returned and processed from competing smartphone users Design a prototype of the HCP Engineering hours spent on initial product smartphone design Make design changes to the Number of design changes smartphone based on customer feedback Production

Manufacture the HCP smartphones Package the HCP smartphones

Machine hours required to run the production equipment Number of smartphones shipped by HCP

Marketing

Market the new design to cell phone companies

Number of cell phone companies purchasing the HCP smartphone

Distribution

Process orders from cell phone companies

Number of smartphone orders processed Number of deliveries made to cell phone companies Number of deliveries made to cell phone companies

Deliver the HCP smartphones to cell phone companies Customer Service

Provide on-line assistance to cell phone users for use of the HCP smartphone

Number of smartphones shipped by HCP Customer Service hours


2-25

(10–15 min.) Cost drivers and functions.

1. 1. 2. 3. 4. 5. 6. 7.

Function Accounting Human Resources Data processing Research and development Purchasing Distribution Billing

Representative Cost Driver Number of transactions processed Number of employees Hours of computer processing unit (CPU) Number of research scientists Number of purchase orders Number of deliveries made Number of invoices sent

1. 2. 3. 4. 5. 6. 7.

Function Accounting Human Resources Data Processing Research and Development Purchasing Distribution Billing

Representative Cost Driver Number of journal entries made Salaries and wages of employees Number of computer transactions Number of new products being developed Number of different types of materials purchased Distance traveled to make deliveries Number of credit sales transactions

2.


2-26

(20 min.) Total costs and unit costs

1. Number of attendees 0 Variable cost per person ($9 caterer charge – $5 student door fee) $4 Fixed Costs $1,600 Variable costs (number of attendees × variable cost per person) 0 Total costs (fixed + variable) $1,600

100

200

300

400

500

600

$4 $1,600

$4 $1,600

$4 $1,600

$4 $1,600

$4 $1,600

$4 $1,600

400 $2,000

800 $2,400

1,200 $2,800

1,600 $3,200

2,000 $3,600

2,400 $4,000

Fixed, Variable and Total Cost of Graduation Party 5000

Costs ($)

4000

3000

Fixed costs Variable costs Total cost

2000

1000

0 0

100

200

300

400

500

600

Number of attendees

2. Number of attendees Total costs (fixed + variable) Costs per attendee (total costs number of attendees)

0 $1,600

100

200

300

400

500

600

$2,000

$2,400

$2,800

$3,200

$3,600

$4,000

$20.00

$12.00

$9.33

$ 8.00

$ 7.20

$ 6.67

As shown in the table above, for 100 attendees the total cost will be $2,000 and the cost per attendee will be $20. 3. As shown in the table in requirement 2, for 500 attendees the total cost will be $3,600 and the cost per attendee will be $7.20.


4. Using the calculations shown in the table in requirement 2, we can construct the cost-perattendee graph shown below:

Cost per Attendee ($)

25 20 15 10 5 0 0

100

200

300

400

500

600

700

Number of Attendees

As president of the student association requesting a grant for the party, you should not use the per unit calculations to make your case. The person making the grant may assume an attendance of 500 students and use a low number like $7.20 per attendee to calculate the size of your grant. Instead, you should emphasize the fixed cost of $1,600 that you will incur even if no students or very few students attend the party, and try to get a grant to cover as much of the fixed costs as possible as well as a variable portion to cover as much of the $4 variable cost to the student association for each person attending the party. 2-27 (25 min.) Total and unit cost, decision making. 1.

Total Manufacturing Costs

$70,000 $60,000

Fixed Costs

$50,000

$40,000

Variable Costs

$30,000 Total Manufacturing Costs

$20,000 $10,000 $0 0

5,000

10,000

Number of Flanges

Note that the production costs include the $28,000 of fixed manufacturing costs but not the $10,000 of period costs. The variable cost is $1 per flange for materials, and $2.80 per flange ($28 per hour divided by 10 flanges per hour) for direct manufacturing labor for a total of $3.80 per flange.


2. The inventoriable (manufacturing) cost per unit for 5,000 flanges is $3.80 × 5,000 + $28,000 = $47,000 Average (unit) cost = $47,000 ÷ 5,000 units = $9.40 per unit. This is below Flora’s selling price of $10 per flange. However, in order to make a profit, Gayle’s Glassworks also needs to cover the period (non-manufacturing) costs of $10,000, or $10,000 ÷ 5,000 = $2 per unit. Thus total costs, both inventoriable (manufacturing) and period (non-manufacturing), for the flanges is $9.40 + $2 = $11.40. Gayle’s Glassworks cannot sell below Flora’s price of $10 and still make a profit on the flanges. Alternatively, At Flora’s price of $10 per flange: Revenue $10 × 5,000 Variable costs $3.80 × 5,000 Fixed costs Operating loss

= =

$50,000 19,000 38,000 $ (7,000)

Gayle’s Glassworks cannot sell below $10 per flange and make a profit. At Flora’s price of $10 per flange, the company has an operating loss of $7,000. 3. If Gayle’s Glassworks produces 10,000 units, then total inventoriable cost will be: Variable cost ($3.80 × 10,000) + fixed manufacturing costs, $28,000 = total manufacturing costs, $66,000. Average (unit) inventoriable (manufacturing) cost will be $66,000 ÷ 10,000 units = $6.60 per flange

Unit total cost including both inventoriable and period costs will be ($66,000 +$10,000) ÷ 10,000 = $7.60 per flange, and Gayle’s Glassworks will be able to sell the flanges for less than Flora and still make a profit. Alternatively, At Flora’s price of $10 per flange: Revenue $10 × 10,000 Variable costs $3.80 × 10,000 Fixed costs Operating income

= =

$100,000 38,000 38,000 $ 24,000

Gayle’s Glassworks can sell at a price below $10 per flange and still make a profit. The company earns operating income of $24,000 at a price of $10 per flange. The company will earn operating income as long as the price exceeds $7.60 per flange. The reason the unit cost decreases significantly is that inventoriable (manufacturing) fixed costs and fixed period (nonmanufacturing) costs remain the same regardless of the number of units produced. So, as Gayle’s Glassworks produces more units, fixed costs are spread over more units, and cost per unit decreases. This means that if you use unit costs to make decisions about pricing, and which product to produce, you must be aware that the unit cost only applies to a particular level of output. 2-13 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

2-28

(20–30 min.) Inventoriable costs versus period costs.

1. Manufacturing-sector companies purchase materials and components and convert them into different finished goods. Merchandising-sector companies purchase and then sell tangible products without changing their basic form. Service-sector companies provide services or intangible products to their customers—for example, legal advice or audits. Only manufacturing and merchandising companies have inventories of goods for sale. 2. Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred and then become cost of goods sold when the product is sold. These costs for a manufacturing company are included in work-in-process and finished goods inventory (they are ―inventoried‖) to build up the costs of creating these assets. Period costs are all costs in the income statement other than cost of goods sold. These costs are treated as expenses of the period in which they are incurred because they are presumed not to benefit future periods (or because there is not sufficient evidence to conclude that such benefit exists). Expensing these costs immediately best matches expenses to revenues. 3. (a) Perrier mineral water purchased for resale by Safeway—inventoriable cost of a merchandising company. It becomes part of cost of goods sold when the mineral water is sold. (b) Electricity used for lighting at GE refrigerator assembly plant—inventoriable cost of a manufacturing company. It is part of the manufacturing overhead that is included in the manufacturing cost of a refrigerator finished good. (c) Depreciation on Google’s computer equipment used to update directories of web sites—period cost of a service company. Google has no inventory of goods for sale and, hence, no inventoriable cost. (d) Electricity used to provide lighting for Safeway’s store aisles—period cost of a merchandising company. It is a cost that benefits the current period and it is not traceable to goods purchased for resale. (e) Depreciation on GE’s assembly testing equipment—inventoriable cost of a manufacturing company. It is part of the manufacturing overhead that is included in the manufacturing cost of a refrigerator finished good. (f) Salaries of Safeway’s marketing personnel—period cost of a merchandising company. It is a cost that is not traceable to goods purchased for resale. It is presumed not to benefit future periods (or at least not to have sufficiently reliable evidence to estimate such future benefits). (g) Perrier mineral water consumed by Google’s software engineers—period cost of a service company. Google has no inventory of goods for sale and, hence, no inventoriable cost. (h) Salaries of Google’s marketing personnel—period cost of a service company. Google has no inventory of goods for sale and, hence, no inventoriable cost.


2-29

(20 min.) Computing cost of goods purchased and cost of goods sold.

1a.

Marvin Department Store Schedule of Cost of Goods Purchased For the Year Ended December 31, 2011 (in thousands)

Purchases Add transportation-in

$155,000 7,000 162,000

Deduct: Purchase returns and allowances Purchase discounts

$4,000 6,000

Cost of goods purchased 1b.

$152,000 Marvin Department Store Schedule of Cost of Goods Sold For the Year Ended December 31, 2011 (in thousands)

Beginning merchandise inventory 1/1/2011 Cost of goods purchased (see above) Cost of goods available for sale Ending merchandise inventory 12/31/2011 Cost of goods sold 2.

10,000

$ 27,000 152,000 179,000 34,000 $145,000

Marvin Department Store Income Statement Year Ended December 31, 2011 (in thousands)

Revenues Cost of goods sold (see above) Gross margin Operating costs Marketing, distribution, and customer service costs Utilities General and administrative costs Miscellaneous costs Total operating costs Operating income

$280,000 145,000 135,000

$37,000 17,000 43,000 4,000 101,000 $ 34,000


2-30

(20 min.) Cost of goods purchased, cost of goods sold, and income statement.

1a.

Montgomery Retail Outlet Stores Schedule of Cost of Goods Purchased For the Year Ended December 31, 2011 (in thousands)

Purchases Add freight—in

$260,000 10,000 270,000

Deduct: Purchase returns and allowances Purchase discounts

$11,000 9,000

Cost of goods purchased 1b.

20,000 $250,000

Montgomery Retail Outlet Stores Schedule of Cost of Goods Sold For the Year Ended December 31, 2011 (in thousands)

Beginning merchandise inventory 1/1/2011 Cost of goods purchased (see above) Cost of goods available for sale Ending merchandise inventory 12/31/2011 Cost of goods sold 2.

$ 45,000 250,000 295,000 52,000 $243,000

Montgomery Retail Outlet Stores Income Statement Year Ended December 31, 2011 (in thousands)

Revenues Cost of goods sold (see above) Gross margin Operating costs Marketing and advertising costs Building depreciation Shipping of merchandise to customers General and administrative costs Total operating costs Operating income

$320,000 243,000 77,000 $24,000 4,200 2,000 32,000 62,200 $ 14,800


2-31

(20 min.) Flow of Inventoriable Costs.

(All numbers below are in millions). 1. Direct materials inventory 10/1/2011 Direct materials purchased Direct materials available for production Direct materials used Direct materials inventory 10/31/2011

$

$

2. Total manufacturing overhead costs Subtract: Variable manufacturing overhead costs Fixed manufacturing overhead costs for October 2011 3. Total manufacturing costs Subtract: Direct materials used (from requirement 1) Total manufacturing overhead costs Direct manufacturing labor costs for October 2011 4. Work-in-process inventory 10/1/2011 Total manufacturing costs Work-in-process available for production Subtract: Cost of goods manufactured (moved into FG) Work-in-process inventory 10/31/2011 5. Finished goods inventory 10/1/2011 Cost of goods manufactured (moved from WIP) Cost of finished goods available for sale in October 2011 6. Finished goods available for sale in October 2011 (from requirement 5) Subtract: Cost of goods sold Finished goods inventory 10/31/2011

$

105 365 470 (385) 85

$

450 (265) 185

$

$ 1,610 (385) (450) 775

$

$

$

$

230 1,610 1,840 (1,660) 180

130 1,660 $ 1,790

$ 1,790 (1,770) 20


2-32 1.

(30–40 min.) Cost of goods manufactured. Canseco Company Schedule of Cost of Goods Manufactured Year Ended December 31, 2011 (in thousands)

Direct materials cost Beginning inventory, January 1, 2011 $ 22,000 Purchases of direct materials 75,000 Cost of direct materials available for use 97,000 Ending inventory, December 31, 2011 26,000 Direct materials used Direct manufacturing labor costs Indirect manufacturing costs Indirect manufacturing labor 15,000 Plant insurance 9,000 Depreciation—plant building & equipment 11,000 Repairs and maintenance—plant 4,000 Total indirect manufacturing costs Manufacturing costs incurred during 2011 Add beginning work-in-process inventory, January 1, 2011 Total manufacturing costs to account for Deduct ending work-in-process inventory, December 31, 2011 Cost of goods manufactured (to Income Statement)

2.

$ 71,000 25,000

39,000 135,000 21,000 156,000 20,000 $136,000

Canseco Company Income Statement Year Ended December 31, 2011 (in thousands)

Revenues Cost of goods sold: Beginning finished goods, January 1, 2011 Cost of goods manufactured Cost of goods available for sale Ending finished goods, December 31, 2011 Cost of goods sold Gross margin Operating costs: Marketing, distribution, and customer-service costs General and administrative costs Total operating costs Operating income

$300,000 $ 18,000 136,000 154,000 23,000 131,000 169,000 93,000 29,000 122,000 $ 47,000


2-33 (30–40 min.) Cost of goods manufactured, income statement, manufacturing company. Piedmont Corporation Schedule of Cost of Goods Manufactured Year Ended December 31, 2011 (in thousands) Direct materials costs Beginning inventory, January 1, 2011 $ 65,000 Purchases of direct materials 128,000 Cost of direct materials available for use 193,000 Ending inventory, December 31, 2011 34,000 Direct materials used Direct manufacturing labor costs Indirect manufacturing costs Indirect manufacturing labor 48,000 Indirect materials 14,000 Plant insurance 2,000 Depreciation—plant building & equipment 21,000 Plant utilities 12,000 Repairs and maintenance—plant 8,000 Equipment lease costs 32,000 Total indirect manufacturing costs Manufacturing costs incurred during 2011 Add beginning work-in-process inventory, January 1, 2011 Total manufacturing costs to account for Deduct ending work-in-process inventory, December 31, 2011 Cost of goods manufactured (to Income Statement)

$159,000 106,000

137,000 402,000 83,000 485,000 72,000 $413,000

Piedmont Corporation Income Statement Year Ended December 31, 2011 (in thousands) Revenues Cost of goods sold: Beginning finished goods, January 1, 2011 Cost of goods manufactured Cost of goods available for sale Ending finished goods, December 31, 2011 Cost of goods sold Gross margin Operating costs: Marketing, distribution, and customer-service costs General and administrative costs Total operating costs Operating income

$600,000 $123,000 413,000 536,000 102,000 434,000 166,000 62,000 34,000 96,000 $ 70,000


2-34

(25–30 min.) Income statement and schedule of cost of goods manufactured. Howell Corporation Income Statement for the Year Ended December 31, 2011 (in millions)

Revenues Cost of goods sold Beginning finished goods, Jan. 1, 2011 Cost of goods manufactured (below) Cost of goods available for sale Ending finished goods, Dec. 31, 2011 Gross margin Marketing, distribution, and customer-service costs Operating income

$950 $ 70 645 715 55

660 290 240 $ 50

Howell Corporation Schedule of Cost of Goods Manufactured for the Year Ended December 31, 2011 (in millions) Direct materials costs Beginning inventory, Jan. 1, 2011 Purchases of direct materials Cost of direct materials available for use Ending inventory, Dec. 31, 2011 Direct materials used Direct manufacturing labor costs Indirect manufacturing costs Indirect manufacturing labor Plant supplies used Plant utilities Depreciation––plant and equipment Plant supervisory salaries Miscellaneous plant overhead Manufacturing costs incurred during 2011 Add beginning work-in-process inventory, Jan. 1, 2011 Total manufacturing costs to account for Deduct ending work-in-process, Dec. 31, 2011 Cost of goods manufactured

$ 15 325 340 20 $320 100 60 10 30 80 5 35

220 640 10 650 5 $645


2-35

(15–20 min.)

Interpretation of statements (continuation of 2-32).

1. The schedule in 2-34 can become a Schedule of Cost of Goods Manufactured and Sold simply by including the beginning and ending finished goods inventory figures in the supporting schedule, rather than directly in the body of the income statement. Note that the term cost of goods manufactured refers to the cost of goods brought to completion (finished) during the accounting period, whether they were started before or during the current accounting period. Some of the manufacturing costs incurred are held back as costs of the ending work in process; similarly, the costs of the beginning work in process inventory become a part of the cost of goods manufactured for 2011. 2. The sales manager’s salary would be charged as a marketing cost as incurred by both manufacturing and merchandising companies. It is basically an operating cost that appears below the gross margin line on an income statement. In contrast, an assembler’s wages would be assigned to the products worked on. Thus, the wages cost would be charged to Work-in-Process and would not be expensed until the product is transferred through Finished Goods Inventory to Cost of Goods Sold as the product is sold. 3. The direct-indirect distinction can be resolved only with respect to a particular cost object. For example, in defense contracting, the cost object may be defined as a contract. Then, a plant supervisor working only on that contract will have his or her salary charged directly and wholly to that single contract. 4.

Direct materials used = $320,000,000 ÷ 1,000,000 units = $320 per unit Depreciation on plant equipment = $80,000,000 ÷ 1,000,000 units = $80 per unit

5. Direct materials unit cost would be unchanged at $320 per unit. Depreciation cost per unit would be $80,000,000 ÷ 1,200,000 = $66.67 per unit. Total direct materials costs would rise by 20% to $384,000,000 ($320 per unit × 1,200,000 units), whereas total depreciation would be unaffected at $80,000,000. 6. Unit costs are averages, and they must be interpreted with caution. The $320 direct materials unit cost is valid for predicting total costs because direct materials is a variable cost; total direct materials costs indeed change as output levels change. However, fixed costs like depreciation must be interpreted quite differently from variable costs. A common error in cost analysis is to regard all unit costs as one—as if all the total costs to which they are related are variable costs. Changes in output levels (the denominator) will affect total variable costs, but not total fixed costs. Graphs of the two costs may clarify this point; it is safer to think in terms of total costs rather than in terms of unit costs.


2-36

(25–30 min.) Income statement and schedule of cost of goods manufactured. Calendar Corporation Income Statement for the Year Ended December 31, 2011 (in millions)

Revenues Cost of goods sold Beginning finished goods, Jan. 1, 2011 Cost of goods manufactured (below) Cost of goods available for sale Ending finished goods, Dec. 31, 2011 Gross margin Marketing, distribution, and customer-service costs Operating income (loss)

$355 $ 47 228 275 11

264 91 94 $ (3)

Calendar Corporation Schedule of Cost of Goods Manufactured for the Year Ended December 31, 2011 (in millions) Direct material costs Beginning inventory, Jan. 1, 2011 Direct materials purchased Cost of direct materials available for use Ending inventory, Dec. 31, 2011 Direct materials used Direct manufacturing labor costs Indirect manufacturing costs Plant supplies used Property taxes on plant Plant utilities Indirect manufacturing labor costs Depreciation––plant and equipment Miscellaneous manufacturing overhead costs Manufacturing costs incurred during 2011 Add beginning work-in-process inventory, Jan. 1, 2011 Total manufacturing costs to account for Deduct ending work-in-process inventory, Dec. 31, 2011 Cost of goods manufactured (to income statement)

$ 32 84 116 8 $108 42 4 2 9 27 6 15

63 213 18 231 3 $228


2-37 1.

2.

(15–20 min.)Terminology, interpretation of statements (continuation of 2-34). Direct materials used Direct manufacturing labor costs Prime costs

$108 million 42 million $150 million

Direct manufacturing labor costs Indirect manufacturing costs Conversion costs

$ 42 million 63 million $105 million

Inventoriable costs (in millions) for Year 2011 Plant utilities Indirect manufacturing labor Depreciation—plant and equipment Miscellaneous manufacturing overhead Direct materials used Direct manufacturing labor Plant supplies used Property tax on plant Total inventoriable costs Period costs (in millions) for Year 2011 Marketing, distribution, and customer-service costs

$

9 27 6 15 108 42 4 2 $213 $ 94

3. Design costs and R&D costs may be regarded as product costs in case of contracting with a governmental agency. For example, if the Air Force negotiated to contract with Lockheed to build a new type of supersonic fighter plane, design costs and R&D costs may be included in the contract as product costs. 4.

Direct materials used = $108,000,000 ÷ 2,000,000 units = $54 per unit Depreciation on plant and equipment = $6,000,000 ÷ 2,000,000 units = $3 per unit

5. Direct materials unit cost would be unchanged at $108. Depreciation unit cost would be $6,000,000 ÷ 3,000,000 = $2 per unit. Total direct materials costs would rise by 50% to $162,000,000 ($54 per unit × 3,000,000 units). Total depreciation cost of $6,000,000 would remain unchanged. 6. In this case, equipment depreciation is a variable cost in relation to the unit output. The amount of equipment depreciation will change in direct proportion to the number of units produced. (a) Depreciation will be $2 million (2 million × $1) when 2 million units are produced. (b) Depreciation will be $3 million (3 million × $1) when 3 million units are produced.


2-38

(20 min.) Labor cost, overtime and idle time.

1.(a) Total cost of hours worked at regular rates 44 hours × $20 per hour 43 hours × $20 per hour 48 hours × $20 per hour 46 hours × $20 per hour Minus idle time (3.5 hours × $20 per hour) (6.4 hours × $20 per hour) (5.8 hours × $20 per hour) (2 hours × $20 per hour) Total idle time Direct manufacturing labor costs

$ 880 860 960 920 3,620 70 128 116 40 354 $3,266

(b) Idle time = 17.7 hours × $20 per hour = (c) Overtime and holiday premium. Week 1: Overtime (44 – 40) hours × Premium, $10 per hour Week 2: Overtime (43 – 40) hours × Premium, $10 per hour Week 3: Overtime (48 – 40) hours × Premium, $20 per hour Week 4: Overtime (46 – 40) hours × Premium, $10 per hour Week 4: Holiday 8 hours × 2 days × Premium, $20 per hour Total overtime and holiday premium (d) Total earnings in December Direct manufacturing labor costs Idle time Overtime and holiday premium Total earnings

$ 354 $

40 30 160 60 320 $ 610

$3,266 354 610 $4,230

2. Idle time caused by regular machine maintenance, slow order periods, or unexpected mechanical problems is an indirect cost of the product because it is not related to a specific product. Overtime premium caused by the heavy overall volume of work is also an indirect cost because it is not related to a particular job that happened to be worked on during the overtime hours. If, however, the overtime is the result of a demanding ―rush job,‖ the overtime premium is a direct cost of that job.


2-39

(30–40 min.) Missing records, computing inventory costs.

1. 2. 3.

Finished goods inventory, 3/31/2011 = $210,000 Work-in-process inventory, 3/31/2011 = $190,000 Direct materials inventory, 3/31/2011 = $85,000

This problem is not as easy as it first appears. These answers are obtained by working from the known figures to the unknowns in the schedule below. The basic relationships between categories of costs are: Manufacturing costs added during the period (given) $840,000 Conversion costs (given) $660,000 Direct materials used = Manufacturing costs added – Conversion costs = $840,000 – $660,000 = $180,000 Cost of goods manufactured = Direct Materials Used × 4 = $180,000 × 4 = $720,000 Schedule of Computations Direct materials, 3/1/2011 (given) $ 25,000 Direct materials purchased (given) 240,000 Direct materials available for use 265,000 Direct materials, 3/31/2011 3= 85,000 Direct materials used 180,000 Conversion costs (given) 660,000 Manufacturing costs added during the period (given) 840,000 Add work in process, 3/1/2011 (given) 70,000 Manufacturing costs to account for 910,000 Deduct work in process, 3/31/2011 2= 190,000 Cost of goods manufactured (4 × $180,000) 720,000 Add finished goods, 3/1/2011 320,000 Cost of goods available for sale 1,040,000 Deduct finished goods, 3/31/2011 1= 210,000 Cost of goods sold (80% × $1,037,500) $830,000 Some instructors may wish to place the key amounts in a Work in Process T-account. This problem can be used to introduce students to the flow of costs through the general ledger (amounts in thousands): Direct Materials BI 25 Purch 240 DM . used 180 EI 85

Work in Process BI 70 DM used COGM 720 (840–660) 180 Conversion 660 To account for 910 EI

190

BI

Finished Goods 320 720 COGS 830

Available for sale EI

1,040 210


Cost of Goods Sold 830

2-40

(30 min.) Comprehensive problem on unit costs, product costs.

1. If 2 pounds of direct materials are used to make each unit of finished product, 123,000 units × 2 lbs., or 246,000 lbs. were used at $0.60 per pound of direct materials ($147,600 ÷ 246,000 lbs.). (The direct material costs of $147,600 are direct materials used, not purchased.) Therefore, the ending inventory of direct materials is 2,400 lbs. $0.60 = $1,440. 2. Direct materials costs Direct manufacturing labor costs Plant energy costs Indirect manufacturing labor costs Other indirect manufacturing costs Cost of goods manufactured

Manufacturing Costs for 123,000 units Variable Fixed Total $147,600 $ – $147,600 38,400 – 38,400 2,000 – 2,000 14,000 19,000 33,000 11,000 14,000 25,000 $213,000 $33,000 $246,000

Average unit manufacturing cost:

$246,000 ÷ 123,000 units = $2.00 per unit $26,000 (given) = $2.00 per unit = 13,000 units

Finished goods inventory in units:

3.

Units sold in 2011 = = Selling price in 2011 = =

Beginning inventory + Production – Ending inventory 0 + 123,000 –13,000 = 110,000 units $594,000 ÷ 110,000 $5.40 per unit

4. Denver Office Equipment Income Statement Year Ended December 31, 2011 (in thousands) Revenues (110,000 units sold × $5.40) Cost of units sold: Beginning finished goods, Jan. 1, 2011 Cost of goods manufactured Cost of goods available for sale Ending finished goods, Dec. 31, 2011 Gross margin Operating costs: Marketing, distribution, and customer-service costs Administrative costs Operating income

$594,000 $

0 246,000 246,000 26,000

176,000 56,000

220,000 374,000

232,000 $142,000


Note: Although not required, the full set of unit variable costs is: Direct materials cost Direct manufacturing labor cost Plant energy cost Indirect manufacturing labor cost Other indirect manufacturing cost

$1.200 0.312 0.016 0.114 0.089

Marketing, distribution, and customer-service costs

$1.041 per unit sold

= $1.731 per unit manufactured


2-41 1.

(20-25 min.) Classification of costs; ethics. Warehousing costs Units produced $3, 250, 000 $16.25 per unit. = 200, 000 units

Warehousing costs per unit =

If the $3,250,000 is treated as period costs, the entire amount would be expensed during the year as incurred. If it is treated as a product cost, it would be ―unitized‖ at $16.25 per unit and expensed as each unit of the product is sold. Therefore, if only 180,000 of the 200,000 units are sold, only $2,925,000 ($16.25 per unit × 180,000 units) of the $3,250,000 would be expensed in the current period. The remaining $3,250,000 – $2,925,000 = $325,000 would be inventoried on the balance sheet until a later period when the units are sold. The value of finished goods inventory can also be calculated directly to be $325,000 ($16.25 per unit × 20,000 units). 2. No. With respect to classifying costs as product or period costs, this determination is made by Generally Accepted Accounting Principles (GAAP). It is not something that can be justified by the plant manager or plant controller. Even though these costs are in fact related to the product, they are not direct costs of manufacturing the product. GAAP requires that research and development, as well as all costs related to warehousing and distribution of goods be classified as period costs, and be expensed in the period they are incurred. 3.

Scott Hewitt would improve his personal bonus and take-home pay by 10% × $325,000 = $32,500

4. The controller should not reclassify costs as product costs just so the plant can reap shortterm benefits, including the increase in Hewitt’s personal year-end bonus. Research and development costs, costs related to the shipping of finished goods and costs related to warehousing finished goods are all period costs under generally accepted accounting principles, and must be treated as such. Changing this classification on Old World’s financial statements would violate generally accepted accounting principles and would likely be considered fraudulent. The idea of costs being classified as product costs versus period costs is to properly reflect on the income statement those costs that are directly related to manufacturing (costs incurred to transform one asset, direct materials into another asset, finished goods) and to properly reflect on the balance sheet those costs that will provide a future benefit (inventory). The controller should not be intimidated by Hewitt. Hewitt stands to personally benefit from the reclassification of costs. The controller should insist that he must adhere to generally accepted accounting principles so as not to submit fraudulent financial statements to corporate headquarters. If Hewitt insists on the reclassification, the controller should raise the issue with the chief financial officer after informing Hewitt that he is doing so. If, after taking all these steps, there is continued pressure to modify the numbers, the controller should consider resigning from the company rather than engage in unethical behavior.


2-42

(20–25 min.) Finding unknown amounts.

Let G = given, I = inferred Step 1: Use gross margin formula Revenues Cost of goods sold Gross margin

Case 1 $ 32,000 G A 20,700 I $ 11,300 G

Case 2 $31,800 G 20,000 G C $11,800 I

Step 2: Use schedule of cost of goods manufactured formula Direct materials used Direct manufacturing labor costs Indirect manufacturing costs Manufacturing costs incurred Add beginning work in process, 1/1 Total manufacturing costs to account for Deduct ending work in process, 12/31 Cost of goods manufactured

$ 8,000 G 3,000 G 7,000 G 18,000 I 0G 18,000 I 0G $ 18,000 I

$ 12,000 G 5,000 G D 6,500 I 23,500 I 800 G 24,300 I 3,000 G $ 21,300 I

$ 4,000 G 18,000 I 22,000 I B1,300 I $ 20,700 I

$ 4,000 G 21,300 I 25,300 I 5,300 G $ 20,000 G

Step 3: Use cost of goods sold formula Beginning finished goods inventory, 1/1 Cost of goods manufactured Cost of goods available for sale Ending finished goods inventory, 12/31 Cost of goods sold For case 1, do steps 1, 2, and 3 in order. For case 2, d o steps 1, 3, and then 2.


CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS NOTATION USED IN CHAPTER 3 SOLUTIONS SP: VCU: CMU: FC: TOI:

Selling price Variable cost per unit Contribution margin per unit Fixed costs Target operating income

3-1 Cost-volume-profit (CVP) analysis examines the behavior of total revenues, total costs, and operating income as changes occur in the units sold, selling price, variable cost per unit, or fixed costs of a product. 3-2 1. 2. 3.

4.

The assumptions underlying the CVP analysis outlined in Chapter 3 are Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units sold. Total costs can be separated into a fixed component that does not vary with the units sold and a variable component that changes with respect to the units sold. When represented graphically, the behaviors of total revenues and total costs are linear (represented as a straight line) in relation to units sold within a relevant range and time period. The selling price, variable cost per unit, and fixed costs are known and constant.

3-3 Operating income is total revenues from operations for the accounting period minus cost of goods sold and operating costs (excluding income taxes): Operating income = Total revenues Costs of goods sold and operating, costs (excluding income taxes)

from

operations

–

Net income is operating income plus nonoperating revenues (such as interest revenue) minus nonoperating costs (such as interest cost) minus income taxes. Chapter 3 assumes nonoperating revenues and nonoperating costs are zero. Thus, Chapter 3 computes net income as: Net income = Operating income – Income taxes 3-4 Contribution margin is the difference between total revenues and total variable costs. Contribution margin per unit is the difference between selling price and variable cost per unit. Contribution-margin percentage is the contribution margin per unit divided by selling price. 3-5 Three methods to express CVP relationships are the equation method, the contribution margin method, and the graph method. The first two methods are most useful for analyzing operating income at a few specific levels of sales. The graph method is useful for visualizing the effect of sales on operating income over a wide range of quantities sold.


3-6 Breakeven analysis denotes the study of the breakeven point, which is often only an incidental part of the relationship between cost, volume, and profit. Cost-volume-profit relationship is a more comprehensive term than breakeven analysis. CVP certainly is simple, with its assumption of output as the only revenue and cost 3-7 driver, and linear revenue and cost relationships. Whether these assumptions make it simplistic depends on the decision context. In some cases, these assumptions may be sufficiently accurate for CVP to provide useful insights. The examples in Chapter 3 (the software package context in the text and the travel agency example in the Problem for Self-Study) illustrate how CVP can provide such insights. In more complex cases, the basic ideas of simple CVP analysis can be expanded. 3-8 An increase in the income tax rate does not affect the breakeven point. Operating income at the breakeven point is zero, and no income taxes are paid at this point. 3-9 Sensitivity analysis is a ―what-if‖ technique that managers use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. The advent of the electronic spreadsheet has greatly increased the ability to explore the effect of alternative assumptions at minimal cost. CVP is one of the most widely used software applications in the management accounting area. 3-10

Examples include: Manufacturing––substituting a robotic machine for hourly wage workers. Marketing––changing a sales force compensation plan from a percent of sales dollars to a fixed salary. Customer service––hiring a subcontractor to do customer repair visits on an annual retainer basis rather than a per-visit basis.

3-11

Examples include: Manufacturing––subcontracting a component to a supplier on a per-unit basis to avoid purchasing a machine with a high fixed depreciation cost. Marketing––changing a sales compensation plan from a fixed salary to percent of sales dollars basis. Customer service––hiring a subcontractor to do customer service on a per-visit basis rather than an annual retainer basis.

3-12 Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold, and hence, in contribution margin. Knowing the degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating incomes. 3-13 CVP analysis is always conducted for a specified time horizon. One extreme is a very short-time horizon. For example, some vacation cruises offer deep price discounts for people who offer to take any cruise on a day’s notice. One day prior to a cruise, most costs are fixed. The other extreme is several years. Here, a much higher percentage of total costs typically is variable.


CVP itself is not made any less relevant when the time horizon lengthens. What happens is that many items classified as fixed in the short run may become variable costs with a longer time horizon. 3-14 A company with multiple products can compute a breakeven point by assuming there is a constant sales mix of products at different levels of total revenue. 3-15 Yes, gross margin calculations emphasize the distinction between manufacturing and nonmanufacturing costs (gross margins are calculated after subtracting variable and fixed manufacturing costs). Contribution margin calculations emphasize the distinction between fixed and variable costs. Hence, contribution margin is a more useful concept than gross margin in CVP analysis. 3-16

a. b. c. d. 3-17

(10 min.) CVP computations. Revenues $2,000 2,000 1,000 1,500

Variable Costs $ 500 1,500 700 900

Fixed Costs $300 300 300 300

Total Operating Contribution Costs Income Margin $ 800 $1,200 $1,500 200 1,800 500 1,000 0 300 1,200 300 600

Contribution Margin % 75.0% 25.0% 30.0% 40.0%

(10–15 min.) CVP computations. 1a.

Sales ($68 per unit × 410,000 units) Variable costs ($60 per unit × 410,000 units) Contribution margin

1b.

Contribution margin (from above) Fixed costs Operating income

2a.

Sales (from above) Variable costs ($54 per unit × 410,000 units) Contribution margin

2b.

Contribution margin Fixed costs Operating income

$27,880,000 24,600,000 $ 3,280,000 $3,280,000 1,640,000 $1,640,000 $27,880,000 22,140,000 $ 5,740,000 $5,740,000 5,330,000 $ 410,000

3. Operating income is expected to decrease by $1,230,000 ($1,640,000 − $410,000) if Ms. Schoenen’s proposal is accepted. The management would consider other factors before making the final decision. It is likely that product quality would improve as a result of using state of the art equipment. Due to increased automation, probably many workers will have to be laid off. Garrett’s management will have to consider the impact of such an action on employee morale. In addition, the proposal increases the company’s fixed costs dramatically. This will increase the company’s operating leverage and risk. 3-3 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

3-18

(35–40 min.) CVP analysis, changing revenues and costs.

1a.

SP VCU CMU FC

= 6% × $1,500 = $90 per ticket = $43 per ticket = $90 – $43 = $47 per ticket = $23,500 a month

Q

=

FC $23,500 = $47 per ticket CMU

= 500 tickets 1b.

Q

=

FC TOI $23,500 $17,000 = $47 per ticket CMU

=

$40,500 $47 per ticket

= 862 tickets (rounded up) 2a.

SP VCU CMU FC

= $90 per ticket = $40 per ticket = $90 – $40 = $50 per ticket = $23,500 a month

Q

=


= 470 tickets 2b.

Q

=


=


= 810 tickets 3a.

SP VCU CMU FC

= $60 per ticket = $40 per ticket = $60 – $40 = $20 per ticket = $23,500 a month

Q

=

FC $23,500 = $20 per ticket CMU = 1,175 tickets


3b.

Q

=


=


= 2,025 tickets The reduced commission sizably increases the breakeven point and the number of tickets required to yield a target operating income of $17,000:

Breakeven point Attain OI of $10,000

6% Commission (Requirement 2) 470 810

Fixed Commission of $60 1,175 2,025

4a. The $5 delivery fee can be treated as either an extra source of revenue (as done below) or as a cost offset. Either approach increases CMU $5: SP VCU CMU FC

= $65 ($60 + $5) per ticket = $40 per ticket = $65 – $40 = $25 per ticket = $23,500 a month

Q

=


= 940 tickets 4b.

Q

=


=


= 1,620 tickets The $5 delivery fee results in a higher contribution margin which reduces both the breakeven point and the tickets sold to attain operating income of $17,000.


3-19

(20 min.) CVP exercises.

Revenues $10,000,000G 10,000,000 10,000,000 10,000,000 10,000,000 10,800,000e 9,200,000g 11,000,000i 10,000,000

Orig. 1. 2. 3. 4. 5. 6. 7. 8. Gstands

Variable Costs

Contribution Margin

$8,000,000G 7,800,000 8,200,000 8,000,000 8,000,000 8,640,000f 7,360,000h 8,800,000j 7,600,000l

$2,000,000 2,200,000a 1,800,000b 2,000,000 2,000,000 2,160,000 1,840,000 2,200,000 2,400,000

Budgeted Operating Income

Fixed Costs $1,800,000G 1,800,000 1,800,000 1,890,000c 1,710,000d 1,800,000 1,800,000 1,980,000k 1,890,000m

$200,000 400,000 0 110,000 290,000 360,000 40,000 220,000 510,000

for given.

a$2,000,000 × 1.10; b$2,000,000 × 0.90; c$1,800,000 × 1.05; d$1,800,000 × 0.95; e$10,000,000 × 1.08; f$8,000,000 × 1.08; g$10,000,000 × 0.92; h$8,000,000 × 0.92; i$10,000,000 × 1.10; j$8,000,000 × 1.10; k$1,800,000 × 1.10; l$8,000,000 × 0.95; m$1,800,000 × 1.05

3-20

(20 min.) CVP exercises.

1a.

[Units sold (Selling price – Variable costs)] – Fixed costs = Operating income [5,000,000 ($0.50 – $0.30)] – $900,000 = $100,000

1b.

Fixed costs ÷ Contribution margin per unit = Breakeven units $900,000 ÷ [($0.50 – $0.30)] = 4,500,000 units Breakeven units × Selling price = Breakeven revenues 4,500,000 units × $0.50 per unit = $2,250,000 or, Selling price -Variable costs Contribution margin ratio = Selling price $0.50 - $0.30 = = 0.40 $0.50 Fixed costs ÷ Contribution margin ratio = Breakeven revenues $900,000 ÷ 0.40 = $2,250,000

2.

5,000,000 ($0.50 – $0.34) – $900,000

=

$ (100,000)

3.

[5,000,000 (1.1) ($0.50 – $0.30)] – [$900,000 (1.1)]

=

$ 110,000

4.

[5,000,000 (1.4) ($0.40 – $0.27)] – [$900,000 (0.8)]

=

$ 190,000

5.

$900,000 (1.1) ÷ ($0.50 – $0.30)

=

4,950,000 units

6.

($900,000 + $20,000) ÷ ($0.55 – $0.30)

=

3,680,000 units


3-21

(10 min.) CVP analysis, income taxes.

1. Monthly fixed costs = $48,200 + $68,000 + $13,000 = Contribution margin per unit = $27,000 – $23,000 – $600 = Monthly fixed costs $129,200 Breakeven units per month = = = Contribution margin per unit $3,400 per car 2. Tax rate Target net income

$129,200 $ 3,400 38 cars 40% $51,000

Target net income $51,000 $51,000 $85,000 1 - tax rate (1 0.40) 0.60 Quantity of output units Fixed costs + Target operating income $129, 200 $85,000 63 cars required to be sold = Contribution margin per unit $3, 400

Target operating income =

3-22 (20–25 min.) CVP analysis, income taxes. 1. Variable cost percentage is $3.40 $8.50 = 40% Let R = Revenues needed to obtain target net income R – 0.40R – $459,000 =

$107,100 1 0.30

0.60R = $459,000 + $153,000 R = $612,000 0.60 R = $1,020,000 Fixed costs + Target operating income Contribution margin percentage Target net income $107,100 Fixed costs + $459, 000 1 Tax rate 1 0.30 Contribution margin percentage 0.60

or, Target revenues

Target revenues

Proof:

2.a.

Revenues Variable costs (at 40%) Contribution margin Fixed costs Operating income Income taxes (at 30%) Net income

$1, 020, 000

$1,020,000 408,000 612,000 459,000 153,000 45,900 $ 107,100

Customers needed to break even: Contribution margin per customer = $8.50 – $3.40 = $5.10 Breakeven number of customers = Fixed costs Contribution margin per customer = $459,000 $5.10 per customer = 90,000 customers


2.b.

Customers needed to earn net income of $107,100: Total revenues Sales check per customer $1,020,000 $8.50 = 120,000 customers

3.

Using the shortcut approach: Change in net income

New net income

=

Change in number of customers

Unit contribution margin

1 Tax rate

= (170,000 – 120,000) $5.10 (1 – 0.30) = $255,000 0.7 = $178,500 = $178,500 + $107,100 = $285,600

Alternatively, with 170,000 customers, Operating income = Number of customers Selling price per customer – Number of customers Variable cost per customer – Fixed costs = 170,000 $8.50 – 170,000 $3.40 – $459,000 = $408,000 Net income = Operating income × (1 – Tax rate) = $408,000 × 0.70 = $285,600 The alternative approach is: Revenues, 170,000 $8.50 Variable costs at 40% Contribution margin Fixed costs Operating income Income tax at 30% Net income

$1,445,000 578,000 867,000 459,000 408,000 122,400 $ 285,600

3-23

(30 min.) CVP analysis, sensitivity analysis.

1.

SP = $30.00 (1 – 0.30 margin to bookstore) = $30.00 0.70 = $21.00 VCU = $ 4.00 variable production and marketing cost 3.15 variable author royalty cost (0.15 $21.00) $ 7.15 CMU = $21.00 – $7.15 = $13.85 per copy FC = $ 500,000 fixed production and marketing cost 3,000,000 up-front payment to Washington $3,500,000


Solution Exhibit 3-23A shows the PV graph. SOLUTION EXHIBIT 3-23A PV Graph for Media Publishers

FC = $3,500,000 CMU = $13.85 per book sold

$4,000

3,000

Operating income (000’s)

2,000

1,000

Units sold

0 100,000

200,000

-1,000

300,000

400,000

500,000

252,708 units

-2,000

-3,000

$3.5 million -4,000

2a. FC CMU $3,500,000 = $13.85

Breakeven,number of units

=

= 252,708 copies sold (rounded up) 2b.

Target OI =

FC OI CMU

$3,500,000 $2,000,000 $13.85 $5,500,000 = $13.85 = 397,112 copies sold (rounded up) =


3a. Decreasing the normal bookstore margin to 20% of the listed bookstore price of $30 has the following effects: =$30.00 (1 – 0.20) =$30.00 0.80 = $24.00 VCU = $ 4.00 variable production and marketing cost + 3.60 variable author royalty cost (0.15 $24.00) $ 7.60 SP

CMU = $24.00 – $7.60 = $16.40 per copy Breakeven,number of units =

FC CMU

$3,500,000 $16.40 = 213,415 copies sold (rounded up)

=

The breakeven point decreases from 252,708 copies in requirement 2 to 213,415 copies. 3b. Increasing the listed bookstore price to $40 while keeping the bookstore margin at 30% has the following effects: =$40.00 (1 – 0.30) =$40.00 0.70 = $28.00 VCU =$ 4.00 variable production and marketing cost + 4.20 variable author royalty cost (0.15 $28.00) $ 8.20 SP

CMU= $28.00 – $8.20 = $19.80 per copy

$3,500,000 $19.80 = 176,768 copies sold (rounded up)

Breakeven,number of units =

The breakeven point decreases from 252,708 copies in requirement 2 to 176,768 copies. 3c. The answers to requirements 3a and 3b decrease the breakeven point relative to that in requirement 2 because in each case fixed costs remain the same at $3,500,000 while the contribution margin per unit increases.


3-24

(10 min.) CVP analysis, margin of safety. Fixed costs 1. Breakeven point revenues = Contributi on margin percentage $660,000 Contribution margin percentage = = 0.60 or 60% $1,100,000 Selling price Variable cost per unit 2. Contribution margin percentage = Selling price SP $16 0.60 = SP 0.60 SP = SP – $16 0.40 SP = $16 SP = $40 3. Breakeven sales in units = Revenues ÷ Selling price = $1,100,000 ÷ $40 = 27,500 units Margin of safety in units = Sales in units – Breakeven sales in units = 95,000 – 27,500 = 67,500 units Revenues, 95,000 units Breakeven revenues Margin of safety

$40

$3,800,000 1,100,000 $2,700,000

3-25

(25 min.) Operating leverage.

1a.

Let Q denote the quantity of carpets sold Breakeven point under Option 1 $500Q $350Q = $5,000 $150Q = $5,000 Q = $5,000

1b.

2.

Breakeven point under Option 2 $500Q $350Q (0.10 $500Q) 100Q Q

= = =

$150 = 34 carpets (rounded up)

0 0 0

Operating income under Option 1 = $150Q Operating income under Option 2 = $100Q

$5,000

Find Q such that $150Q

$5,000 = $100Q $50Q = $5,000 Q = $5,000 $50 = 100 carpets Revenues = $500 × 100 carpets = $50,000 For Q = 100 carpets, operating income under both Option 1 ($150 × 100 – $5,000) and Option 2 ($100 × 100) = $10,000


For Q > 100, say, 101 carpets, Option 1 gives operating income = ($150 101) Option 2 gives operating income = $100 101 So Color Rugs will prefer Option 1. For Q < 100, say, 99 carpets, Option 1 gives operating income = ($150 99) Option 2 gives operating income = $100 99 So Color Rugs will prefer Option 2. 3.

$5,000 = $10,150 = $10,100

$5,000 = $9,850 = $9,900

Contribution margin Operating income Contribution margin per unit Quantity of carpets sold Operating income Under Option 1, contribution margin per unit = $500 – $350, so $150 100 Degree of operating leverage = = 1.5 $10,000 Under Option 2, contribution margin per unit = $500 – $350 – 0.10 $500, so $100 100 Degree of operating leverage = = 1.0 $10,000

Degree of operating leverage =

4. The calculations in requirement 3 indicate that when sales are 100 units, a percentage change in sales and contribution margin will result in 1.5 times that percentage change in operating income for Option 1, but the same percentage change in operating income for Option 2. The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on operating incomes.


3-26

(15 min.) CVP analysis, international cost structure differences.

Variable Variable Sales Price Annual Manufacturing Marketing and to Retail Fixed Cost per Distribution Cost Country Outlets Costs Rug per Rug (1) (2) (3) (4) Singapore $250.00 $ 9,000,000 $75.00 $25.00 Brazil $250.00 8,400,000 60.00 15.00 United States $250.00 12,400,000 82.50 12.50

Contribution Operating Income Margin Breakeven Breakeven for Budgeted Sales Per Rug Units Revenues of 75,000 Rugs (5)=(1)–(3)–(4) (6)=(2) (5) (6) (1) (7)=[75,000 (5)]–(2) $150.00 60,000 $15,000,000 $2,250,000 175.00 48,000 12,000,000 4,725,000 155.00 80,000 20,000,000 (775,000)

Requirement 1

Requirement 2

Brazil has the lowest breakeven point since it has both the lowest fixed costs ($8,400,000) and the lowest variable cost per unit ($75.00). Hence, for a given selling price, Brazil will always have a higher operating income (or a lower operating loss) than Singapore or the U.S. The U.S. breakeven point is 80,000 units. Hence, with sales of only 75,000 units, it has an operating loss of $775,000.


3-27

(30 min.) Sales mix, new and upgrade customers.

1.

SP VCU CMU

New Customers $275 100 175

Upgrade Customers $100 50 50

The 60%/40% sales mix implies that, in each bundle, 3 units are sold to new customers and 2 units are sold to upgrade customers. Contribution margin of the bundle = 3 $175 + 2 $50 = $525 + $100 = $625 $15, 000, 000 Breakeven point in bundles = = 24,000 bundles $625 Breakeven point in units is: Sales to new customers: 24,000 bundles 3 units per bundle 72,000 units Sales to upgrade customers: 24,000 bundles 2 units per bundle 48,000 units Total number of units to breakeven (rounded) 120,000 units Alternatively, Let S = Number of units sold to upgrade customers 1.5S = Number of units sold to new customers Revenues – Variable costs – Fixed costs = Operating income [$275 (1.5S) + $100S] – [$100 (1.5S) + $50S] – $15,000,000 = OI $512.5S – $200S – $15,000,000 = OI Breakeven point is 120,000 units when OI = $0 because $312.5S S 1.5S BEP

= $15,000,000 = 48,000 units sold to upgrade customers = 72,000 units sold to new customers = 120,000 units

Check Revenues ($275 72,000) + ($100 48,000) Variable costs ($100 72,000) + ($50 48,000) Contribution margin Fixed costs Operating income

$24,600,000 9,600,000 15,000,000 15,000,000 $ 0


2.

When 220,000 units are sold, mix is: Units sold to new customers (60% 220,000) Units sold to upgrade customers (40% 220,000) Revenues ($275 132,000) + ($100 88,000) Variable costs ($100 132,000) + ($50 88,000) Contribution margin Fixed costs Operating income

3a.

132,000 88,000 $45,100,000 17,600,000 27,500,000 15,000,000 $12,500,000

At New 40%/Upgrade 60% mix, each bundle contains 2 units sold to new customers and 3 units sold to upgrade customers. Contribution margin of the bundle = 2 $175 + 3 $50 = $350 + $150 = $500 $15, 000, 000 Breakeven point in bundles = = 30,000 bundles $500 Breakeven point in units is: Sales to new customers: 30,000 bundles × 2 unit per bundle 60,000 units Sales to upgrade customers: 30,000 bundles × 3 unit per bundle 90,000 units Total number of units to breakeven 150,000 units Alternatively, Let S = Number of units sold to new customers then 1.5S = Number of units sold to upgrade customers [$275S + $100 (1.5S)] – [$100S + $50 (1.5S)] – $15,000,000 = OI 425S – 175S = $15,000,000 250S = $15,000,000 S = 60,000 units sold to new customers 1.5S = 90,000 units sold to upgrade customers BEP = 150,000 units Check Revenues ($275 60,000) + ($100 90,000) $25,500,000 Variable costs ($100 60,000) + ($50 90,000) 10,500,000 Contribution margin 15,000,000 Fixed costs 15,000,000 Operating income $ 0

3b. At New 80%/ Upgrade 20% mix, each bundle contains 4 units sold to new customers and 1 unit sold to upgrade customers. Contribution margin of the bundle = 4 $175 + 1 $50 = $700 + $50 = $750 $15, 000, 000 Breakeven point in bundles = = 20,000 bundles $750 Breakeven point in units is: Sales to new customers: 20,000 bundles 4 units per bundle 80,000 units Sales to upgrade customers: 20,000 units 20,000 bundles 1 unit per bundle Total number of units to breakeven 100,000 units 3-15 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Alternatively, Let S = Number of units sold to upgrade customers then 4S = Number of units sold to new customers [$275 (4S) + $100S] – [$100 (4S) + $50S] – $15,000,000 = OI 1,200S – 450S = $15,000,000 750S = $15,000,000 S = 20,000 units sold to upgrade customers 4S = 80,000 units sold to new customers 100,000 units Check Revenues ($275 80,000) + ($100 20,000) Variable costs ($100 80,000) + ($50 20,000) Contribution margin Fixed costs Operating income

$24,000,000 9,000,000 15,000,000 15,000,000 $ 0

3c. As Data increases its percentage of new customers, which have a higher contribution margin per unit than upgrade customers, the number of units required to break even decreases:

Requirement 3(a) Requirement 1 Requirement 3(b)

New Customers 40% 60 80

Upgrade Customers 60% 40 20

Breakeven Point 150,000 120,000 100,000


3-28

(30 min.) Sales mix, three products.

1. SP VCU CMU

Coffee $2.50 1.25 $1.25

Bagels $3.75 1.75 $2.00

The sales mix implies that each bundle consists of 4 cups of coffee and 1 bagel. Contribution margin of the bundle = 4 Breakeven point in bundles =

$1.25 + 1

$2 = $5.00 + $2.00 = $7.00

Fixed costs Contribution margin per bundle

$7, 000 $7.00

1, 000 bundles

Breakeven point is: Coffee: 1,000 bundlex 4 cups per bundle = 4,000 cups Bagels: 1,000 bundles 1 bagel per bundle = 1,000 bagels Alternatively, Let S = Number of bagels sold 4S = Number of cups of coffee sold Revenues – Variable costs – Fixed costs = Operating income [$2.50(4S) + $3.75S] – [$1.25(4S) + $1.75S] – $7,000 = OI $13.75S – $6.75S – $7,000 = OI $7.00 S=$7,000 S = 1,000 units of the sales mix or S =1,000 bagels sold 4S=4,000 cups of coffee sold Breakeven point, therefore, is 1,000 bagels and 4,000 cups of coffee when OI = 0 Check Revenues ($2.50 4,000) + ($3.75 1,000) Variable costs ($1.25 4,000) + ($1.75 1,000) Contribution margin Fixed costs Operating income

2. SP VCU CMU

Coffee $2.50 1.25 $1.25

$

$13,750 6,750 7,000 7,000 0

Bagels $3.75 1.75 $2.00

The sales mix implies that each bundle consists of 4 cups of coffee and 1 bagel. Contribution margin of the bundle = 4

$1.25 + 1

$2 = $5.00 + $2.00 = $7.00

Breakeven point in bundles 3-17 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

=

Fixed costs + Target operating income Contribution margin per bundle

Breakeven point is: Coffee: 5,000 bundles Bagels: 5,000 bundles

$7, 000 $28, 000 $7.00

5, 000 bundles

4 cups per bundle = 20,000 cups 1 bagel per bundle = 5,000 bagels

Alternatively, Let S = Number of bagels sold 4S = Number of cups of coffee sold Revenues – Variable costs – Fixed costs = Operating income [$2.50(4S) + $3.75S] – [$1.25(4S) + $1.75S] – $7,000 = OI [$2.50(4S) + $3.75S] – [$1.25(4S) + $1.75S] – $7,000 = 28,000 $13.75S – $6.75S = 35,000 $7.00 S=$35,000 S = 5,000 units of the sales mix or S =5,000 bagels sold 4S=20,000 cups of coffee sold The target number of units to reach an operating income before tax of $28,000 is 5,000 bagels and 20,000 cups of coffee. Check Revenues ($2.50 20,000) + ($3.75 5,000) Variable costs ($1.25 20,000) + ($1.75 5,000) Contribution margin Fixed costs Operating income 3. SP VCU CMU

Coffee $2.50 1.25 $1.25

Bagels $3.75 1.75 $2.00

$68,750 33,750 35,000 7,000 $28,000 Muffins $3.00 0.75 $2.25

The sales mix implies that each bundle consists of 3 cups of coffee, 2 bagels and 1 muffin Contribution margin of the bundle = 3 $1.25 + 2 $2 + 1 $2.25 = $3.75 + $4.00 + $2.25 = $10.00 Breakeven point in bundles = Breakeven point is: Coffee: 700 bundles Bagels: 700 bundles Muffins: 700 bundles

Fixed costs Contribution margin per bundle

$7, 000 $10.00

700 bundles

3 cups per bundle = 2,100 cups 2 bagels per bundle = 1,400 bagels 1 muffin per bundle = 700 muffins 3-18


Alternatively, Let S = Number of muffins sold 2S = Number of bagels sold 3S = Number of cups of coffee sold Revenues – Variable costs – Fixed costs = Operating income [$2.50(3S) + $3.75(2S) +3.00S] – [$1.25(3S) + $1.75(2S) + $0.75S] – $7,000 = OI $18.00S – $8S – $7,000 = OI $10.00 S=$7,000 S = 700 units of the sales mix or S =700 muffins 2S=1,400 bagels 3S=2,100 cups of coffee Breakeven point, therefore, is 2,100 cups of coffee 1,400 bagels, and 700 muffins when OI = 0 Check Revenues ($2.50 2,100) + ($3.75 1,400) +($3.00 700) Variable costs ($1.25 2,100) + ($1.75 1,400) +($0.75 700) Contribution margin Fixed costs Operating income

$

$12,600 5,600 7,000 7,000 0

Bobbie should definitely add muffins to her product mix because muffins have the highest contribution margin ($2.25) of all three products. This lowers Bobbie’s overall breakeven point. If the sales mix ratio above can be attained, the result is a lower breakeven revenue ($12,600) of the options presented in the problem.


3-29

CVP, Not for profit 1.

Ticket sales per concert Variable costs per concert: Guest performers Marketing and advertising Total variable costs per concert Contribution margin per concert Fixed costs Salaries Mortgage payments ($2,000 × 12) Total fixed costs Less donations Net fixed costs

Breakeven point in units =

$ 2,500 $ 1,000 500 1,500 $ 1,000

$50,000 24,000 $74,000 40,000 $34,000

Net fixed costs $34,000 = = 34 concerts Contribution margin per concert $1,000

Check Donations Revenue ($2,500 × 34) Total revenue

$ 40,000 85,000 125,000

Less variable costs Guest performers ($1,000 × 34) Marketing and advertising ($500 × 34) Total variable costs Less fixed costs Salaries Mortgage payments Total fixed costs Operating income 2.

$34,000 17,000 51,000

$50,000 24,000 74,000 0

$

Ticket sales per concert Variable costs per concert: Guest performers Marketing and advertising Total variable costs per concert Contribution margin per concert Fixed costs Salaries ($50,000 + $40,000) Mortgage payments ($2,000 × 12) Total fixed costs Less donations Net fixed costs

$

2,500

$1,000 500 1,500 $ 1,000 $90,000 24,000 $114,000 40,000 $ 74,000





$ 40,000 185,000 225,000

Less variable costs Guest performers ($1,000 × 74) Marketing and advertising ($500 × 74) Total variable costs Less fixed costs Salaries Mortgage payments Total fixed costs Operating income

$74,000 37,000 111,000

$90,000 24,000 $

Operating Income if 60 concerts are held Donations Revenue ($2,500 × 60) Total revenue

114,000 0

$ 40,000 150,000 190,000

Less variable costs Guest performers ($1,000 × 60) Marketing and advertising ($500 × 60) Total variable costs Less fixed costs Salaries Mortgage payments Total fixed costs Operating income (loss)

$60,000 30,000 90,000

$90,000 24,000 114,000 $ (14,000)

The Music Society would not be able to afford the new marketing director if the number of concerts were to increase to only 60 events. The addition of the new marketing director would require the Music Society to hold at least 74 concerts in order to breakeven. If only 60 concerts were held, the organization would lose $14,000 annually. The Music Society could look for other contributions to support the new marketing director’s salary or perhaps increase the number of attendees per concert if the number of concerts could not be increased beyond 60. 3.

Ticket sales per concert Variable costs per concert: Guest performers Marketing and advertising Total variable costs per concert Contribution margin per concert

$ 2,500 $ 1,000 500 1,500 $ 1,000


Fixed costs Salaries ($50,000 + $40,000) Mortgage payments ($2,000 × 12) Total fixed costs Deduct donations Net fixed costs Breakeven point in units =

$90,000 24,000 $114,000 60,000 $ 54,000



$ 60,000 135,000 195,000

Less variable costs Guest performers ($1,000 × 54) Marketing and advertising ($500 × 54) Total variable costs Less fixed costs Salaries Mortgage payments Total fixed costs Operating income

$54,000 27,000 81,000

$90,000 24,000 $

114,000 0


3-30

(15 min.) Contribution margin, decision making.

1.

Revenues Deduct variable costs: Cost of goods sold Sales commissions Other operating costs Contribution margin

$600,000 $300,000 60,000 30,000

390,000 $210,000

$210,000 = 35% $600,000

2.

Contribution margin percentage =

3.

Incremental revenue (15% × $600,000) = $90,000 Incremental contribution margin (35% × $90,000) Incremental fixed costs (advertising) Incremental operating income

$31,500 13,000 $18,500

If Mr. Lurvey spends $13,000 more on advertising, the operating income will increase by $18,500, decreasing the operating loss from $49,000 to an operating loss of $30,500. Proof (Optional): Revenues (115% × $600,000) Cost of goods sold (50% of sales) Gross margin

$690,000 345,000 345,000

Operating costs: Salaries and wages Sales commissions (10% of sales) Depreciation of equipment and fixtures Store rent Advertising Other operating costs: $30,000 $690, 000 Variable $600,000 Fixed Operating income

$170,000 69,000 20,000 54,000 13,000 34,500 15,000

375,500 $ (30,500)


3-31

(20 min.) Contribution margin, gross margin and margin of safety.

1. Mirabella Cosmetics Operating Income Statement, June 2011 Units sold Revenues Variable costs Variable manufacturing costs Variable marketing costs Total variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed marketing & administration costs Total fixed costs Operating income 2.

10,000 $100,000 $ 55,000 5,000 60,000 40,000 $ 20,000 10,000 30,000 $ 10,000

$40,000 $4 per unit 10,000 units Fixed costs $30, 000 Breakeven quantity = Contribution margin per unit $4 per unit Revenues $100, 000 $10 per unit Selling price = Units sold 10,000 units Breakeven revenues = 7,500 units $10 per unit = $75,000

Contribution margin per unit =

7,500 units

Alternatively, Contribution margin percentage =

Breakeven revenues =

Contribution margin Revenues

Fixed costs Contribution margin percentage

$40, 000 $100, 000 $30, 000 0.40

40%

$75, 000

3. Margin of safety (in units) = Units sold – Breakeven quantity = 10,000 units – 7,500 units = 2,500 units 4.

Units sold Revenues (Units sold Selling price = 8,000 $10) Contribution margin (Revenues CM percentage = $80,000 Fixed costs Operating income Taxes (30% $2,000) Net income

40%)

8,000 $80,000 $32,000 30,000 2,000 600 $ 1,400


3-32 (30 min.) Uncertainty and expected costs. 1. Monthly Number of Orders 350,000 450,000 550,000 650,000 750,000

Cost of Current System $2,500,000 + $50(350,000) = $20,000,000 $2,500,000 + $50(450,000) = $25,000,000 $2,500,000 + $50(550,000) = $30,000,000 $2,500,000 + $50(650,000) = $35,000,000 $2,500,000 + $50(750,000) = $40,000,000

Monthly Number of Orders 350,000 450,000 550,000 650,000 750,000

Cost of Partially Automated System $10,000,000 + $40(350,000) = $24,000,000 $10,000,000 + $40(450,000) = $28,000,000 $10,000,000 + $40(550,000) = $32,000,000 $10,000,000 + $40(650,000) = $36,000,000 $10,000,000 + $40(750,000) = $40,000,000

Monthly Number of Orders 350,000 450,000 550,000 650,000 750,000

Cost of Fully Automated System $20,000,000 + $25(350,000) = $28,750,000 $20,000,000 + $25(450,000) = $31,250,000 $20,000,000 + $25(550,000) = $33,750,000 $20,000,000 + $25(650,000) = $36,250,000 $20,000,000 + $25(750,000) = $38,750,000

2. Current System Expected Cost: $20,000,000 × 0.15 = 25,000,000 × 0.20 = 30,000,000 × 0.35 = 35,000,000 × 0.20 = 40,000,000 × 0.10 =

$ 3,000,000 5,000,000 10,500,000 7,000,000 4,000,000 $29,500,000

Partially Automated System Expected Cost: $24,000,000 × 0.15 = $ 3,600,000 28,000,000 × 0.20 = 5,600,000 32,000,000 × 0.35 = 11,200,000 36,000,000 × 0.20 = 7,200,000 40,000,000 × 0.10 = 4,000,000 $31,600,000 Fully Automated System Expected Cost: $28,750,000 × 0.15 = $ 4,312,500 31,250,000 × 0.20 = 6,250,000 33,750,000 × 0.35 = 11,812,500 36,250,000 × 0.20 = 7,250,000 38,750,000 × 0.10 = 3,875,000 $33,500,000


3. Foodmart should consider the impact of the different systems on its relationship with suppliers. The interface with Foodmart’s system may require that suppliers also update their systems. This could cause some suppliers to raise the cost of their merchandise. It could force other suppliers to drop out of Foodmart’s supply chain because the cost of the system change would be prohibitive. Foodmart may also want to consider other factors such as the reliability of different systems and the effect on employee morale if employees have to be laid off as it automates its systems. 3-33

(15–20 min.) CVP analysis, service firm.

1.

Revenue per package Variable cost per package Contribution margin per package

$5,000 3,700 $1,300

Breakeven (packages) = Fixed costs ÷ Contribution margin per package $520,000 = = 400 tour packages $1,300 per package 2.

Contribution margin ratio =

Contributi on margin per package $1,300 = = 26% Selling price $5,000

Revenue to achieve target income = (Fixed costs + target OI) ÷ Contribution margin ratio = Number of tour packages to earn $91,000 operating income

$520,000 $91,000 = $2,350,000, or 0.26 $520, 000 $91, 000 $1,300

470 tour packages

Revenues to earn $91,000 OI = 470 tour packages × $5,000 = $2,350,000. 3.

Fixed costs = $520,000 + $32,000 = $552,000 Breakeven (packages) =

Fixed costs Contribution margin per package

Contribution margin per package = =

Fixed costs Breakeven (packages) $552,000 = $1,380 per tour package 400 tour packages

Desired variable cost per tour package = $5,000 – $1,380 = $3,620 Because the current variable cost per unit is $3,700, the unit variable cost will need to be reduced by $80 to achieve the breakeven point calculated in requirement 1. Alternate Method: If fixed cost increases by $32,000, then total variable costs must be reduced by $32,000 to keep the breakeven point of 400 tour packages. Therefore, the variable cost per unit reduction = $32,000 ÷ 400 = $80 per tour package. 3-26 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

3-34

(30 min.) CVP, target operating income, service firm.

1.

Revenue per child Variable costs per child Contribution margin per child Breakeven quantity =

=

2.

Target quantity =

= 3.

$580 230 $350

Fixed costs Contributi on margin per child

$5,600 = 16 children $350

Fixed costs Target operating income Contributi on margin per child

$5,600 $10,500 = 46 children $350

Increase in rent ($3,150 – $2,150) Field trips Total increase in fixed costs Divide by the number of children enrolled Increase in fee per child

$1,000 1,300 $2,300 ÷ 46 $ 50

Therefore, the fee per child will increase from $580 to $630. Alternatively, New contribution margin per child =

$5,600

$2,300 $10,500 = $400 46

New fee per child = Variable costs per child + New contribution margin per child = $230 + $400 = $630


3-35

(20–25 min.)

CVP analysis.

1.

Selling price Variable costs per unit: Production costs Shipping and handling Contribution margin per unit (CMU)

$300 $120 5

125 $175

Fixed costs $1,260,000 = = 7,200 units Contribution margin per unit $175 Margin of safety (units) = 10,000 – 7,200 = 2,800 units


2. Since fixed costs remain the same, any incremental increase in sales will increase contribution margin and operating income dollar for dollar. Increase in units sales = 10% × 10,000 = 1,000 Incremental contribution margin = $175 × 1,000 = $175,000 Therefore, the increase in operating income will be equal to $175,000. Technology Solutions’s operating income in 2011 would be $490,000 + $175,000 = $665,000. 3.

Selling price Variable costs: Production costs $120 × 130% Shipping and handling ($5 – ($5 0.20)) Contribution margin per unit Target sales in units =

$300 $156 4

160 $140

FC TOI $1,260,000 $490,000 = = 12,500 units CMU $140

Target sales in dollars = $300 × 12,500 = $3,750,000


3-36

(30–40 min.) CVP analysis, income taxes.

1.

Revenues – Variable costs – Fixed costs =

Target net income 1 Tax rate

Let X = Net income for 2011 20,000($25.00) – 20,000($13.75) – $135,000 = $500,000 – $275,000 – $135,000 =

X 1 0.40 X

0.60 $300,000 – $165,000 – $81,000 = X X = $54,000

Alternatively, Operating income = Revenues – Variable costs – Fixed costs = $500,000 – $275,000 – $135,000 = $90,000

Income taxes = 0.40 × $90,000 = $36,000 Net income = Operating income – Income taxes = $90,000 – $36,000 = $54,000 2.

Let Q = Number of units to break even $25.00Q – $13.75Q – $135,000 = 0 Q = $135,000 $11.25 = 12,000 units

3.

Let X = Net income for 2012 22,000($25.00) – 22,000($13.75) – ($135,000 + $11,250)

=

$550,000 – $302,500 – $146,250

=

$101,250

=

X 1 0.40 X 0.60 X

0.60 X = $60,750

4.

Let Q = Number of units to break even with new fixed costs of $146,250 $25.00Q – $13.75Q – $146,250 Q = $146,250 $11.25 Breakeven revenues = 13,000 $25.00

5.

Let S = Required sales units to equal 2011 net income $25.00S – $13.75S – $146,250 = $11.25S = $236,250 S = 21,000 units Revenues = 21,000 units

6.

= 0 = 13,000 units = $325,000

$54,000 0.60

$25 = $525,000

Let A = Amount spent for advertising in 2012 $550,000 – $302,500 – ($135,000 + A) =

$60,000

0.60 $550,000 – $302,500 – $135,000 – A = $100,000 $550,000 – $537,500 = A A = $12,500


3-37 (25 min.) CVP, sensitivity analysis. Contribution margin per pair of shoes = $60 – $25 = $35 Fixed costs = $100,000 Units sold = Total sales ÷ Selling price = $300,000 ÷ $60 per pair= 5,000 pairs of shoes 1. Variable costs decrease by 20%; Fixed costs increase by 15% Sales revenues 5,000 $60 $300,000 Variable costs 5,000 $25 (1 – 0.20) 100,000 Contribution margin 200,000 Fixed costs $100,000 x 1.15 115,000 Operating income $ 85,000 2. Increase advertising (fixed costs) by $30,000; Increase sales 20% Sales revenues 5,000 1.20 $60.00 $360,000 Variable costs 5,000 1.20 $25.00 150,000 Contribution margin 210,000 Fixed costs ($100,000 + $30,000) 130,000 Operating income $ 80,000

3. Increase selling price by $10.00; Sales decrease 10%; Variable costs increase by $7 Sales revenues 5,000 0.90 ($60 + $10) $315,000 Variable costs 5,000 0.90 ($25 + $7) 144,000 Contribution margin 171,000 Fixed costs 100,000 Operating income $ 71,000 4. Double fixed costs; Increase sales by 60% Sales revenues 5,000 1.60 $60 Variable costs 5,000 1.60 $25 Contribution margin Fixed costs $100,000 2 Operating income

$480,000 200,000 280,000 200,000 $ 80,000

Alternative 1 yields the highest operating income. Choosing alternative 1 will give Brown a 13.33% increase in operating income [($85,000 – $75,000)/$75,000 = 13.33%], which is less than the company’s 25% targeted increase. Alternatives 2 and 4 also generate more operating income for Brown, but they too do not meet Brown’s target of 25% increase in operating income. Alternative 3 actually results in lower operating income than under Brown’s current cost structure. There is no reason, however, for Brown to think of these alternatives as being mutually exclusive. For example, Brown can combine actions 1 and 2, automate the machining process and advertise. This will result in a 26.67% increase in operating income as follows:


Sales revenue 5,000 1.20 $60 Variable costs 5,000 1.20 $25 × (1 – 0.20) Contribution margin Fixed costs $100,000 1.15 + $30,000 Operating income

$360,000 120,000 240,000 145,000 $ 95,000

The point of this problem is that managers always need to consider broader rather than narrower alternatives to meet ambitious or stretch goals.

3-38 (20–30 min.) CVP analysis, shoe stores. 1. CMU (SP – VCU = $30 – $21) a. Breakeven units (FC CMU = $360,000 $9 per unit) b. Breakeven revenues (Breakeven units SP = 40,000 units $30 per unit)

$

2. Pairs sold Revenues, 35,000 $30 Total cost of shoes, 35,000 $19.50 Total sales commissions, 35,000 $1.50 Total variable costs Contribution margin Fixed costs Operating income (loss)

35,000 $1,050,000 682,500 52,500 735,000 315,000 360,000 $ (45,000)

3. Unit variable data (per pair of shoes) Selling price Cost of shoes Sales commissions Variable cost per unit Annual fixed costs Rent Salaries, $200,000 + $81,000 Advertising Other fixed costs Total fixed costs

9.00 40,000

$1,200,000

$

$

30.00 19.50 0 19.50

$

60,000 281,000 80,000 20,000 $ 441,000

CMU, $30 – $19.50 a. Breakeven units, $441,000 $10.50 per unit b. Breakeven revenues, 42,000 units $30 per unit

$

10.50 42,000 $1,260,000


4. Unit variable data (per pair of shoes) Selling price Cost of shoes Sales commissions Variable cost per unit Total fixed costs

$

30.00 19.50 1.80 $ 21.30 $ 360,000

CMU, $30 – $21.30 a. Break even units = $360,000 $8.70 per unit b. Break even revenues = 41,380 units $30 per unit 5. Pairs sold Revenues (50,000 pairs $30 per pair) Total cost of shoes (50,000 pairs $19.50 per pair) Sales commissions on first 40,000 pairs (40,000 pairs Sales commissions on additional 10,000 pairs [10,000 pairs ($1.50 + $0.30 per pair)] Total variable costs Contribution margin Fixed costs Operating income

$

$1.50 per pair)

8.70 41,380 (rounded up) $1,241,400

50,000 $1,500,000 $ 975,000 60,000 18,000 $1,053,000 $ 447,000 360,000 $ 87,000

Alternative approach: Breakeven point in units = 40,000 pairs Store manager receives commission of $0.30 on 10,000 (50,000 – 40,000) pairs. Contribution margin per pair beyond breakeven point of 10,000 pairs = $8.70 ($30 – $21 – $0.30) per pair. Operating income = 10,000 pairs $8.70 contribution margin per pair = $87,000.


3-39

(30 min.) CVP analysis, shoe stores (continuation of 3-38). Salaries + Commission Plan

No. of CM units sold per Unit (1) (2) 40,000 $9.00 42,000 9.00 44,000 9.00 46,000 9.00 48,000 9.00 50,000 9.00 52,000 9.00 54,000 9.00 56,000 9.00 58,000 9.00 60,000 9.00 62,000 9.00 64,000 9.00 66,000 9.00

CM (3)=(1) (2) $360,000 378,000 396,000 414,000 432,000 450,000 468,000 486,000 504,000 522,000 540,000 558,000 576,000 594,000

Fixed Costs (4) $360,000 360,000 360,000 360,000 360,000 360,000 360,000 360,000 360,000 360,000 360,000 360,000 360,000 360,000

Operating Income (5)=(3)–(4) 0 18,000 36,000 54,000 72,000 90,000 108,000 126,000 144,000 162,000 180,000 198,000 216,000 234,000

Higher Fixed Salaries Only CM per Unit (6) $10.50 10.50 10.50 10.50 10.50 10.50 10.50 10.50 10.50 10.50 10.50 10.50 10.50 10.50

Operating CM Fixed Costs Income (7)=(1) (6) (8) (9)=(7)–(8) $420,000 $441,000 $ (21,000) 441,000 441,000 0 462,000 441,000 21,000 483,000 441,000 42,000 504,000 441,000 63,000 525,000 441,000 84,000 546,000 441,000 105,000 567,000 441,000 126,000 588,000 441,000 147,000 609,000 441,000 168,000 630,000 441,000 189,000 651,000 441,000 210,000 672,000 441,000 231,000 693,000 441,000 252,000


Difference in favor of higher-fixedsalary-only (10)=(9)–(5) $(21,000) (18,000) (15,000) (12,000) (9,000) (6,000) (3,000) 0 3,000 6,000 9,000 12,000 15,000 18,000

1. See preceding table. The new store will have the same operating income under either compensation plan when the volume of sales is 54,000 pairs of shoes. This can also be calculated as the unit sales level at which both compensation plans result in the same total costs: Let Q = unit sales level at which total costs are same for both plans $19.50Q + $360,000 + $81,000 = $21Q + $360,000 $1.50 Q = $81,000 Q = 54,000 pairs 2. When sales volume is above 54,000 pairs, the higher-fixed-salaries plan results in lower costs and higher operating incomes than the salary-plus-commission plan. So, for an expected volume of 55,000 pairs, the owner would be inclined to choose the higher-fixed-salaries-only plan. But it is likely that sales volume itself is determined by the nature of the compensation plan. The salary-plus-commission plan provides a greater motivation to the salespeople, and it may well be that for the same amount of money paid to salespeople, the salary-plus-commission plan generates a higher volume of sales than the fixed-salary plan. 3.

Let TQ = Target number of units For the salary-only plan, $30.00TQ – $19.50TQ – $441,000 $10.50TQ TQ TQ For the salary-plus-commission plan, $30.00TQ – $21.00TQ – $360,000 $9.00TQ TQ TQ

= $168,000 = $609,000 = $609,000 ÷ $10.50 = 58,000 units = $168,000 = $528,000 = $528,000 ÷ $9.00 = 58,667 units (rounded up)

The decision regarding the salary plan depends heavily on predictions of demand. For instance, the salary plan offers the same operating income at 58,000 units as the commission plan offers at 58,667 units. 4.

WalkRite Shoe Company Operating Income Statement, 2011 Revenues (48,000 pairs $30) + (2,000 pairs $18) Cost of shoes, 50,000 pairs $19.50 Commissions = Revenues 5% = $1,476,000 0.05 Contribution margin Fixed costs Operating income

$1,476,000 975,000 73,800 427,200 360,000 $ 67,200


3-40

(40 min.) Alternative cost structures, uncertainty, and sensitivity analysis.

1. Contribution margin per page assuming current fixed leasing agreement

= $0.15 – $0.03 – $0.04 = $0.08 per page

Fixed costs = $1,000 Breakeven point =

Fixed costs Contribution margin per page

$1, 000 $0.08 per page

12,500 pages

Contribution margin per page assuming $10 per 500 page = $0.15–$0.02a – $0.03 – $.04 = $0.06 per page commission agreement Fixed costs = $0 Breakeven point =

Fixed costs Contribution margin per page

$0 $0.06 per page

0 pages

(i.e., Stylewise makes a profit no matter how few pages it sells) a $10/500 pages = $0.02 per page 2. Let x denote the number of pages Stylewise must sell for it to be indifferent between the fixed leasing agreement and commission based agreement. To calculate x we solve the following equation. $0.15 x – $0.03 x – $0.04 x – $1,000 = $0.15 x – $0.02 x – $0.03 x – $.04 x $0.08 x – $1,000 = $0.06 x $0.02 x = $1,000 x = $1,000 ÷ $0.02 = 50,000 pages For sales between 0 to 50,000 pages, Stylewise prefers the commission based agreement because in this range, $0.06 x > $0.08 x – $1,000. For sales greater than 50,000 pages, Stylewise prefers the fixed leasing agreement because in this range, $0.08 x – $1,000 > $.06 x . 3. Fixed leasing agreement Pages Variable Sold Revenue Costs (1) (2) (3) 20,000 20,000 $.15=$ 3,000 20,000 $.07=$1,400 40,000 40,000 $.15=$ 6,000 40,000 $.07=$2,800 60,000 60,000 $.15=$ 9,000 60,000 $.07=$4,200 80,000 80,000 $.15=$12,000 80,000 $.07=$5,600 100,000 100,000 $.15=$15,000 100,000 $.07=$7,000 Expected value of fixed leasing agreement

Fixed Costs (4) $1,000 $1,000 $1,000 $1,000 $1,000

Operating Income (Loss) (5)=(2)–(3)–(4) $ 600 $2,200 $3,800 $5,400 $7,000

Probability (6) 0.20 0.20 0.20 0.20 0.20


Expected Operating Income (7)=(5) (6) $ 120 440 760 1,080 1,400 $3,800

Commission-based leasing agreement: Pages Variable Sold Revenue Costs (1) (2) (3) 20,000 20,000 $.15=$ 3,000 20,000 $.09=$1,800 40,000 40,000 $.15=$ 6,000 40,000 $.09=$3,600 60,000 60,000 $.15=$ 9,000 60,000 $.09=$5,400 80,000 80,000 $.15=$12,000 80,000 $.09=$7,200 100,000 100,000 $.15=$15,000 100,000 $.09=$9,000 Expected value of commission based agreement

Operating Income (4)=(2)–(3) $1,200 $2,400 $3,600 $4,800 $6,000

Probability (5) 0.20 0.20 0.20 0.20 0.20

Expected Operating Income (6)=(4) (5) $ 240 480 720 960 1,200 $3,600

Stylewise should choose the fixed cost leasing agreement because the expected value is higher than under the commission-based leasing agreement. The range of sales is high enough to make the fixed leasing agreement more attractive.


3-41 (20-30 min.) CVP, alternative cost structures. 1.

Variable cost per computer = $100 + ($15 10) + $50 = $300 Contribution margin per computer = Selling price –Variable cost per computer = $500 – $300 = $200 Breakeven point = Fixed costs ÷ Contribution margin per computer = $4,000 ÷ $200 = 20 computers (per month)

2.

Target number of computers =

=

$4,000 + $5,000 $200

Fixed costs + Target operating income Contribution margin per computer

45 computers

3.

Contribution margin per computer = Selling price – Variable cost per computer = $500 – $200 – $50 = $250 Fixed costs = $4,000 Fixed costs $4, 000 16 computers Breakeven point = Contribution margin per computer $250

4.

Let x be the number of computers for which PC Planet is indifferent between paying a monthly rental fee for the retail space and paying a 20% commission on sales. PC Planet will be indifferent when the profits under the two alternatives are equal. $500 x – $300 x – $4,000 = $500 x – $300 x – $500 (0.20) x $200 x – $4,000 = $100 x $100 x = $4,000 x = 40 computers

For sales between 0 and 40 computers, PC Planet prefers to pay the 20% commission because in this range, $100 x > $200 x – $4,000. For sales greater than 40 computers, the company prefers to pay the monthly fixed rent of $4,000 because $200 x – $4,000 > $100 x


3-42

(30 min.)

CVP analysis, income taxes, sensitivity.

1a.To breakeven, Agro Engine Company must sell 1,200 units. This amount represents the point where revenues equal total costs. Let Q denote the quantity of engines sold. Revenue = Variable costs + Fixed costs $3,000Q = $500Q + $3,000,000 $2,500Q = $3,000,000 Q = 1,200 units Breakeven can also be calculated using contribution margin per unit. Contribution margin per unit = Selling price – Variable cost per unit = $3,000 – $500 = $2,500 Breakeven = Fixed Costs Contribution margin per unit = $3,000,000 $2,500 = 1,200 units 1b. To achieve its net income objective, Agro Engine Company must sell 2,000 units. This amount represents the point where revenues equal total costs plus the corresponding operating income objective to achieve net income of $1,500,000. Revenue = Variable costs + Fixed costs + [Net income ÷ (1 – Tax rate)] $3,000Q = $500Q + $3,000,000 + [$1,500,000 (1 0.25)] $3,000Q = $500Q + $3,000,000 + $2,000,000 Q = 2,000 units 2. To achieve its net income objective, Agro Engine Company should select alternative c, where fixed costs are reduced by 20% and selling price is reduced by 10% resulting in 1,700 additional units being sold through the end of the year. This alternative results in the highest net income and is the only alternative that equals or exceeds the company’s net income objective of $1,500,000. Calculations for the three alternatives are shown below. Alternative a Revenues = Variable costs = Operating income Net income = a

($3,000 300) + ($2,400a 2,000) = $5,700,000 $500 2,300b = $1,150,000 = $5,700,000 $1,150,000 $3,000,000 = $1,550,000 $1,550,000 (1 0.25) = $1,162,500

$3,000 – ($3,000 × 0.20) = ;

b

300 units + 2,000 units.


Alternative b Revenues = Variable costs = Operating income Net income = c

($3,000 300) + ($2,750c 1,800) = $5,850,000 ($500 300) + ($450d 1,800) = $960,000 = $5,850,000 $960,000 $3,000,000 = $1,890,000 $1,890,000 (1 0.25) = $1,417,500

$3,000 – $250; d$450.

Alternative c Revenues Variable costs Operating income Net income

= = = =

($3,000 300) + ($2,700e 1,700) = $5,490,000 $500 2000f = $1,000,000 $5,490,000 $1,000,000 $2,400,000g = $2,090,000 $2,090,000 (1 0.25) = $1,567,500

e

$3,000 – (0.10 $3,000) = $3,000 – $300; f300units + 1,700 units; $3,000,000 – (0.20 × $3,000,000)

g


3-43

(30 min.) Choosing between compensation plans, operating leverage.

1. We can recast Marston’s income statement to emphasize contribution margin, and then use it to compute the required CVP parameters. Marston Corporation Income Statement For the Year Ended December 31, 2011 Using Sales Agents $26,000,000

Revenues Variable Costs Cost of goods sold—variable Marketing commissions Contribution margin Fixed Costs Cost of goods sold—fixed Marketing—fixed Operating income

$11,700,000 4,680,000

16,380,000 9,620,000

2,870,000 3,420,000

6,290,000 $ 3,330,000

Contribution margin percentage ($9,620,000 26,000,000; $11,700,000 $26,000,000) Breakeven revenues ($6,290,000 0.37; $8,370,000 0.45) Degree of operating leverage ($9,620,000 $3,330,000; $11,700,000 $3,330,000)

Using Own Sales Force $26,000,000 $11,700,000 2,600,000

2,870,000 5,500,000

14,300,000 11,700,000

8,370,000 $ 3,330,000

37%

45%

$17,000,000

$18,600,000

2.89

3.51

The calculations indicate that at sales of $26,000,000, a percentage change in sales and contribution margin will result in 2.89 times that percentage change in operating income if Marston continues to use sales agents and 3.51 times that percentage change in operating income if Marston employs its own sales staff. The higher contribution margin per dollar of sales and higher fixed costs gives Marston more operating leverage, that is, greater benefits (increases in operating income) if revenues increase but greater risks (decreases in operating income) if revenues decrease. Marston also needs to consider the skill levels and incentives under the two alternatives. Sales agents have more incentive compensation and hence may be more motivated to increase sales. On the other hand, Marston’s own sales force may be more knowledgeable and skilled in selling the company’s products. That is, the sales volume itself will be affected by who sells and by the nature of the compensation plan. 2.

3.

Variable costs of marketing Fixed marketing costs

Operating income = Revenues

= 15% of Revenues = $5,500,000

Variable manuf. costs

Fixed manuf. costs

Variable marketing costs

Fixed marketing costs

Denote the revenues required to earn $3,330,000 of operating income by R, then


R

0.45R

3-44

$2,870,000

0.15R $5,500,000 = $3,330,000 R 0.45R 0.15R = $3,330,000 + $2,870,000 + $5,500,000 0.40R = $11,700,000 R = $11,700,000 0.40 = $29,250,000

(15–25 min.) Sales mix, three products.

1. Sales of A, B, and C are in ratio 20,000 : 100,000 : 80,000. So for every 1 unit of A, 5 (100,000 ÷ 20,000) units of B are sold, and 4 (80,000 ÷ 20,000) units of C are sold. Contribution margin of the bundle = 1 $3 + 5 $2 + 4 $1 = $3 + $10 + $4 = $17 $255,000 Breakeven point in bundles = = 15,000 bundles $17 Breakeven point in units is: Product A: 15,000 bundles × 1 unit per bundle 15,000 units Product B: 15,000 bundles × 5 units per bundle 75,000 units Product C: 15,000 bundles × 4 units per bundle 60,000 units Total number of units to breakeven 150,000 units Alternatively, Let Q = Number of units of A to break even 5Q = Number of units of B to break even 4Q = Number of units of C to break even Contribution margin – Fixed costs = Zero operating income $3Q + $2(5Q) + $1(4Q) – $255,000 $17Q Q 5Q 4Q Total 2.

Contribution margin: A: 20,000 $3 B: 100,000 $2 C: 80,000 $1 Contribution margin Fixed costs Operating income

= 0 = $255,000 = 15,000 ($255,000 ÷ $17) units of A = 75,000 units of B = 60,000 units of C = 150,000 units $ 60,000 200,000 80,000 $340,000 255,000 $ 85,000


3.

Contribution margin A: 20,000 $3 B: 80,000 $2 C: 100,000 $1 Contribution margin Fixed costs Operating income

$ 60,000 160,000 100,000 $320,000 255,000 $ 65,000

Sales of A, B, and C are in ratio 20,000 : 80,000 : 100,000. So for every 1 unit of A, 4 (80,000 ÷ 20,000) units of B and 5 (100,000 ÷ 20,000) units of C are sold. Contribution margin of the bundle = 1 $3 + 4 $2 + 5 $1 = $3 + $8 + $5 = $16 $255,000 Breakeven point in bundles = = 15,938 bundles (rounded up) $16 Breakeven point in units is: Product A: 15,938 bundles × 1 unit per bundle 15,938 units Product B: 15,938 bundles × 4 units per bundle 63,752 units Product C: 15,938 bundles × 5 units per bundle 79,690 units Total number of units to breakeven 159,380 units Alternatively, Let Q = Number of units of A to break even 4Q = Number of units of B to break even 5Q = Number of units of C to break even Contribution margin – Fixed costs = Breakeven point $3Q + $2(4Q) + $1(5Q) – $255,000 $16Q Q 4Q 5Q Total

= 0 = $255,000 = 15,938 ($255,000 ÷ $16) units of A (rounded up) = 63,752 units of B = 79,690 units of C = 159,380 units

Breakeven point increases because the new mix contains less of the higher contribution margin per unit, product B, and more of the lower contribution margin per unit, product C.


3-45 (40 min.) Multi-product CVP and decision making. 1. Faucet filter: Selling price Variable cost per unit Contribution margin per unit

$80 20 $60

Pitcher-cum-filter: Selling price Variable cost per unit Contribution margin per unit

$90 25 $65

Each bundle contains 2 faucet models and 3 pitcher models. So contribution margin of a bundle = 2 $60 + 3 $65 = $315

Breakeven Fixed costs point in = Contribution margin per bundle bundles

$945,000 $315

3,000 bundles

Breakeven point in units of faucet models and pitcher models is: Faucet models: 3,000 bundles 2 units per bundle = 6,000 units Pitcher models: 3,000 bundles 3 units per bundle = 9,000 units Total number of units to breakeven 15,000 units Breakeven point in dollars for faucet models and pitcher models is: Faucet models: 6,000 units $80 per unit = $ 480,000 Pitcher models: 9,000 units $90 per unit = 810,000 Breakeven revenues $1,290,000 Alternatively, weighted average contribution margin per unit = Breakeven point =

$945,000 15,000 units $63

(2 $60) + (3 $65) = $63 5

2 15,000 units = 6,000 units 5 3 Pitcher-cum-filter: 15,000 units 9,000 units 5 Breakeven point in dollars Faucet filter: 6,000 units $80 per unit = $480,000 Pitcher-cum-filter: 9,000 units $90 per unit = $810,000 Faucet filter:

2. Faucet filter: Selling price Variable cost per unit Contribution margin per unit

$80 15 $65


Pitcher-cum-filter: Selling price Variable cost per unit Contribution margin per unit

$90 16 $74

Each bundle contains 2 faucet models and 3 pitcher models. So contribution margin of a bundle = 2 $65 + 3 $74 = $352

Breakeven Fixed costs point in = Contribution margin per bundle bundles

$945,000 $181, 400 $352

3, 200 bundles

Breakeven point in units of faucet models and pitcher models is: Faucet models: 3,200 bundles 2 units per bundle = 6,400 units Pitcher models: 3,200 bundles 3 units per bundle = 9,600 units Total number of units to breakeven 16,000 units Breakeven point in dollars for faucet models and pitcher models is: Faucet models: 6,400 bundles $80 per unit = $ 512,000 Pitcher models: 9,600 bundles $90 per unit = 864,000 Breakeven revenues $1,376,000 Alternatively, weighted average contribution margin per unit = Breakeven point =

$945,000 + $181,400 $70.40

(2 $65) + (3 $74) = $70.40 5

16, 000 units

2 16,000 units = 6,400 units 5 3 Pitcher-cum-filter: 16, 000 units 9, 600 units 5 Breakeven point in dollars: Faucet filter: 6,400 units $80 per unit = $512,000 Pitcher-cum-filter: 9,600 units $90 per unit = $864,000 Faucet filter:

3. Let x be the number of bundles for Pure Water Products to be indifferent between the old and new production equipment. Operating income using old equipment = $315 x – $945,000 Operating income using new equipment = $352 x – $945,000 – $181,400 At point of indifference: $315 x – $945,000 = $352 x – $1,126,400 $352 x – $315 x = $1,126,400 – $945,000 $37 x = $181,400 x = $181,400 ÷ $37 = 4,902.7 bundles = 4,903 bundles (rounded) 3-44 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Faucet models = 4,903 bundles 2 units per bundle = 9,806 units Pitcher models = 4,903 bundles 3 units per bundle = 14,709 units Total number of units 24,515 units Let x be the number of bundles, When total sales are less than 24,515 units (4,903 bundles), $315x $945,000 > $352x $1,126,400, so Pure Water Products is better off with the old equipment. When total sales are greater than 24,515 units (4,903 bundles), $352x $1,126,400 > $315x $945,000, so Pure Water Products is better off buying the new equipment.

At total sales of 30,000 units (6,000 bundles), Pure Water Products should buy the new production equipment. Check $352 6,000 – $1,126,400 = $985,600 is greater than $315 6,000 –$945,000 = $945,000. 3-46

(20–25 min.) Sales mix, two products.

1. Sales of standard and deluxe carriers are in the ratio of 187,500 : 62,500. So for every 1 unit of deluxe, 3 (187,500 ÷ 62,500) units of standard are sold. Contribution margin of the bundle = 3 $10 + 1 $20 = $30 + $20 = $50 $2, 250, 000 Breakeven point in bundles = = 45,000 bundles $50 Breakeven point in units is: Standard carrier: 45,000 bundles × 3 units per bundle 135,000 units Deluxe carrier: 45,000 bundles × 1 unit per bundle 45,000 units Total number of units to breakeven 180,000 units Alternatively, Let Q = Number of units of Deluxe carrier to break even 3Q = Number of units of Standard carrier to break even Revenues – Variable costs – Fixed costs = Zero operating income $28(3Q) + $50Q – $18(3Q) – $30Q – $2,250,000 = $84Q + $50Q – $54Q – $30Q = $50Q = Q = 3Q =

0 $2,250,000 $2,250,000 45,000 units of Deluxe 135,000 units of Standard

The breakeven point is 135,000 Standard units plus 45,000 Deluxe units, a total of 180,000 units.


2a.

2b.

Unit contribution margins are: Standard: $28 – $18 = $10; Deluxe: $50 – $30 = $20 If only Standard carriers were sold, the breakeven point would be: $2,250,000 $10 = 225,000 units. If only Deluxe carriers were sold, the breakeven point would be: $2,250,000 $20 = 112,500 units

3. Operating income = Contribution margin of Standard + Contribution margin of Deluxe - Fixed costs = 200,000($10) + 50,000($20) – $2,250,000 = $2,000,000 + $1,000,000 – $2,250,000 = $750,000

Sales of standard and deluxe carriers are in the ratio of 200,000 : 50,000. So for every 1 unit of deluxe, 4 (200,000 ÷ 50,000) units of standard are sold. Contribution margin of the bundle = 4 $10 + 1 $20 = $40 + $20 = $60 $2, 250, 000 Breakeven point in bundles = = 37,500 bundles $60 Breakeven point in units is: Standard carrier: 37,500 bundles × 4 units per bundle 150,000 units Deluxe carrier: 37,500 bundles × 1 unit per bundle 37,500 units Total number of units to breakeven 187,500 units Alternatively, Let Q = Number of units of Deluxe product to break even 4Q = Number of units of Standard product to break even $28(4Q) + $50Q – $18(4Q) – $30Q – $2,250,000 $112Q + $50Q – $72Q – $30Q $60Q Q 4Q

= = = = =

0 $2,250,000 $2,250,000 37,500 units of Deluxe 150,000 units of Standard

The breakeven point is 150,000 Standard +37,500 Deluxe, a total of 187,500 units. The major lesson of this problem is that changes in the sales mix change breakeven points and operating incomes. In this example, the budgeted and actual total sales in number of units were identical, but the proportion of the product having the higher contribution margin declined. Operating income suffered, falling from $875,000 to $750,000. Moreover, the breakeven point rose from 180,000 to 187,500 units.


3-47 1.

(20 min.) Gross margin and contribution margin. Ticket sales ($24 525 attendees) Variable cost of dinner ($12a 525 attendees) Variable invitations and paperwork ($1b 525) Contribution margin Fixed cost of dinner Fixed cost of invitations and paperwork Operating profit (loss) a b

2.

Ticket sales ($24 1,050 attendees) Variable cost of dinner ($12 1,050 attendees) Variable invitations and paperwork ($1 1,050) Contribution margin Fixed cost of dinner Fixed cost of invitations and paperwork Operating profit (loss) (30 min.)

1.

Contribution margin percentage =

10,975 $ (5,200)

$25,200 $12,600 1,050 9,000 1,975

13,650 11,550 10,975 $ 575

Ethics, CVP analysis.

= = Breakeven revenues

= =

Revenues Variable costs Revenues $5,000,000 $3,000,000 $5,000,000 $2,000,000 = 40% $5,000,000 Fixed costs Contributi on margin percentage $2,160,000 = $5,400,000 0.40

If variable costs are 52% of revenues, contribution margin percentage equals 48% (100% 52%) Breakeven revenues

= =

3.

9,000 1,975

6,825 5,775

$6,300/525 attendees = $12/attendee $525/525 attendees = $1/attendee

3-48

2.

$12,600 $6,300 525

Revenues Variable costs (0.52 Fixed costs Operating income

Fixed costs Contributi on margin percentage $2,160,000 = $4,500,000 0.48

$5,000,000 2,600,000 2,160,000 $ 240,000

$5,000,000)


4. Incorrect reporting of environmental costs with the goal of continuing operations is unethical. In assessing the situation, the specific ―Standards of Ethical Conduct for Management Accountants‖ (described in Exhibit 1-7) that the management accountant should consider are listed below. Competence Clear reports using relevant and reliable information should be prepared. Preparing reports on the basis of incorrect environmental costs to make the company’s performance look better than it is violates competence standards. It is unethical for Bush not to report environmental costs to make the plant’s performance look good. Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Bush may be tempted to report lower environmental costs to please Lemond and Woodall and save the jobs of his colleagues. This action, however, violates the responsibility for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. Credibility The management accountant’s Standards of Ethical Conduct require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, underreporting environmental costs to make performance look good would violate the standard of objectivity. Bush should indicate to Lemond that estimates of environmental costs and liabilities should be included in the analysis. If Lemond still insists on modifying the numbers and reporting lower environmental costs, Bush should raise the matter with one of Lemond’s superiors. If after taking all these steps, there is continued pressure to understate environmental costs, Bush should consider resigning from the company and not engage in unethical behavior.


3-49

(35 min.) Deciding where to produce. Peoria

Selling price Variable cost per unit Manufacturing Marketing and distribution Contribution margin per unit (CMU) Fixed costs per unit Manufacturing Marketing and distribution Operating income per unit

Moline $150.00

$72.00 14.00

30.00 19.00

86.00 64.00

49.00 $ 15.00

CMU of normal production (as shown above) CMU of overtime production ($64 – $3; $48 – $8) 1. Annual fixed costs = Fixed cost per unit Daily production rate Normal annual capacity ($49 400 units 240 days; $29.50 320 units 240 days) Breakeven volume = FC CMU of normal production ($4,704,000 $64; $2,265,600 48) 2. Units produced and sold Normal annual volume (units) (400 × 240; 320 × 240) Units over normal volume (needing overtime) CM from normal production units (normal annual volume CMU normal production) (96,000 × $64; 76,800 × 48) CM from overtime production units (0; 19,200 $40) Total contribution margin Total fixed costs Operating income Total operating income

$150.00 $88.00 14.00

15.00 14.50

102.00 48.00

29.50 $ 18.50

$64

$48

61

40

$4,704,000

$2,265,600

73,500 units

47,200 units

96,000

96,000

96,000 0

76,800 19,200

$6,144,000

$3,686,400

0 6,144,000 4,704,000 $1,440,000

768,000 4,454,400 2,265,600 $2,188,800 $3,628,800

3. The optimal production plan is to produce 120,000 units at the Peoria plant and 72,000 units at the Moline plant. The full capacity of the Peoria plant, 120,000 units (400 units × 300 days), should be used because the contribution from these units is higher at all levels of production than is the contribution from units produced at the Moline plant.


Contribution margin per plant: Peoria, 96,000 × $64 Peoria 24,000 × ($64 – $3) Moline, 72,000 × $48 Total contribution margin Deduct total fixed costs Operating income

$ 6,144,000 1,464,000 3,456,000 11,064,000 6,969,600 $ 4,094,400

The contribution margin is higher when 120,000 units are produced at the Peoria plant and 72,000 units at the Moline plant. As a result, operating income will also be higher in this case since total fixed costs for the division remain unchanged regardless of the quantity produced at each plant.


CHAPTER 4 JOB COSTING 4-1

Cost pool––a grouping of individual indirect cost items. Cost tracing––the assigning of direct costs to the chosen cost object. Cost allocation––the assigning of indirect costs to the chosen cost object. Cost-allocation base––a factor that links in a systematic way an indirect cost or group of indirect costs to cost objects.

4-2 In a job-costing system, costs are assigned to a distinct unit, batch, or lot of a product or service. In a process-costing system, the cost of a product or service is obtained by using broad averages to assign costs to masses of identical or similar units. 4-3 An advertising campaign for Pepsi is likely to be very specific to that individual client. Job costing enables all the specific aspects of each job to be identified. In contrast, the processing of checking account withdrawals is similar for many customers. Here, process costing can be used to compute the cost of each checking account withdrawal. 4-4 The seven steps in job costing are: (1) identify the job that is the chosen cost object, (2) identify the direct costs of the job, (3) select the cost-allocation bases to use for allocating indirect costs to the job, (4) identify the indirect costs associated with each cost-allocation base, (5) compute the rate per unit of each cost-allocation base used to allocate indirect costs to the job, (6) compute the indirect costs allocated to the job, and (7) compute the total cost of the job by adding all direct and indirect costs assigned to the job. 4-5 Major cost objects that managers focus on in companies using job costing are a product such as a specialized machine, a service such as a repair job, a project such as running the Expo, or a task such as an advertising campaign. 4-6 Three major source documents used in job-costing systems are (1) job cost record or job cost sheet, a document that records and accumulates all costs assigned to a specific job, starting when work begins (2) materials requisition record, a document that contains information about the cost of direct materials used on a specific job and in a specific department; and (3) labor-time sheet, a document that contains information about the amount of labor time used for a specific job in a specific department. 4-7 The main advantages of using computerized source documents for job cost records are the accuracy of the records and the ability to provide managers with instantaneous feedback to help control job costs. 4-8 a. b.

Two reasons for using an annual budget period are The numerator reason––the longer the time period, the less the influence of seasonal patterns in overhead costs, and The denominator reason––the longer the time period, the less the effect of variations in output levels or quantities of the cost-allocation bases on the allocation of fixed costs.


4-9 Actual costing and normal costing differ in their use of actual or budgeted indirect cost rates: Actual Normal Costing Costing Direct-cost rates Actual rates Actual rates Indirect-cost rates Actual rates Budgeted rates Each costing method uses the actual quantity of the direct-cost input and the actual quantity of the cost-allocation base. 4-10 A house construction firm can use job cost information (a) to determine the profitability of individual jobs, (b) to assist in bidding on future jobs, and (c) to evaluate professionals who are in charge of managing individual jobs. 4-11 The statement is false. In a normal costing system, the Manufacturing Overhead Control account will not, in general, equal the amounts in the Manufacturing Overhead Allocated account. The Manufacturing Overhead Control account aggregates the actual overhead costs incurred while Manufacturing Overhead Allocated allocates overhead costs to jobs on the basis of a budgeted rate times the actual quantity of the cost-allocation base. Underallocation or overallocation of indirect (overhead) costs can arise because of (a) the Numerator reason––the actual overhead costs differ from the budgeted overhead costs, and (b) the Denominator reason––the actual quantity used of the allocation base differs from the budgeted quantity. 4-12 Debit entries to Work-in-Process Control represent increases in work in process. Examples of debit entries under normal costing are (a) direct materials used (credit to Materials Control), (b) direct manufacturing labor billed to job (credit to Wages Payable Control), and (c) manufacturing overhead allocated to job (credit to Manufacturing Overhead Allocated). 4-13 Alternative ways to make end-of-period adjustments to dispose of underallocated or overallocated overhead are as follows: (i) Proration based on the total amount of indirect costs allocated (before proration) in the ending balances of work in process, finished goods, and cost of goods sold. (ii) Proration based on total ending balances (before proration) in work in process, finished goods, and cost of goods sold. (iii) Year-end write-off to Cost of Goods Sold. (iv) The adjusted allocation rate approach that restates all overhead entries using actual indirect cost rates rather than budgeted indirect cost rates. 4-14 A company might use budgeted costs rather than actual costs to compute direct labor rates because it may be difficult to trace direct labor costs to jobs as they are completed (for example, because bonuses are only known at the end of the year). 4-15 Modern technology of electronic data interchange (EDI) is helpful to managers because it ensures that a purchase order is transmitted quickly and accurately to suppliers with minimum paperwork and costs.


4-16 a. b. c. d. e. f. g. h. i. j. k.

(10 min) Job order costing, process costing.

Job costing Process costing Job costing Process costing Job costing Process costing Job costing Job costing (but some process costing) Process costing Process costing Job costing

l. m. n. o. p. q. r. s. t. u.

Job costing Process costing Job costing Job costing Job costing Job costing Process costing Job costing Process costing Job costing


4-17

1.

(20 min.) Actual costing, normal costing, accounting for manufacturing overhead.

Budgeted manufacturing overhead rate

Actual manufactur ing overhead rate

=

Budgeted manufactur ing overhead costs Budgeted direct manufactur ing labor costs

=

$2, 700, 000 = 1.80 or 180% $1,500, 000

=

Actual manufactur ing overhead costs Actual direct manufactur ing labor costs

$2, 755, 000 = 1.9 or 190% $1, 450, 000 Costs of Job 626 under actual and normal costing follow:

=

2.

Actual Costing Direct materials Direct manufacturing labor costs Manufacturing overhead costs $30,000 1.90; $30,000 1.80 Total manufacturing costs of Job 626 3.

Total manufacturing overhead allocated under normal costing =

$ 40,000 30,000

$ 40,000 30,000

57,000 $127,000

54,000 $124,000

Actual manufacturing labor costs

= $1,450,000

Normal Costing

Budgeted overhead rate

1.80

= $2,610,000 Underallocated manufacturing = overhead

Actual manufacturing – Manufacturing overhead costs overhead allocated

= $2,755,000

$2,610,000 = $145,000

There is no under- or overallocated overhead under actual costing because overhead is allocated under actual costing by multiplying actual manufacturing labor costs and the actual manufacturing overhead rate. This, of course equals the actual manufacturing overhead costs. All actual overhead costs are allocated to products. Hence, there is no under- or overallocated overhead.


4-18 1.

(20 -30 min.) Job costing, normal and actual costing. Budgeted indirectcost rate

=

Budgeted indirect costs (assembly support) $8,300,000 = Budgeted direct labor-hours 166,000 hours

= $50 per direct labor-hour Actual indirectcost rate

=

$6,520,000 Actual indirect costs (assembly support) = 163,000 hours Actual direct labor-hours

= $40 per direct labor-hour These rates differ because both the numerator and the denominator in the two calculations are different—one based on budgeted numbers and the other based on actual numbers. 2a.

Laguna Model Normal costing Direct costs Direct materials Direct labor

Indirect costs Assembly support ($50 Total costs 2b. Actual costing Direct costs Direct materials Direct labor Indirect costs Assembly support ($40 Total costs

960; $50

960; $40

1,050)

1,050)

Mission Model

$106,760 36,950 143,710

$127,550 41,320 168,870

48,000 $191,710

52,500 $221,370

$106,760 36,950 143,710

$127,550 41,320 168,870

38,400 $182,110

42,000 $210,870

3. Normal costing enables Amesbury to report a job cost as soon as the job is completed, assuming that both the direct materials and direct labor costs are known at the time of use. Once the 960 direct labor-hours are known for the Laguna Model (June 2011), Amesbury can compute the $191,710 cost figure using normal costing. Amesbury can use this information to manage the costs of the Laguna Model job as well as to bid on similar jobs later in the year. In contrast, Amesbury has to wait until the December 2011 year-end to compute the $182,110 cost of the Laguna Model using actual costing. Although not required, the following overview diagram summarizes Amesbury Construction’s job-costing system.


INDIRECT COST POOL

Assembly Support

COST ALLOCATION BASE

Direct Labor-Hours

COST OBJECT: RESIDENTIAL HOME

Indirect Costs Direct Costs

DIRECT COSTS

Direct Materials

Direct Manufacturing Labor


4-19

(10 min.) Budgeted manufacturing overhead rate, allocated manufacturing overhead.

1.

Budgeted manufacturing overhead rate =

= 2.

Manufacturing overhead allocated

=

Budgeted manufacturing overhead Budgeted machine hours $4, 200, 000 = $24 per machine-hour 175, 000 machine-hours

Actual machine-hours

Budgeted manufacturing overhead rate

= 170,000 × $24 = $4,080,000 3. Since manufacturing overhead allocated is greater than the actual manufacturing overhead costs, Gammaro overallocated manufacturing overhead: Manufacturing overhead allocated Actual manufacturing overhead costs Overallocated manufacturing overhead

$4,080,000 4,050,000 $ 30,000


4-20

(20-30 min.) Job costing, accounting for manufacturing overhead, budgeted rates.

1.

An overview of the product costing system is INDIRECT COST POOL


Machining Department Manufacturing Overhead

Assembly Department Manufacturing Overhead

Machine-Hours

Indirect Costs

COST OBJECT: PRODUCT

DIRECT COST

Direct Manuf. Labor Cost

Direct Costs


Direct Materials

Budgeted manufacturing overhead divided by allocation base: Machining overhead: Assembly overhead: 2.

$1,800 ,000 = $36 per machine-hour 50,000 $3,600 ,000 = 180% of direct manuf. labor costs $2,000 ,000

Machining department, 2,000 hours $36 Assembly department, 180% $15,000 Total manufacturing overhead allocated to Job 494

3.

$72,000 27,000 $99,000

Machining Assembly $2,100,000 $ 3,700,000

Actual manufacturing overhead Manufacturing overhead allocated, $36 55,000 machine-hours 180% $2,200,000 Underallocated (Overallocated)

1,980,000 — $ 120,000

— 3,960,000 $ (260,000)


4-21

(20 25 min.) Job costing, consulting firm.

1.

Budgeted indirect-cost rate for client support can be calculated as follows: Budgeted indirect-cost rate = $13,600,000 ÷ $5,312,500 = 256% of professional labor costs

INDIRECT COST POOL

Client Consulting Consulting Support Support


Professional Professional Labor LaborCosts Costs

COST OBJECT: JOB FOR CONSULTING CLIENT


DIRECT COSTS

2.

Professional Labor

At the budgeted revenues of $21,250,000 Taylor’s operating income of $2,337,500 equals 11% of revenues. Markup rate = $21,250,000 ÷ $5,312,500 = 400% of direct professional labor costs


3.

Budgeted costs Direct costs: Director, $198 4 $ 792 Partner, $101 17 1,717 Associate, $49 42 2,058 Assistant, $36 153 5,508 Indirect costs: Consulting support, 256% $10,075 Total costs

$10,075 25,792 $35,867

As calculated in requirement 2, the bid price to earn an 11% income-to-revenue margin is 400% of direct professional costs. Therefore, Taylor should bid 4 $10,075 = $40,300 for the Red Rooster job. Bid price to earn target operating income-to-revenue margin of 11% can also be calculated as follows: Let R = revenue to earn target income R – 0.11R = $35,867 0.89R = $35,867 R = $35,867 ÷ 0.89 = $40,300 Or Direct costs Indirect costs Operating income (0.11 Bid price

$40,300)

$10,075 25,792 4,433 $40,300


4-22

(15–20 min.) Time period used to compute indirect cost rates.

1. (1) (2) (3) (4)

Pools sold Direct manufacturing labor hours (0.5 Row 1) Fixed manufacturing overhead costs Budgeted fixed manufacturing overhead rate per direct manufacturing labor hour ($10,500 Row 2)

Quarter 3 150

1 700

2 500

350

250

$10,500

$10,500

$30

$42

Direct material costs ($7.50 500 pools; 150 pools) Direct manufacturing labor costs ($16 250 hours; 75 hours) Variable manufacturing overhead costs ($12 250 hours; 75 hours) Fixed manufacturing overhead costs ($42 250 hours; $140 × 75 hours) Total manufacturing costs Divided by pools manufactured each quarter Manufacturing cost per pool

75 $10,500

$140

4 150

Annual 1,500

75

750

$10,500

$140

$56

Budgeted Costs Based on Quarterly Manufacturing Overhead Rate nd 2 Quarter 3rd Quarter $ 3,750 $ 1,125 4,000 3,000 10,500 $21,250 ÷ 500 $ 42.50

1,200 900 10,500 $13,725 ÷ 150 $ 91.50

2.

Direct material costs ($7.50 500 pools; 150 pools) Direct manufacturing labor costs ($16 250 hours; 75 hours) Variable manufacturing overhead costs ($12 250 hours; 75 hours) Fixed manufacturing overhead costs ($56 250 hours; 75 hours) Total manufacturing costs Divided by pools manufactured each quarter Manufacturing cost per pool

Budgeted Costs Based on Annual Manufacturing Overhead Rate 2nd Quarter 3rd Quarter $ 3,750 $1,125 4,000 3,000 14,000 $24,750 500 $ 49.50

$42,000

1,200 900 4,200 $7,425 150 $49.50


3. Prices based on quarterly budgeted manufacturing overhead rates calculated in requirement 1 ($42.50 130%; $91.50 130%) Price based on annual budgeted manufacturing overhead rates calculated in requirement 2 ($49.50 130%; $49.50 130%)

2nd Quarter

3rd Quarter

$55.25

$118.95

$64.35

$64.35

Splash should use the budgeted annual manufacturing overhead rate because capacity decisions are based on longer annual periods rather than quarterly periods. Prices should not vary based on quarterly fluctuations in production. Splash could vary prices based on market conditions and demand for its pools. In this case, Splash would charge higher prices in quarter 2 when demand for its pools is high. Pricing based on quarterly budgets would cause Splash to do the opposite— to decrease rather than increase prices!


4-23 1.

(10–15 min.) Accounting for manufacturing overhead. Budgeted manufacturing overhead rate =

$7,500, 000 250,000 machine-hours

= $30 per machine-hour 2.

Work-in-Process Control Manufacturing Overhead Allocated (245,000 machine-hours $30 per machine-hour = $7,350,000)

7,350,000 7,350,000

3. $7,350,000– $7,300,000 = $50,000 overallocated, an insignificant amount of actual manufacturing overhead costs $50,000 ÷ $7,300,000 = 0.68%. Manufacturing Overhead Allocated Manufacturing Department Overhead Control Cost of Goods Sold

7,350,000 7,300,000 50,000


4-24

(35 45 min.) Job costing, journal entries.

Some instructors may also want to assign Exercise 4-25. It demonstrates the relationships of the general ledger to the underlying subsidiary ledgers and source documents. 1.

An overview of the product costing system is:

INDIRECT COST POOL


Manufacturing Overhead

Direct Manufacturing Labor Costs

Indirect Costs

COST OBJECT: PRINT JOB

DIRECT COST

Direct Costs

Direct Materials

Direct Manuf. Labor


2. & 3. This answer assumes COGS given of $4,020 does not include the writeoff of overallocated manufacturing overhead. 2.

(1) Materials Control Accounts Payable Control (2) Work-in-Process Control Materials Control (3) Manufacturing Overhead Control Materials Control (4) Work-in-Process Control Manufacturing Overhead Control Wages Payable Control (5) Manufacturing Overhead Control Accumulated Depreciation––buildings and manufacturing equipment (6) Manufacturing Overhead Control Miscellaneous accounts (7) Work-in-Process Control Manufacturing Overhead Allocated (1.60 $1,300 = $2,080) (8) Finished Goods Control Work-in-Process Control (9) Accounts Receivable Control (or Cash) Revenues (10) Cost of Goods Sold Finished Goods Control (11) Manufacturing Overhead Allocated Manufacturing Overhead Control Cost of Goods Sold

800 800 710 710 100 100 1,300 900 2,200 400 400 550 550 2,080 2,080 4,120 4,120 8,000 8,000 4,020 4,020 2,080 1,950 130


3. Bal. 1/1/2011 (1) Accounts Payable Control (Purchases) Bal. 12/31/2011

Bal. 1/1/2011 (2) Materials Control (Direct materials) (4) Wages Payable Control (Direct manuf. labor) (7) Manuf. Overhead Allocated Bal. 12/31/2011

Bal. 1/1/2011 (8) WIP Control (Goods completed) Bal. 12/31/2011

(10) Finished Goods Control (Goods sold) Bal. 12/31/2011

Materials Control 100 (2) Work-in-Process Control (Materials used) 800 (3) Manufacturing Overhead Control (Materials used) 90 Work-in-Process Control 60 (8) Finished Goods Control (Goods completed) 710

100

4,120

1,300 2,080 30 Finished Goods Control 500 (10) Cost of Goods Sold

4,020

4,120 600 Cost of Goods Sold (11) Manufacturing Overhead 4,020 Allocated (Adjust for overallocation) 3,890

Manufacturing Overhead Control (3) Materials Control (11) To close (Indirect materials) 100 (4) Wages Payable Control (Indirect manuf. labor) 900 (5) Accum. Deprn. Control (Depreciation) 400 (6) Accounts Payable Control (Miscellaneous) 550 Bal. 0

(11) To close

710

Manufacturing Overhead Allocated 2,080 (7) Work-in-Process Control (Manuf. overhead allocated) Bal.

130

1,950

2,080 0


4-25

(35 minutes) Journal entries, T-accounts, and source documents.

1. i. Direct Materials Control 124,000 Accounts Payable Control Source Document: Purchase Invoice, Receiving Report Subsidiary Ledger: Direct Materials Record, Accounts Payable

124,000

ii. Work in Process Control a 122,000 Direct Materials Control 122,000 Source Document: Material Requisition Records, Job Cost Record Subsidiary Ledger: Direct Materials Record, Work-in-Process Inventory Records by Jobs iii. Work in Process Control 80,000 Manufacturing Overhead Control 54,500 Wages Payable Control 134,500 Source Document: Labor Time Sheets, Job Cost Records Subsidiary Ledger:, Manufacturing Overhead Records, Employee Labor Records, Work-inProcess Inventory Records by Jobs iv. Manufacturing Overhead Control 129,500 Salaries Payable Control 20,000 Accounts Payable Control 9,500 Accumulated Depreciation Control 30,000 Rent Payable Control 70,000 Source Document: Depreciation Schedule, Rent Schedule, Maintenance wages due, Invoices for miscellaneous factory overhead items Subsidiary Ledger: Manufacturing Overhead Records v. Work in Process Control 200,000 Manufacturing Overhead Allocated ($80,000 $2.50) Source Document: Labor Time Sheets, Job Cost Record Subsidiary Ledger: Work-in-Process Inventory Records by Jobs

200,000

vi. Finished Goods Control b 387,000 Work in Process Control 387,000 Source Document: Job Cost Record, Completed Job Cost Record Subsidiary Ledger: Work-in-Process Inventory Records by Jobs, Finished Goods Inventory Records by Jobs vii. Cost of Goods Sold c 432,000 Finished Goods Control Source Document: Sales Invoice, Completed Job Cost Record Subsidiary Ledger: Finished Goods Inventory Records by Jobs

432,000


viii.

Manufacturing Overhead Allocated Manufacturing Overhead Control ($129,500 + $54,500) Cost of Goods Sold Source Document: Prior Journal Entries

200,000 184,000 16,000

ix. Administrative Expenses 7,000 Marketing Expenses 120,000 Salaries Payable Control 30,000 Accounts Payable Control 90,000 Accumulated Depreciation, Office Equipment 7,000 Source Document: Depreciation Schedule, Marketing Payroll Request, Invoice for Advertising, Sales Commission Schedule. Subsidiary Ledger: Employee Salary Records, Administration Cost Records, Marketing Cost Records. a

Beginning direct Ending direct Materials used = materials inventory + Purchases – materials inventory

= $9,000 + $124,000 b

$11,000 = $122,000

Cost of Beginning WIP Ending WIP + Manufacturing – inventory goods manufactured = inventory cost = $6,000 + ($122,000 + $80,000 + $200,000)

c

$21,000 = $387,000

Beginning finished Ending finished Cost of goods sold = goods inventory + Cost of goods – goods inventory manufactured = $69,000 + $387,0000 $24,000 = $432,000


2.

T-accounts Bal. 1/1/2011 (1) Accounts Payable Control (Purchases) Bal. 12/31/2011 Bal. 1/1/2011 (2) Materials Control (Direct materials used) (3) Wages Payable Control (Direct manuf. labor) (5) Manuf. Overhead Allocated Bal. 12/31/2011 Bal. 1/1/2011 (6) WIP Control (Cost of goods manuf.) Bal. 12/31/2011 (7) Finished Goods Control (Goods sold)

Direct Materials Control 9,000 (2) Work-in-Process Control (Materials used) 124,000 11,000 Work-in-Process Control 6,000 (6) Finished Goods Control (Cost of goods 122,000 manufactured)

387,000

80,000 200,000 21,000 Finished Goods Control 69,000 (7) Cost of Goods Sold

432,000

387,000 24,000 Cost of Goods Sold (8) Manufacturing Overhead 432,000 Allocated (Adjust for overallocation)

Manufacturing Overhead Control (3) Wages Payable Control (8) To close (Indirect manuf. labor) 54,500 (4) Salaries Payable Control (Maintenance) 20,000 (4) Accounts Payable Control (Miscellaneous) 9,500 (4) Accum. Deprn. Control (Depreciation) 30,000 (4) Rent Payable Control (Rent) 70,000 Bal. 0 (8) To close

122,000

Manufacturing Overhead Allocated 200,000 (5) Work-in-Process Control (Manuf. overhead allocated) Bal.

16,000

184,000

200,000 0


4-26

(45 min.) Job costing, journal entries.

Some instructors may wish to assign Problem 4-24. It demonstrates the relationships of journal entries, general ledger, subsidiary ledgers, and source documents. 1.

An overview of the product-costing system is INDIRECT COST POOL

Manufacturing Overhead


Machine-Hours


COST OBJECT PRODUCT

DIRECT COSTS

2. (1) (2) (3) (4) (5) (6) (7) (8) (9) (10a) (10b)

Direct Materials

Direct Manuf. Labor

Amounts in millions. Materials Control Accounts Payable Control Work-in-Process Control Materials Control Manufacturing Department Overhead Control Materials Control Work-in-Process Control Wages Payable Control Manufacturing Department Overhead Control Wages Payable Control Manufacturing Department Overhead Control Accumulated Depreciation Manufacturing Department Overhead Control Various liabilities Work-in-Process Control Manufacturing Overhead Allocated Finished Goods Control Work-in-Process Control Cost of Goods Sold Finished Goods Control Accounts Receivable Control (or Cash ) Revenues

150 150 145 145 10 10 90 90 30 30 19 19 9 9 63 63 294 294 292 292 400 400


The posting of entries to T-accounts is as follows:

Bal (1) Bal.

Materials Control 12 (2) 150 (3) 7

Bal. (9) Bal.

Finished Goods Control 6 (10a) 294 8

(3) (5) (6) (7)

Manufacturing Department Overhead Control 10 (11) 30 19 9

(10b)

145 10

Bal. (2) (4) (8) Bal.

Work-in-Process Control 2 (9) 145 90 63 6

292

(10a) (11)

Cost of Goods Sold 292 5

Manufacturing Overhead Allocated (11) 63 (8) 63

68

Accounts Payable Control (1)

150

Accumulated Depreciation (6)

19

294

Accounts Receivable Control 400

Wages Payable Control (4) (5)

90 30

Various Liabilities (7)

9

Revenues (10b)

400

The ending balance of Work-in-Process Control is $6. 3.

(11) Manufacturing Overhead Allocated Cost of Goods Sold Manufacturing Department Overhead Control

63 5 68

Entry posted to T-accounts in Requirement 2.


4-27

(15 min.)

Job costing, unit cost, ending work in progress.

1. Direct manufacturing labor rate per hour Manufacturing overhead cost allocated per manufacturing labor-hour Direct manufacturing labor costs Direct manufacturing labor hours ($273,000 $26; $208,000 $26) Manufacturing overhead cost allocated (10,500 $20; 8,000 $20) Job Costs May 2011 Direct materials Direct manufacturing labor Manufacturing overhead allocated Total costs

$26 $20 Job M1 $273,000

Job M2 $208,000

10,500

8,000

$210,000

$160,000

Job M1 $ 78,000 273,000 210,000 $561,000

Job M2 $ 51,000 208,000 160,000 $419,000

2. Number of pipes produced for Job M1 Cost per pipe ($561,000 1,100)

1,100 $510

3. Finished Goods Control Work-in-Process Control

561,000 561,000

4. Rafael Company began May 2011 with no work-in-process inventory. During May, it started and finished M1. It also started M2, which is still in work-in-process inventory at the end of May. M2’s manufacturing costs up to this point, $419,000, remain as a debit balance in the Work-in-Process Inventory account at the end of May 2011.


4-28 1.

(20 30 min.) Job costing; actual, normal, and variation from normal costing. Actual direct cost rate for professional labor = $59 per professional labor-hour $735,000 17,500 hours

= $42 per professional labor-hour

=

$990,000 18,000 hours


Budgeted indirect cost rate =

$774,000 18,000 hours


Actual indirect cost rate = Budgeted direct cost rate for professional labor

Direct-Cost Rate Indirect-Cost Rate

2.

Direct Costs Indirect Costs Total Job Costs

(a) (b) Actual Normal Costing Costing $59 $59 (Actual rate) (Actual rate) $42 $43 (Actual rate) (Budgeted rate)

(c) Variation of Normal Costing $55 (Budgeted rate) $43 (Budgeted rate)

(a) (b) (c) Actual Normal Variation of Costing Costing Normal Costing $59 160 = $ 9,440 $59 160 = $ 9,440 $55 160 = $ 8,800 $42 160 = 6,720 $43 160 = 6,880 $43 160 = 6,880 $16,160 $16,320 $15,680

All three costing systems use the actual professional labor time of 160 hours. The budgeted 150 hours for the Pierre Enterprises audit job is not used in job costing. However, Chico may have used the 150 hour number in bidding for the audit. The actual costing figure of $16,160 is less than the normal costing figure of $16,320 because the actual indirect-cost rate ($42) is less than the budgeted indirect-cost rate ($43). The normal costing figure of $16,320 is more than the variation of normal costing (based on budgeted rates for direct costs) figure of $15,680, because the actual direct-cost rate ($59) is more than the budgeted direct-cost rate ($55).


Although not required, the following overview diagram summarizes Chico’s job-costing system. INDIRECT COST POOL


COST OBJECT: JOB FOR AUDITING PIERRE & CO.

Audit Support

Professional Labor-Hours


DIRECT COST Professional Labor


4-29 1.

(20 30 min.) Job costing; actual, normal, and variation from normal costing. Actual direct cost rate for architectural labor = $92 per architectural labor-hour $1, 729,500 34,590

= $50 per architectural labor-hour

=

$2,880,000 32,000


Budgeted indirect cost rate =

$1,728,000 32,000


Actual indirect cost rate = Budgeted direct cost rate for professional labor

Direct-Cost Rate Indirect-Cost Rate

2.

Direct Costs Indirect Costs Total Job Costs

(a) (b) Actual Normal Costing Costing $92 $92 (Actual rate) (Actual rate) $50 $54 (Actual rate) (Budgeted rate)

(a) Actual Costing $92 250 = $23,000 $50 250 = 12,500 $35,500

(c) Variation of Normal Costing $90 (Budgeted rate) $54 (Budgeted rate)

(b) (c) Normal Variation of Costing Normal Costing $92 250 = $23,000 $90 250 = $22,500 $54 250 = 13,500 $54 250 = 13,500 $36,500 $36,000

All three costing systems use the actual architectural labor time of 250 hours. The budgeted 275 hours for the Champ Tower job is not used in job costing. However, Braden Brothers may have used the budgeted number of hours in bidding for the job.


4-30 (30 min.) Proration of overhead. 1. Budgeted manufacturing overhead rate

Budgeted manufacturing overhead cost Budgeted direct manufacturing labor cost

=

$125, 000 $250, 000

2. Overhead allocated = 50% = 50% Underallocated manufacturing overhead

50% of direct manufacturing labor cost

Actual direct manufacturing labor cost $228,000 = $114,000

=

Actual manufacturing overhead costs

Allocated plant overhead costs

–

= $117,000 – $114,000 = $3,000 Underallocated manufacturing overhead = $3,000 3a. All underallocated manufacturing overhead is written off to cost of goods sold. Both work in process (WIP) and finished goods inventory remain unchanged.

Account WIP Finished Goods Cost of Goods Sold Total

Dec. 31, 2011 Balance (Before Proration) (1) $ 50,700 245,050 549,250 $845,000

Proration of $3,000 Underallocated Manuf. Overhead (2) $ 0 0 3,000 $3,000

Dec. 31, 2011 Balance (After Proration) (3) = (1) + (2) $ 50,700 245,050 552,250 $848,000

3b. Underallocated manufacturing overhead prorated based on ending balances:


Dec. 31, 2011 Account Balance (Before Proration) (1) $ 50,700 245,050 549,250 $845,000

Account Balance as a Percent of Total (2) = (1) ÷ $845,000 0.06 0.29 0.65 1.00

Proration of $3,000 Underallocated Manuf. Overhead (3) = (2) $3,000 0.06 $3,000 = $ 180 0.29 $3,000 = 870 0.65 $3,000 = 1,950 $3,000

Dec. 31, 2011 Account Balance (After Proration) (4) = (1) + (3) $ 50,880 245,920 551,200 $848,000


3c. Underallocated manufacturing overhead prorated based on 2011 overhead in ending balances:


a,b,c

Dec. 31, 2011 Account Balance (Before Proration) (1) $ 50,700 245,050 549,250 $845,000

Allocated Manuf. Overhead in Dec. 31, 2011 Balance (Before Proration) (2) $ 10,260a 29,640b 74,100c $114,000

Allocated Manuf. Overhead in Dec. 31, 2011 Balance as a Percent of Total (3) = (2) ÷ $114,000 0.09 0.26 0.65 1.00

Proration of $3,000 Underallocated Manuf. Overhead (4) = (3) $3,000 0.09 $3,000 = $ 270 0.26 $3,000 = 780 0.65 $3,000 = 1,950 $3,000

Dec. 31, 2011 Account Balance (After Proration) (5) = (1) + (4) $ 50,970 245,830 551,200 $848,000

Overhead allocated = Direct manuf. labor cost 50% = $20,520; $59,280; $148,200 50%

4. Writing off all of the underallocated manufacturing overhead to Cost of Goods Sold (CGS) is usually warranted when CGS is large relative to Work-in-Process and Finished Goods Inventory and the underallocated manufacturing overhead is immaterial. Both these conditions apply in this case. ROW should write off the $3,000 underallocated manufacturing overhead to Cost of Goods Sold Account.


4-31 (20 30 min) 1.

Job costing, accounting for manufacturing overhead, budgeted rates.

An overview of the job-costing system is: INDIRECT COST POOL


Machining Department Manufacturing Overhead

Finishing Department Manufacturing Overhead

Machine-Hours in Machining Dept.

Direct Manufacturing Labor Costs in Finishing Dept.

Indirect Costs

COST COSTOBJECT: OBJECT: PRODUCT JOB

DIRECT COST

2.

Direct Costs

Direct Materials


Budgeted manufacturing overhead divided by allocation base: a. Machining Department: $10,660,000 = $52 per machine-hour 205,000 machine-hours

b. Finishing Department: $7,372,000 $3,800,000

3.

= 194% of direct manufacturing labor costs

Machining Department overhead, $52 130 machine-hours Finishing Department overhead, 194% of $1,100 Total manufacturing overhead allocated

$6,760 2,134 $8,894


4.

Total costs of Job 431: Direct costs: Direct materials––Machining Department ––Finishing Department Direct manufacturing labor —Machining Department —Finishing Department Indirect costs: Machining Department overhead, $52 130 Finishing Department overhead, 194% of $1,100 Total costs

$15,500 5,000 400 1,100 $ 6,760 2,134

$22,000

8,894 $30,894

The per-unit product cost of Job 431 is $30,894 ÷ 400 units = $77.235 per unit The point of this part is (a) to get the definitions straight and (b) to underscore that overhead is allocated by multiplying the actual amount of the allocation base by the budgeted rate. 5. Manufacturing overhead incurred (actual)

Machining Finishing $11,070,000 $8,236,000

Manufacturing overhead allocated 210,000 hours $52 10,920,000 194% of $4,400,000 8,536,000 Underallocated manufacturing overhead $ 150,000 Overallocated manufacturing overhead $ 300,000 Total overallocated overhead = $300,000 – $150,000 = $150,000 6. A homogeneous cost pool is one where all costs have the same or a similar cause-andeffect or benefits-received relationship with the cost-allocation base. Fasano likely assumes that all its manufacturing overhead cost items are not homogeneous. Specifically, those in the Machining Department have a cause-and-effect relationship with machine-hours, while those in the Finishing Department have a cause-and-effect relationship with direct manufacturing labor costs. Fasano believes that the benefits of using two cost pools (more accurate product costs and better ability to manage costs) exceeds the costs of implementing a more complex system.


4-32

(15 20 min.) Service industry, job costing, law firm.

1. INDIRECT COST POOL

Legal Support



COST OBJECT: JOB FOR CLIENT

DIRECT COST


} Professional Labor

2.

Budgeted professional = Budgeted direct labor compensation per professional labor-hour direct cost rate Budgeted direct labor-hours per professional $104,000 = 1,600 hours = $65 per professional labor-hour

Note that the budgeted professional labor-hour direct-cost rate can also be calculated by dividing total budgeted professional labor costs of $2,600,000 ($104,000 per professional 25 professionals) by total budgeted professional labor-hours of 40,000 (1,600 hours per professional 25 professionals), $2,600,000 40,000 = $65 per professional labor-hour. 3.

Budgeted total costs in indirect cost pool Budgeted total professional labor-hours $2,200,000 = 1,600 hours per professional 25 professionals $2,200,000 = 40,000 hours = $55 per professional labor-hour

Budgeted indirect = cost rate

4. Direct costs: Professional labor, $65 100; $65 150 Indirect costs: Legal support, $55 100; $55 150

Richardson

Punch

$ 6,500

$ 9,750

5,500 $12,000

8,250 $18,000


4-33

(25–30 min.) Service industry, job costing, two direct- and indirect-cost categories, law firm (continuation of 4-32).

Although not required, the following overview diagram is helpful to understand Keating’s jobcosting system. INDIRECT COST POOL COST ALLOCATION BASE

General Support

Secretarial Support


Partner Labor-Hours

COST OBJECT: JOB FOR CLIENT

DIRECT COST


} Professional Associate Labor

Professional Partner Labor

1. Budgeted compensation per professional Divided by budgeted hours of billable time per professional Budgeted direct-cost rate *Can also be calculated as †

Can also be calculated as

Professional Professional Partner Labor Associate Labor $ 200,000 $80,000 ÷1,600 $125 per hour*

÷1,600 $50 per hour†

$200,000 5 $1,000,000 = 1,600 5 8,000

= $125

Total budgeted associate labor costs $80,000 20 $1,600,000 = = 1,600 20 32,000 Total budgeted associate labor - hours

= $ 50

Total budgeted partner labor costs Total budgeted partner labor - hours

2. Budgeted total costs Divided by budgeted quantity of allocation base Budgeted indirect cost rate

=

General Secretarial Support Support $1,800,000 $400,000 ÷ 40,000 hours ÷ 8,000 hours $45 per hour $50 per hour


3.

Richardson Direct costs: Professional partners, $125 60 hr.; $125 30 hr. Professional associates, $50 40 hr.; $50 120 hr. Direct costs Indirect costs: General support, $45 100 hr.; $45 150 hr. Secretarial support, $50 60 hr.; $50 30 hr. Indirect costs Total costs

Punch

$7,500

$3,750

2,000

6,000 $ 9,500

4,500

6,750

3,000

1,500 7,500 $17,000

4.

Richardson Single direct – Single indirect (from Problem 4-32) Multiple direct – Multiple indirect (from requirement 3 of Problem 4-33) Difference

$ 9,750

8,250 $18,000 Punch

$12,000

$18,000

17,000

18,000

$ 5,000 undercosted

$ 0 no change

The Richardson and Punch jobs differ in their use of resources. The Richardson job has a mix of 60% partners and 40% associates, while Punch has a mix of 20% partners and 80% associates. Thus, the Richardson job is a relatively high user of the more costly partner-related resources (both direct partner costs and indirect partner secretarial support). The Punch job, on the other hand, has a mix of partner and associate-related hours (1 : 4) that exactly equals the mix of partner and associate hours for the firm as a whole. The refined-costing system in Problem 433 increases the reported cost in Problem 4-32 for the Richardson job by 41.7% (from $12,000 to $17,000) while it happens to correctly cost the Punch job.


4-34

(20 25 min.) Proration of overhead.

1. Budgeted manufacturing overhead rate is $4,800,000 ÷ 80,000 hours = $60 per machine-hour.

2.

*$60

a.

Manufacturing overhead = Manufacturing overhead – Manufacturing overhead underallocated incurred allocated = $4,900,000 – $4,500,000* = $400,000 75,000 actual machine-hours = $4,500,000

Write-off to Cost of Goods Sold Write-off of $400,000 Underallocated Manufacturing Overhead (3)

Dec. 31, 2011 Account Balance (Before Proration) (2)

Account (1) Work in Process Finished Goods Cost of Goods Sold Total

$

750,000 1,250,000 8,000,000 $10,000,000

$

0 0 400,000 $400,000

Dec. 31, 2011 Account Balance (After Proration) (4) = (2) + (3) $

750,000 1,250,000 8,400,000 $10,400,000

b. Proration based on ending balances (before proration) in Work in Process, Finished Goods and Cost of Goods Sold. Proration of $400,000 Dec. 31, 2011 Dec. 31, 2011 Underallocated Account Account Balance Manufacturing Balance (Before Proration) Overhead (After Proration) (2) (3) (4) = (2) + (3) $ 750,000 ( 7.5%) 0.075 $400,000 = $ 30,000 $ 780,000 1,250,000 (12.5%) 0.125 $400,000 = 1,300,000 50,000 8,000,000 (80.0%) 0.800 $400,000 = 320,000 8,320,000 $10,000,000 100.0% $10,400,000 $400,000

Account (1) Work in Process Finished Goods Cost of Goods Sold Total

c. Proration based on the allocated overhead amount (before proration) in the ending balances of Work in Process, Finished Goods, and Cost of Goods Sold. Dec. 31, 2011 Allocated Overhead Dec. 31, 2011 Account Included in Account Balance Dec. 31, 2011 Proration of $400,000 Balance (Before Account Balance Underallocated (After Account Proration) (Before Proration) Manufacturing Overhead Proration) (1) (2) (3) (4) (5) (6) = (2) + (5) Work in Process Finished Goods Cost of Goods Sold Total a

$60

$

750,000 1,250,000

8,000,000 $10,000,000 b

4,000 machine-hours; $60

a

$ 240,000

b

660,000

c

3,600,000 $4,500,000

(5.33%) 0.0533 $400,000 = $ 21,320 (14.67%) 0.1467 $400,000 =

$

771,320

58,680

1,308,680

(80.00%) 0.8000 $400,000 = 320,000 100.00% $400,000

8,320,000 $10,400,000

c

11,000 machine-hours; $60

60,000 machine-hours


3. Alternative (c) is theoretically preferred over (a) and (b) because the underallocated amount and the balances in work-in-process and finished goods inventories are material. Alternative (c) yields the same ending balances in work in process, finished goods, and cost of goods sold that would have been reported had actual indirect cost rates been used. Chapter 4 also discusses an adjusted allocation rate approach that results in the same ending balances as does alternative (c). This approach operates via a restatement of the indirect costs allocated to all the individual jobs worked on during the year using the actual indirect cost rate.

4-35 1a.

(15 min.) Normal costing, overhead allocation, working backward. Manufacturing overhead allocated = 200% × Direct manufacturing labor cost $3,600,000 = 2 × Direct manufacturing labor cost Direct manufacturing labor cost =

b.

$3,600,000 = $1,800,000 2

Total manufacturing = Direct material + Direct manufacturing + Manufacturing cost used labor cost overhead allocated

$8,000,000 = Direct material used + $1,800,000 + $3,600,000 Direct material used = $2,600,000 2.

Total Cost of goods Work in process Work in process + manufacturing cost = manufactured + 12/31/2011 1/1/2011

Denote Work in process on 12/31/2011 by X $320,000 + $8,000,000 = $7,920,000 + X X = $400,000 Work-in-process inventory, 12/31/11 = $400,000.


4-36 (40 min.) Proration of overhead with two indirect cost pools. 1.a. Molding department: Overhead allocated = $4,602 + $957 + $12,489 = $18,048 Overallocated overhead = Actual overhead costs – Overhead allocated = $17,248 – $18,048 = $800 overallocated 1.b. Painting department: Overhead allocated = $2,306 + $1,897 + $24,982 = $29,185 Underallocated overhead = Actual overhead costs – Overhead allocated = $31,485 – $29,185 = $2,300 underallocated 2a. All under/overallocated overhead is written off to cost of goods sold. Both Work in Process and Finished goods inventory remain unchanged.


Account Balance (Before Proration) (1) $ 27,720.00 15,523.20 115,156.80 $158,400.00

Proration of $1,500 Underallocated Overhead (2) 0 0 –$800 + $2,300 $ 1,500

Account Balance (After Proration) (3) = (1) + (2) $ 27,720.00 15,523.20 116,656.80 $159,900.00

2b. Underallocated overhead prorated based on ending balances


Account Balance (Before Proration) (1) $ 27,720.00 15,523.20 115,156.80 $158,400.00

Account Balance as a Percent of Total (2) = (1) ÷ $2,000,000 0.175 0.098 0.727 1.000

Proration of $1,500 Underallocated Overhead (3) = (2) 10,000 0.175 $1,500 = $ 262.50 0.098 $1,500 = 147.00 0.727 $1,500 = 1,090.50 $1,500.00


2c. Under/overallocated overhead prorated based on overhead in ending balances. (Note: overhead must be allocated separately from each department. This can be done using the number of machine hours/direct labor hours as a surrogate for overhead in ending balances.)


For Molding department:


Allocated Overhead in Account Balance as a Percent of Total (2) = (1) ÷ $18,048 0.255 0.053 0.692 1.000

Allocated Overhead in Account Balance (1) $ 4,602 957 12,489 $18,048

Proration of $800 Overallocated Overhead (3) = (2) $800 0.255 $800 = $204.00 0.053 $800 = 42.40 0.692 $800 = 553.60 $800.00

For finishing department:


Allocated Overhead in Account Balance (4) $ 2,306 1,897 24,982 $29,185


Account Balance (Before Proration) (7) $27,720.00 15,523.20 115,156.80 $158,400.00

Allocated Overhead in Account Balance as a Percent of Total (5) = (4) ÷ $29,185 0.079 0.065 0.856 1.000

Proration of $2,300 Underallocated Overhead (6) = (5) $2,300 0.079 $2,300 = $ 181.70 0.065 $2,300 = 149.50 0.856 $2,300 = 1,968.80 $2,300.00

Underallocated/ Overallocated Overhead (8) = (3) – (6) –$204 + $181.70 =$ (22.30) –$42.40 + $149.50 = 107.10 –$553.60 + $1,968.80 = 1,415.20 $1,500.00


3. The first method is simple and Cost of Goods Sold accounts for almost 73% of the three account amounts. The amount of overallocated and underallocated overhead is also immaterial. Allocation to the other two accounts is minimal. Therefore, write-off to cost of goods sold is the most cost effective alternative.


4-37

(35 min.) General ledger relationships, under- and overallocation.

The solution assumes all materials used are direct materials. A summary of the T-accounts for Needham Company before adjusting for under- or overallocation of overhead follows: Direct Materials Control 1-1-2011 Purchases 12-31-2011

Work-in-Process Control

30,000 Material used for 400,000 manufacturing 380,000 50,000

1-1-2011 Direct materials Direct manuf. Labor Manuf. overhead allocated 12-31-2011

Finished Goods Control 1-1-2011 10,000 Cost of goods Transferred in sold from WIP 940,000 12-31-2011 50,000

20,000 Transferred to 380,000 finished goods 940,000 360,000 480,000 300,000

Cost of Goods Sold Finished goods sold

900,000

Manufacturing Overhead Control

900,000

Manufacturing Overhead Allocated

Manufacturing overhead costs 540,000

Manufacturing overhead allocated to work in process

1.

From Direct Materials Control T-account, Direct materials issued to production = $380,000 that appears as a credit.

2.

Direct manufacturing labor-hours = =

Manufacturing overhead allocated

= =

480,000

Direct manufacturing labor costs Direct manufacturing wage rate per hour $360,000 = 24,000 hours $15 per hour Manufacturing Direct manufacturing overhead rate labor hours 24,000 hours $20 per hour = $480,000

3.

From the debit entry to Finished Goods T-account, Cost of jobs completed and transferred from WIP = $940,000

4.

From Work-in-Process T-account, Work in process inventory = $20,000 + $380,000 + $360,000 + $480,000 – $940,000 on 12/31/2011 = $300,000

5. From the credit entry to Finished Goods Control T-account, Cost of goods sold (before proration) = $900,000


6.

Manufacturing overhead underallocated

7.

a. b.

Debits to Manufacturing Credit to Manufacturing – Overhead Allocated Overhead Control = $540,000 – $480,000 = $60,000 underallocated =

Write-off to Cost of Goods Sold will increase (debit) Cost of Goods Sold by $60,000. Hence, Cost of Goods Sold = $900,000 + $60,000 = $960,000. Proration based on ending balances (before proration) in Work in Process, Finished Goods, and Cost of Goods Sold.

Account balances in each account after proration follows:

Account (1) Work in Process Finished Goods Cost of Goods Sold

Account Balance (Before Proration) (2) $ 300,000 (24%) 50,000 ( 4%) 900,000 (72%) $1,250,000 100%

Proration of $60,000 Underallocated Account Balance Manufacturing Overhead (After Proration) (3) (4)=(2)+(3) $ 314,400 0.24 $60,000 = $14,400 0.04

$60,000 =

2,400

52,400

0.72

$60,000 =

43,200

943,200

$60,000

$1,310,000

8. Needham’s operating income using write-off to Cost of Goods Sold and Proration based on ending balances (before proration) follows: Write-off to Cost of Goods Sold Revenues Cost of goods sold Gross margin Marketing and distribution costs Operating income/(loss)

$1,090,000 960,000 130,000 140,000 $ (10,000)

Proration Based on Ending Balances $1,090,000 943,200 146,800 140,000 $ 6,800

9. If the purpose is to report the most accurate inventory and cost of goods sold figures, the preferred method is to prorate based on the manufacturing overhead allocated component in the inventory and cost of goods sold accounts. Proration based on the balances in Work in Process, Finished Goods, and Cost of Goods Sold will equal the proration based on the manufacturing overhead allocated component if the proportions of direct costs to manufacturing overhead costs are constant in the Work in Process, Finished Goods and Cost of Goods Sold accounts. Even if this is not the case, the prorations based on Work in Process, Finished Goods, and Cost of Goods Sold will better approximate the results if actual cost rates had been used rather than the write-off to Cost of Goods Sold method. Another consideration in Needham’s decision about how to dispose of underallocated manufacturing overhead is the effects on operating income. The write-off to Cost of Goods Sold will lead to an operating loss. Proration based on the balances in Work in Process, Finished Goods, and Cost of Goods Sold will help Needham avoid the loss and show an operating income.


The main merit of the write-off to Cost of Goods Sold method is its simplicity. However, accuracy and the effect on operating income favor the preferred and recommended proration approach.


4-38

(40 55 min.) Overview of general ledger relationships.

1. Adjusting entry for 12/31 payroll. (a) Work-in-Process Control Manufacturing Department Overhead Control Wages Payable Control To recognize payroll costs

3,850 950 4,800

(b) Work-in-Process Control Manufacturing Overhead Allocated To allocate manufacturing overhead at 120% $3,850 = $4,620 on $3,850 of direct manufacturing labor incurred on 12/31

4,620 4,620

Note: Students tend to forget entry (b) entirely. Stress that a budgeted overhead allocation rate is used consistently throughout the year. This point is a major feature of this problem. 2. a-e An effective approach to this problem is to draw T-accounts and insert all the known figures. Then, working with T-account relationships, solve for the unknown figures. Entries (a) and (b) are posted into the T-accounts that follow.

Beginning balance 12/1 Purchases Balance 12/30 a $1,200 + $65,400 – $7,600 = $59,000 (a)

Materials Control 1,200 65,400 59,000a Materials requisitioned 7,600

Direct materials requisitioned into work in process during December equals $59,000 because no materials are requisitioned on December 31. Work-in-Process Control 5,800 $59,000 76,500b

Beginning balance 12/1 Direct materials Direct manf. labor Manf. overhead allocated 91,800b Balance 12/30 (a) Direct manuf. labor 12/31 payroll (b) Manuf. overhead allocated 12/31 Ending balance 12/31

227,300 8,100 3,850 4,620c 16,570

225,000 Cost of goods manufactured

b

Direct manufacturing labor and manufacturing overhead allocated are unknown. Let x = Direct manufacturing labor up to 12/30 payroll, then manufacturing overhead allocated up to 12/30 payroll = 1.20x


Use the T-account equation and solve for x: $5,800 + $59,000 + x + 1.20x – $225,000 = $8,100 2.20x = $8,100 – $5,800 – $59,000 + $225,000 = $168,300 $168,300 $76,500 x= 2.2 Direct manufacturing labor up to 12/30 payroll = $76,500 Manufacturing overhead allocated up to 12/30 = 1.20x × $76,500 = $91,800 Total direct manufacturing labor for December = $76,500 + $3,850 (direct manufacturing labor for 12/31 calculated in requirement 1) = $80,350 Total manufacturing overhead allocated for December = $91,800 + $4,620c = $96,420 c

$3,850 120% = $4,620, manufacturing overhead allocated on $3,850 of direct manufacturing labor incurred on 12/31. (b) (c) (d)

Total direct manufacturing labor for December = $80,350. Total manufacturing overhead allocated (recorded) in work in process equals $96,420. Ending balance in work-in-process inventory on December 31 equals $8,100 + $3,850 (direct manufacturing labor added on 12/31, requirement 1) + $4,620 (manufacturing overhead allocated on 12/31, requirement 1) = $16,570.

An alternative approach to solving requirements 2b, 2c, and 2d is to calculate the work-inprocess inventory on December 31, recognizing that because no new units were started or completed, no direct materials were added and the direct manufacturing labor and manufacturing overhead allocated on December 31 were added to the work-in-process inventory balance of December 30. Work-in-process inventory on 12/31

=

Work-in-process inventory on 12/30

+

Direct manufacturing labor incurred on 12/31

+

Manufacturing overhead allocated on 12/31

= $8,100 + $3,850 + $4,620 = $16,570 We can now use the T-account equation for work-in-process inventory account from 12/1 to 12/31, as follows. Let x = Direct manufacturing labor for December Then 1.20x = Manufacturing overhead allocated for December Work-inDirect Direct Manufacturing Work-inCost of goods process materials manufacturing overhead process + + + – manufactured = inventory added in labor added in allocated in inventory on in December on 12/1 December December December 12/31

$5,800 + $59,000 + x + 1.20x – $225,000 = $16,570 2.20x = $16,570 – $5,800 – $59,000 + $225,000 2.20x = $176,700 $176, 700 $80,350 x= 2.20 4-41 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Total direct manufacturing labor for December = $80,350 Total manufacturing overhead allocated in December = 1.20

$80,350 = $96,420

Finished Goods Control Beginning balance 12/1 3,500 Cost of goods manufactured 225,000 210,000c Cost of goods sold Balance 12/30 18,500 c $3,500 + $225,000 – $18,500 = $210,000 (e)

Cost of goods sold for December before adjustments for under- or overallocated overhead equals $210,000:

Cost of goods sold

Cost of Goods Sold 210,000 1,400 (c) Closing entry

Manufacturing Department Overhead Control Balance through 12/30 94,070 (a) Indirect manufacturing labor 12/31 950 95,020 (c) Closing entry (c) Closing entry

Manufacturing Overhead Allocated 96,420 91,800 Balance through 12/30 4,620 (b) Manufacturing overhead allocated, 12/31 Wages Payable Control 4,800 (a) 12/31 payroll

3. Closing entries: (c) Manufacturing Overhead Allocated 96,420 Manufacturing Department Overhead Control 95,020 Cost of Goods Sold 1,400 To close manufacturing overhead accounts and overallocated overhead to cost of goods sold


4-39 (30 min.) Allocation and proration of overhead. 1. Budgeted overhead rate = Budgeted overhead costs ÷ Budgeted labor costs = $180,000 ÷ $150,000 = 120% of labor cost 2. Ending work in process

Direct material costs Direct labor costs Overhead (1.20 × Direct labor costs) Total costs

Job 1 $ 3,620 4,500

Job 2 $ 6,830 7,250

Total $10,450 11,750

5,400 $13,520

8,700 $22,780

14,100 $36,300

Cost of goods sold = Beginning WIP + Manufacturing costs (Actual direct materials + Actual direct labor + Allocated overhead) – Ending WIP = $0 + ($126,500 + $148,750 + 148,750 1.20) – $36,300 = $417,450 3. Overhead allocated = 1.20

$148,750 = $178,500

Overallocated overhead = Actual overhead – Allocated overhead = $176,000 – $178,500 = $2,500 overallocated 4.a. All overallocated overhead is written off to cost of goods sold. WIP inventory remains unchanged. Dec. 31, 2010 Account Balance Account (Before Proration) (1) (2) Work in Process $ 36,300 Cost of goods sold 417,450 $453,750 4b.

Write-off of $2,500 Overallocated overhead (3) $ 0 (2,500) $(2,500)

Dec. 31, 2010 Account Balance (After Proration) (4) = (2) + (3) $ 36,300 414,950 $451,250

Overallocated overhead prorated based on ending balances

Account (1) Work in Process Cost of Goods Sold

Dec. 31, 2010 Balance (Before Proration) (2) $ 36,300 417,450 $453,750

Balance as a Percent of Total (3) = (2) ÷ $453,750 0.08 0.92 1.00

Proration of $2,500 Overallocated Overhead (4) = (3) $2,500 $ (200) (2,300) $(2,500)

Dec. 31, 2010 Balance (After Proration) (5) = (2) + (4) $ 36,100 415,150 $451,250

5. Writing off all of the overallocated overhead to Cost of Goods Sold (CGS) is warranted when CGS is large relative to Work-in-Process Inventory and Finished Goods Inventory and the overallocated overhead is immaterial. Both these conditions apply in this case. Tamden Inc. should write off the $2,500 overallocated overhead to Cost of Goods Sold account.


4-40 1.

2.

(20 min.) Job costing, contracting, ethics. Direct manufacturing costs: Direct materials ($8,000 x 150 huts) Direct manufacturing labor ($600 150 huts) Manufacturing overhead ($3 90,000) Total costs Markup (15% $1,560,000) Total bid price Direct manufacturing costs: Direct materials Direct manufacturing labor Production labor Inspection labor Setup labor Manufacturing overhead Total costs Markup (15% of $1,795,200) Total bid price

$1,200,000 90,000 270,000 $1,560,000 234,000 $1,794,000

$1,380,000 $84,000 9,000 10,800

103,800 311,400 $1,795,200 269,280 $2,064,480

Direct materials = ($1,840,000/200) 150 = $1,380,000 Direct labor = production labor + inspection labor + setup labor Production labor = 28 hours 150 $20 = $84,000 Inspection labor = 4 hours x 150 $15 = $9,000 Setup labor = 6 hours x 150 $12 = $10,800 $138, 400 150 huts = $103,800 Alternatively, Direct manufacturing labor 200 huts Manufacturing overhead = (3 $103,800) = $311,400

3. The main discrepancies in costs (before the mark up) in requirements 1 and 2 are as follows: a. Materials are marked up by 15% in the Sept. 15, 2005 invoice ($1,380,000 – $1,200,000)/$1,200,000 = 15%. b. Costs are double-counted based on the Sept. 15, 2005 invoice (inspection and setup costs are included as both a direct cost as part of direct manufacturing labor and in manufacturing overhead allocated at 3 times direct manufacturing labor cost). c. The standard cost sheet includes 30 direct manufacturing labor hours while the Sept. 15, 2005 invoice includes 28 hours of production labor. 4. According to the IMA Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management, the following principles should guide your decision to present the bid based on the retail cost of producing the huts: a. Competence – responsibility to provide information that is accurate. b. Integrity – refraining from engaging in any conduct that would prejudice carrying out duties ethically or that would discredit the profession. c. Credibility – disclose all relevant information. 4-44 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

I would go to my boss with the bid in requirement 1 after checking (a) If any direct material savings is possible and (b) If direct manufacturing labor can be reduced to 28 hours from 30 hours. Assuming that only the latter is the case, then the bid I would propose is: Direct materials $800 150 Direct manufacturing labor 28 hours Manufacturing overhead Total costs Mark up at 15% of total costs

$20

150

$1,200,000 84,000 252,000 1,536,000 230,400 $1,766,400


4-41 (35 min.) Job costing-service industry. 1.

Signings in Process (SIP) April 30, 2010

Author Asher ($425 + $90; $750 + $225) Brown ($200 + $320; $550 + $450) Sherman Total

2.

Direct Labor Overhead (2) (3) = 80% × (2) $ 975 $ 780 1,000 800 200 160 $2,175 $1,740

Materials (1) $ 515 520 150 $1,185

Total (4) $2,270 2,320 510 $5,100

Cost of Completed Signings (CCS) in April 2010

Author Bucknell ($710 + $150; $575 + $75) King Total

Materials (1) $ 860 650 $1,510

Direct Labor (2)

Overhead (3) = 80% × (2)

$ 650 400 $1,050

$ 520 320 $ 840

Total (4) $2,030 1,370 $3,400

3. Overhead allocated = 0.80 × 1,350a = $1,080 Underallocated overhead = Actual overhead – Allocated overhead = $1,980 – 1,080 = $900 underallocated a

Total direct labor in April = $225 + $75 + $450 + $400 + $200 = $1,350

4a. Underallocated overhead is written off to CCS SIP inventory remains unchanged.

Account SIP CCS

April 30, 2010 Balance (Before Proration) (1) $5,100 3,400 $8,500

Proration of $900 Underallocated Overhead (2) $ 0 900 $900

April 30, 2010 Balance (After Proration) (3) = (1) + (2) $5,100 4,300 $9,400


4b.

Account SIP CCS

4c.

Account SIP CCS

a

Underallocated overhead prorated based on ending balances April 30, 2010 Balance (Before Proration) (1) $5,100 3,400 $8,500

Balance as a Percent of Total (2) = (1) ÷ $8,500 0.60 0.40 1.00

Proration of $900 Underallocated Overhead (3) = (2) $900 0.60 $900 = $540 0.40 $900 = 360 $900

April 30, 2010 Balance (After Proration) (4) = (1) + (3) $5,640 3,760 $9,400

Underallocated overhead prorated based on April overhead in ending balances April 30, 2010 Balance (Before Proration) (1) $5,100 3,400 $8,500

Overhead Allocated in April Included in April 30, 2010 Balance (2) $ 700a 380b $1,080

Overhead Allocated in April Included in April 30, 2010 as a Percent of Total (3) = (2) ÷ $1,080 0.648 0.352 1.000

Proration of $900 Underallocated Overhead (4) = (3) $900 0.648 $900 = $ 583.20 0.352 $900 = 316.80 $ 900.00

April 30, 2010 Balance (After Proration) (5) = (1) + (4) $5,683.20 3,716.80 $9,400.00

April labor for Asher, Brown, and Sherman 80% = ($225 + $450 + $200) × 80% = $875 × 80% = $700

b

April labor for Bucknell and King 80% = ($75 + $400) 80% = $475 80% = $380

5. I would choose the method in 4c (proration based on overhead allocated) because this method results in account balances based on actual overhead allocation rates. The account balances before proration in SIP and CCS are significant and underallocated overhead is material. However, the ratio of ending balances in SIP and CCS is not very different from the ratio of overhead allocated to each of these accounts in April and so method 4b (proration based on ending balances in SIP and CCS) and method 4c will result in similar overhead allocations and balances after proration.


CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT 5-1 Broad averaging (or ―peanut-butter costing‖) describes a costing approach that uses broad averages for assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly to cost objects when the individual products or services, in fact, use those resources in non-uniform ways. Broad averaging, by ignoring the variation in the consumption of resources by different cost objects, can lead to inaccurate and misleading cost data, which in turn can negatively impact the marketing and operating decisions made based on that information. 5-2 Overcosting may result in overpricing and competitors entering a market and taking market share for products that a company erroneously believes are low-margin or even unprofitable. Undercosting may result in companies selling products on which they are in fact losing money, when they erroneously believe them to be profitable. 5-3 Costing system refinement means making changes to a simple costing system that reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of overhead resources used by different cost objects. Three guidelines for refinement are 1. Classify as many of the total costs as direct costs as is economically feasible. 2. Expand the number of indirect cost pools until each of these pools is more homogenous. 3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for each indirect-cost pool. 5-4 An activity-based approach refines a costing system by focusing on individual activities (events, tasks, or units of work with a specified purpose) as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as products or services. 5-5

Four levels of a cost hierarchy are (i) Output unit-level costs: costs of activities performed on each individual unit of a product or service. (ii) Batch-level costs: costs of activities related to a group of units of products or services rather than to each individual unit of product or service. (iii) Product-sustaining costs or service-sustaining costs: costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced. (iv) Facility-sustaining costs: costs of activities that cannot be traced to individual products or services but support the organization as a whole.

5-6 It is important to classify costs into a cost hierarchy because costs in different cost pools relate to different cost-allocation bases and not all cost-allocation bases are unit-level. For example, an allocation base like setup hours is a batch-level allocation base, and design hours is a product-sustaining base, both insensitive to the number of units in a batch or the number of units of product produced. If costs were not classified into a cost hierarchy, the alternative would 5-1 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

be to consider all costs as unit-level costs, leading to misallocation of those costs that are not unit-level costs. 5-7 An ABC approach focuses on activities as the fundamental cost objects. The costs of these activities are built up to compute the costs of products, and services, and so on. Simple costing systems have one or a few indirect cost pools, irrespective of the heterogeneity in the facility while ABC systems have multiple indirect cost pools. An ABC approach attempts to use cost drivers as the allocation base for indirect costs, whereas a simple costing system generally does not. The ABC approach classifies as many indirect costs as direct costs as possible. A simple costing system has more indirect costs. 5-8

Four decisions for which ABC information is useful are 1. pricing and product mix decisions, 2. cost reduction and process improvement decisions, 3. product design decisions, and 4. decisions for planning and managing activities.

5-9 No. Department indirect-cost rates are similar to activity-cost rates if (1) a single activity accounts for a sizable fraction of the department’s costs, or (2) significant costs are incurred on different activities within a department but each activity has the same cost-allocation base, or (3) significant costs are incurred on different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions. 5-10 ―Tell-tale‖ signs that indicate when ABC systems are likely to provide the most benefits are as follows: 1. Significant amounts of indirect costs are allocated using only one or two cost pools. 2. All or most indirect costs are identified as output-unit-level costs (i.e., few indirect costs are described as batch-level, product-sustaining, or facility-sustaining costs). 3. Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. 4. Products that a company is well suited to make and sell show small profits, whereas products that a company is less suited to produce and sell show large profits. 5. Operations staff has significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services. 5-11 The main costs and limitations of ABC are the measurements necessary to implement the systems. Even basic ABC systems require many calculations to determine costs of products and services. Activity-cost rates often need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand. Sometimes the allocations necessary to calculate activity costs often result in activity-cost pools and quantities of cost-allocation bases being measured with error. When measurement errors are large, activity-cost information can be misleading. 5-12 No, ABC systems apply equally well to service companies such as banks, railroads, hospitals, and accounting firms, as well merchandising companies such as retailers and distributors.


5-13 No. An activity-based approach should be adopted only if its expected benefits exceed its expected costs. It is not always a wise investment. If the jobs, products or services are alike in the way they consume indirect costs of a company, then a simple costing system will suffice. 5-14 Increasing the number of indirect-cost pools does NOT guarantee increased accuracy of product or service costs. If the existing cost pool is already homogeneous, increasing the number of cost pools will not increase accuracy. If the existing cost pool is not homogeneous, accuracy will increase only if the increased cost pools themselves increase in homogeneity vis-à-vis the single cost pool. 5-15 The controller faces a difficult challenge. The benefits of a better accounting system show up in improved decisions by managers. It is important that the controller have the support of these managers when seeking increased investments in accounting systems. Statements by these managers showing how their decisions will be improved by a better accounting system are the controller’s best arguments when seeking increased funding. For example, the new system will result in more accurate product costs which will influence pricing and product mix decisions. The new system can also be used to reduce product costs which will lower selling prices. As a result, the customer will benefit from the new system.


5-16

(20 min.) Cost hierarchy.

1.

a. Indirect manufacturing labor costs of $1,450,000 support direct manufacturing labor and are output unit-level costs. Direct manufacturing labor generally increases with output units, and so will the indirect costs to support it. b. Batch-level costs are costs of activities that are related to a group of units of a product rather than each individual unit of a product. Purchase order-related costs (including costs of receiving materials and paying suppliers) of $850,000 relate to a group of units of product and are batch-level costs. c. Cost of indirect materials of $275,000 generally changes with labor hours or machine hours which are unit-level costs. Therefore, indirect material costs are output unitlevel costs. d. Setup costs of $630,000 are batch-level costs because they relate to a group of units of product produced after the machines are set up. e. Costs of designing processes, drawing process charts, and making engineering changes for individual products, $775,000, are product-sustaining because they relate to the costs of activities undertaken to support individual products regardless of the number of units or batches in which the product is produced. f. Machine-related overhead costs (depreciation and maintenance) of $1,500,000 are output unit-level costs because they change with the number of units produced. g. Plant management, plant rent, and insurance costs of $925,000 are facility-sustaining costs because the costs of these activities cannot be traced to individual products or services but support the organization as a whole.

2. The complex boom box made in many batches will use significantly more batch-level overhead resources compared to the simple boom box that is made in a few batches. In addition, the complex boom box will use more product-sustaining overhead resources because it is complex. Because each boom box requires the same amount of machine-hours, both the simple and the complex boom box will be allocated the same amount of overhead costs per boom box if Hamilton uses only machine-hours to allocate overhead costs to boom boxes. As a result, the complex boom box will be undercosted (it consumes a relatively high level of resources but is reported to have a relatively low cost) and the simple boom box will be overcosted (it consumes a relatively low level of resources but is reported to have a relatively high cost). 3. Using the cost hierarchy to calculate activity-based costs can help Hamilton to identify both the costs of individual activities and the cost of activities demanded by individual products. Hamilton can use this information to manage its business in several ways: a. Pricing and product mix decisions. Knowing the resources needed to manufacture and sell different types of boom boxes can help Hamilton to price the different boom boxes and also identify which boom boxes are more profitable. It can then emphasize its more profitable products. b. Hamilton can use information about the costs of different activities to improve processes and reduce costs of the different activities. Hamilton could have a target of reducing costs of activities (setups, order processing, etc.) by, say, 3% and constantly seek to eliminate activities and costs (such as engineering changes) that its customers perceive as not adding value. c. Hamilton management can identify and evaluate new designs to improve performance by analyzing how product and process designs affect activities and costs. d. Hamilton can use its ABC systems and cost hierarchy information to plan and manage activities. What activities should be performed in the period and at what cost? 5-4 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

5-17

(25 min.) ABC, cost hierarchy, service.

1.

Output unit-level costs a. Direct-labor costs, $146,000 b. Equipment-related costs (rent, maintenance, energy, and so on), $350,000 These costs are output unit-level costs because they are incurred on each unit of materials tested, that is, for every hour of testing. Batch-level costs c. Setup costs, $430,000 These costs are batch-level costs because they are incurred each time a batch of materials is set up for either HT or ST, regardless of the number of hours for which the tests are subsequently run. Service-sustaining costs d. Costs of designing tests, $264,000. These costs are service-sustaining costs because they are incurred to design the HT and ST tests, regardless of the number of batches tested or the number of hours of test time.

2. Heat Testing (HT) Total Per Hour (1) (2) = (1)  40,000 Direct labor costs (given) Equipment-related costs $5 per hour*  40,000 hours $5 per hour*  30,000 hours Setup costs $25 per setup-hour†  13,600 setup-hours $25 per setup-hour†  3,600 setup-hours Costs of designing tests $60 per hour**  3,000 hours $60 per hour**  1,400 hours Total costs

$100,000

$ 2.50

200,000

5.00

340,000

Stress Testing (ST) Total Per Hour (3) (4) = (3)  30,000 $ 46,000

$ 1.53

150,000

5.00

90,000

3.00

84,000 $370,000

2.80 $12.33

8.50

180,000

4.50

$820,000

$20.50

*$350,000  (40,000 + 30,000) hours = $5 per test-hour † $430,000  (13,600 + 3,600) setup hours = $25 per setup-hour **$264,000  (3,000 + 1,400) hours = $60 per hour

At a cost per test-hour of $17, the simple costing system undercosts heat testing ($20.50) and overcosts stress testing ($12.33). The reason is that heat testing uses direct labor, setup, and design resources per hour more intensively than stress testing. Heat tests are more complex, take longer to set up, and are more difficult to design. The simple costing system assumes that testing costs per hour are the same for heat testing and stress testing.


3. The ABC system better captures the resources needed for heat testing and stress testing because it identifies all the various activities undertaken when performing the tests and recognizes the levels of the cost hierarchy at which costs vary. Hence, the ABC system generates more accurate product costs. Vineyard’s management can use the information from the ABC system to make better pricing and product mix decisions. For example, it might decide to increase the prices charged for the more costly heat testing and consider reducing prices on the less costly stress testing. Vineyard should watch if competitors are underbidding Vineyard in stress testing, and causing it to lose business. Vineyard can also use ABC information to reduce costs by eliminating processes and activities that do not add value, identifying and evaluating new methods to do testing that reduce the activities needed to do the tests, reducing the costs of doing various activities, and planning and managing activities.


5-18

(15 min.) Alternative allocation bases for a professional services firm.

1.

Client (1) SAN ANTONIO DOMINION Walliston Boutin Abbington AMSTERDAM ENTERPRISES Walliston Boutin Abbington

Direct Professional Time Rate per Number Hour of Hours Total (2) (3) (4) = (2)  (3)

Support Services Rate (5)

Amount Billed to Total Client (6) = (4)  (5) (7) = (4) + (6)

$640 220 100

26 5 39

$16,640 1,100 3,900

30% 30 30

$4,992 330 1,170

$21,632 1,430 5,070 $28,132

$640 220 100

4 14 52

$2,560 3,080 5,200

30% 30 30

$768 924 1,560

$ 3,328 4,004 6,760 $14,092

2.

Client (1) SAN ANTONIO DOMINION Walliston Boutin Abbington AMSTERDAM ENTERPRISES Walliston Boutin Abbington

Direct Professional Time Support Services Rate per Number Rate per Hour of Hours Total Hour Total (2) (3) (5) (4) = (2)  (3) (6) = (3)  (5)

Amount Billed to Client (7) = (4) + (6)

$640 220 100

26 5 39

$16,640 1,100 3,900

$75 75 75

$1,950 375 2,925

$18,590 1,475 6,825 $26,890

$640 220 100

4 14 52

$2,560 3,080 5,200

$75 75 75

$ 300 1,050 3,900

$ 2,860 4,130 9,100 $16,090

San Antonio Dominion Amsterdam Enterprises

Requirement 1 $28,132 14,092 $42,224

Requirement 2 $26,890 16,090 $42,980

Both clients use 70 hours of professional labor time. However, San Antonio Dominion uses a higher proportion of Walliston’s time (26 hours), which is more costly. This attracts the highest support-services charge when allocated on the basis of direct professional labor costs. 5-7 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

3. Assume that the Walliston Group uses a cause-and-effect criterion when choosing the allocation base for support services. You could use several pieces of evidence to determine whether professional labor costs or hours is the driver of support-service costs: a. Interviews with personnel. For example, staff in the major cost categories in support services could be interviewed to determine whether Walliston requires more support per hour than, say, Abbington. The professional labor costs allocation base implies that an hour of Walliston’s time requires 6.40 ($640 ÷ $100) times more supportservice dollars than does an hour of Abbington’s time. b. Analysis of tasks undertaken for selected clients. For example, if computer-related costs are a sizable part of support costs, you could determine if there was a systematic relationship between the percentage involvement of professionals with high billing rates on cases and the computer resources consumed for those cases.


5-19

(20 min.) Plantwide, department and ABC indirect cost rates.

1. Actual plant-wide variable MOH rate based on machine hours, $308,600  4,000

$77.15 per machine hour United Motors

Variable manufacturing overhead, allocated based on machine hours ($77.15  120; $77.15  2,800; $77.15  1,080)

$9,258

Holden Motors

Leland Vehicle

Total

$216,020 $83,322 $308,600

2. Department Design Production Engineering

Variable MOH in 2011 $39,000 29,600 240,000

Total Driver Units 390 370 4,000

Design-related overhead, allocated on CAD-design hours (110  $100; 200  $100; 80  $100) Production-related overhead, allocated on engineering hours (70  $80; 60  $80; 240  $80) Engineering-related overhead, allocated on machine hours (120  $60; 2,800  $60; 1,080  $60) Total

Rate $100 $ 80 $ 60

per CAD-design hour per engineering hour per machine hour

United Motors

Holden Motors

Leland Vehicle

Total

$11,000

$ 20,000

$ 8,000

$ 39,000

5,600

4,800

19,200

29,600

7,200 $23,800

168,000 $192,800

64,800 $92,000

240,000 $308,600

3. United Motors a. Department rates (Requirement 2) b. Plantwide rate (Requirement 1) Ratio of (a) ÷ (b)

Holden Motors

Leland Vehicle

$23,800

$192,800

$92,000

$ 9,258 2.57

$216,020 0.89

$83,322 1.10

The variable manufacturing overhead allocated to United Motors increases by 157% under the department rates, the overhead allocated to Holden decreases by about 11% and the overhead allocated to Leland increases by about 10%. The three contracts differ sizably in the way they use the resources of the three departments.


The percentage of total driver units in each department used by the companies is: Cost Department Driver Design CAD-design hours Engineering Engineering hours Production Machine hours

United Motors 28% 19 3

Holden Motors 51% 16 70

Leland Vehicle 21% 65 27

The United Motors contract uses only 3% of total machines hours in 2011, yet uses 28% of CAD design-hours and 19% of engineering hours. The result is that the plantwide rate, based on machine hours, will greatly underestimate the cost of resources used on the United Motors contract. This explains the 157% increase in indirect costs assigned to the United Motors contract when department rates are used. The Leland Vehicle contract also uses far fewer machine-hours than engineering-hours and is also undercosted. In contrast, the Holden Motors contract uses less of design (51%) and engineering (16%) than of machine-hours (70%). Hence, the use of department rates will report lower indirect costs for Holden Motors than does a plantwide rate. Holden Motors was probably complaining under the use of the simple system because its contract was being overcosted relative to its consumption of MOH resources. United and Leland, on the other hand, were having their contracts undercosted and underpriced by the simple system. Assuming that AP is an efficient and competitive supplier, if the new department-based rates are used to price contracts, United and Leland will be unhappy. AP should explain to United and Leland how the calculation was done, and point out United’s high use of design and engineering resources and Leland’s high use of engineering resources relative to production machine hours. Discuss ways of reducing the consumption of those resources, if possible, and show willingness to partner with them to do so. If the price rise is going to be steep, perhaps offer to phase in the new prices. 4. Other than for pricing, AP can also use the information from the department-based system to examine and streamline its own operations so that there is maximum value-added from all indirect resources. It might set targets over time to reduce both the consumption of each indirect resource and the unit costs of the resources. The department-based system gives AP more opportunities for targeted cost management. 5. It would not be worthwhile to further refine the cost system into an ABC system if (1) a single activity accounts for a sizable proportion of the department’s costs or (2) significant costs are incurred on different activities within a department, but each activity has the same cost driver or (3) there wasn’t much variation among contracts in the consumption of activities within a department. If, for example, most activities within the design department were, in fact, driven by CAD-design hours, then the more refined system would be more costly and no more accurate than the department-based cost system. Even if there was sufficient variation, considering the relative sizes of the 3 department cost pools, it may only be cost-effective to further analyze the engineering cost pool, which consumes 78% ($240,000  $308,600) of the manufacturing overhead.


5-20 (50 min.) Plantwide, department, and activity-cost rates. 1. Trophies Direct materials Forming Assembly Total Direct Labor Forming Assembly Total Total direct costs

Plaques

$13,000 2,600 15,600

$11,250 9,375 20,625

15,600 7,800

9,000 10,500

23,400 $39,000

19,500 $40,125

Total

$79,125

$0.712114 Budgeted = ($12, 000  $10,386  $23, 000  $10,960)  $56,346 = overhead rate $79,125 $79,125 per dollar of direct cost

Trophies Direct materials Direct labor Total direct cost Allocated overhead* Total costs

$15,600 23,400 39,000 27,772 $66,772

Plaques $20,625 19,500 40,125 28,574 $68,699

Total $ 36,225 42,900 79,125 56,346 $135,471

*Allocated overhead = Total direct cost  Budgeted overhead rate (0.712114).

Budgeted Budgeted Forming Department overhead cos ts 2. overhead rate — = Budgeted Forming Department direct-labor costs Forming Dept. $12, 000  $10,386 = $15, 600  $9, 000 $22,386  $0.91 per Forming Department direct-labor dollar = $24, 600 Budgeted Budgeted Assembly Department overhead costs overhead rate — = Budgeted Assembly Department direct costs Assembly Dept. $23, 000  $10,960 = ($2, 600  $9,375  $7,800  $10,500) $33,960  $1.121718 per Assembly Department direct cost dollar = $30, 275


Direct materials Direct labor Total direct cost Allocated overhead Forming Dept.a Assembly Dept.b Total costs

Trophies $15,600 23,400 39,000

Plaques $20,625 19,500 40,125

Total $ 36,225 42,900 79,125

14,196 11,666 $64,862

8,190 22,294 $70,609

22,386 33,960 $135,471

3. Trophies

Plaques

Total

a

Forming Dept. Direct labor costs Allocated overhead (0.91 × $15,600; $9,000)

$15,600

$ 9,000

$24,600

$14,196

$ 8,190

$22,386

Total direct costs ($2,600 + $7,800; $9,375 + $10,500)

$10,400

$19,875

$30,275

Allocated overhead (1.121718  $10,400; $19,875)

$11,666

$22,294

$33,960

b

Assembly Dept.

Forming Department Budgeted setup rate =

$12, 000 = $76.92308 per batch 156 batches

Budgeted supervision rate =

$10,386 = $0.422195 per direct-labor dollar $24, 600

Assembly Department Budgeted set up rate =

$23, 000 = $157.5342 per batch 146 batches

Budgeted supervision rate =

$10,960 = $0.598907 per direct-labor dollar $18,300


Trophies Direct material costs Direct labor costs Total direct costs

Plaques

Total

$15,600 23,400 39,000

$20,625 19,500 40,125

$36,225 42,900 79,125

Forming Dept. overhead Set up $76.92308  40; 116 Supervision 0.422195  $15,600; $9,000

3,077

8,923

12,000

6,586

3,800

10,386

Assembly Department overhead Set up $157.5342  43; 103 Supervision 0.598907  $7,800; $10,500

6,774

16,226

23,000

4,671

6,289

10,960

$60,108

$75,363

$135,471

Total costs

4. Tarquin uses more refined cost pools the costs of trophies decreases and costs of plaques increases. This is because plaques use a higher proportion of cost drivers (batches of set ups and direct manufacturing labor costs) than trophies whereas the direct costs (the allocation base used in the simple costing system) are slightly smaller for plaques compared to trophies. This results in plaques being undercosted and trophies overcosted in the simple costing system. Department costing systems increases the costs of plaques relative to trophies because the forming department costs are allocated based on direct manufacturing labor costs in the forming department and plaques use more direct manufacturing labor in this department compared to trophies. Disaggregated information can improve decisions by allowing managers to see the details which helps them understand how different aspects of cost influence total cost per unit. Managers can also understand the drivers of different cost categories and use this information for pricing and product-mix decisions, cost reduction and process-improvement decisions, design decisions, and to plan and manage activities. However, too much detail can overload managers who don’t understand the data or what it means. Also, managers looking at per-unit data may be misled when considering costs that aren’t unit-level costs.


5-21 1.

(10–15 min.) ABC, process costing. Rates per unit cost driver. Activity Cost Driver Machining Machine-hours

Rate $375,000 ÷ (25,000 + 50,000) = $5 per machine-hour

Set up

Production runs

$120,000 ÷ (50 + 50) = $1,200 per production run

Inspection

Inspection-hours

$105,000 ÷ (1,000 + 500) = $70 per inspection-hour

Overhead cost per unit: Machining: $5 × 25,000; 50,000 Set up: $1,200 × 50; $1,200 × 50 Inspection: $70 × 1,000; $70 × 500 Total manufacturing overhead costs Divide by number of units Manufacturing overhead cost per unit

Mathematical $125,000 60,000 70,000 $255,000 ÷ 50,000 $ 5.10

Financial $250,000 60,000 35,000 $345,000 ÷100,000 $ 3.45

2. Mathematical Financial Manufacturing cost per unit: Direct materials $150,000 ÷ 50,000 $300,000 ÷ 100,000 Direct manufacturing labor $50,000 ÷ 50,000 $100,000 ÷ 100,000 Manufacturing overhead (from requirement 1) Manufacturing cost per unit

$3.00 $3.00 1.00 5.10 $9.10

1.00 3.45 $7.45


5-22 1.

(30 min.) Activity-based costing, service company.

Total indirect costs = $150,000 + $90,000 + $36,000 + $40,000 + $39,000 + $48,000 = $403,000 Total machine-hours = (400  10) + (200  10) = 6,000 Indirect cost rate per machine-hour = $403,000  6,000 = $67.17 per machine-hour

Simple Costing System Cost of supplies per job Direct manufacturing labor cost per job Indirect cost allocated to each job (10 machine hours  $67.17 per machine hour) Total costs 2.

Standard Job $ 200.00 180.00

Special Job $ 250.00 200.00

671.70 $1,051.70

671.70 $1,121.70

Activity-based Costing System Quantity of Cost Driver Consumed during 2011 (see column (1))

Activity (1) Machine operations (400 jobs  10 mach. hrs. per job; 200 jobs  10 mach. hrs. per job) Setups (4  400; 7  200) Purchase orders (given) Design Marketing Administration ($180  400; $200  200)

Cost Driver (2) machine hours

setup hours no. of purchase orders selling price dir. labor costs

Standard Job (3) 4,000

Special Job (4) 2,000

1,600 400

1,400 500

$72,000

$40,000

Cost of supplies ($200  400; $250  200) Direct manuf. labor costs ($180  400; $200  200) Indirect costs allocated: Machine operations ($25 per mach. hr.  4,000; 2,000) Setups ($30 per setup hr.  1,600; 1,400) Purchase orders ($40 per order  400; 500) Design Marketing (0.05  $1,200  400; 0.05  $1,500  200) Administration (0.42857  $72,000; $40,000) Total costs Cost of each job ($378,857  400; $266,143  200)

Total Cost of Activity (given) (5) $150,000

$ $ $ $ $

90,000 36,000 40,000 39,000 48,000

Allocation Rate (6) = (5)  ((3) + (4)), or given $ 25.00 per machine hour

$ $

30.00 40.00

per setup hour per purchase order

$ 0.05 $0.42857

per dollar of sales per dollar of direct manuf. labor cost

Total Costs Standard Special Job Job $ 80,000 $ 50,000 72,000 40,000 100,000 48,000 16,000 8,000 24,000 30,857 $378,857 $ 947.14

50,000 42,000 20,000 32,000 15,000 17,143 $ 266,143 $1,330.72


3. Cost per job Simple Costing System Activity-based Costing System Difference (Simple – ABC)

Standard Job $1,051.70 $ 947.14 $ 104.56

Special Job $1,121.70 $1,330.72 $ (209.02)

Relative to the ABC system, the simple costing system overcosts standard jobs and undercosts special jobs. Both types of jobs need 10 machine hours per job, so in the simple system, they are each allocated $671.70 in indirect costs. But, the ABC study reveals that each standard job consumes less of the indirect resources such as setups, purchase orders, and design costs than a special job, and this is reflected in the higher indirect costs allocated to special jobs in the ABC system. 4. Quikprint can use the information revealed by the ABC system to change its pricing based on the ABC costs. Under the simple system, Quikprint was making a gross margin of 12% on each standard job (($1,200 – $1,051.70)  $1,200) and 25% on each special job (($1,500 – $1,121.70)  $1,500). But, the ABC system reveals that it is actually making a gross margin of about 21% (($1,200 – $947)  $1,200) on each standard job and about 11% (($1,500 – $1,331)  $1,500) on each special job. Depending on the market competitiveness, Quikprint may either want to reprice the different types of jobs, or, it may choose to market standard jobs more aggressively than before. Quikprint can also use the ABC information to improve its own operations. It could examine each of the indirect cost categories and analyze whether it would be possible to deliver the same level of service, but consume fewer indirect resources, or find a way to reduce the perunit-cost-driver cost of some of those indirect resources.


5-23

(30 min.) Activity-based costing, manufacturing.

1. Simple costing system: Total indirect costs = $95,000 + $45,000 + $25,000 + $60,000 + $8,000 + 3%[($125  3,200) + ($200  1,800)] = $255,800 Total machine-hours = 5,500 + 4,500 = 10,000 Indirect cost rate per machine-hour = $255,800  10,000 = $25.58 per machine-hour Simple Costing System Direct materialsa Direct manufacturing laborb Indirect cost allocated to each job ($25.58 × 5,500; 4,500 machine hours) Total costs

Interior $ 96,000 76,800

Exterior $ 81,000 64,800

140,690

115,110

$313,490

$260,910

Total cost per unit ($313,490  3,200; $260,910  1,800) a b

2.

97.97

$ 144.95

$30 × 3,200 units; $45  1,800 units $16 × 1.5 × 3,200 units; $16  2.25  1,800 units

Activity-based Costing System Total Cost of Activity (2)

Activity (1) Product scheduling Material handling Machine setup Assembly Inspection Marketing c

$

40 + 85 = 125;

$ $ $ $ $ d

95,000 45,000 25,000 60,000 8,000

72 + 168 = 240;

Cost Driver Quantity (4)

Cost Driver (3)

125c 240d 200e 10,000 400f

production runs material moves machine setups machine hours inspections selling price e

45 + 155 = 200;

f

Allocation Rate (5) = (2)  (4) $ 760.00 $ 187.50 $ 125.00 $ 6.00 $ 20.00 $ 0.03

per production run per material move per setup per machine hour per inspection per dollar of sales

250 + 150 = 400


ABC System Direct materials Direct manufacturing labor Indirect costs allocated: Product scheduling ($760 per run  40; 85) Material handling ($187.50 per move  72; 168) Machine setup ($125 per setup  45; 155) Assembly ($6 per MH × 5,500; 4,500) Inspection ($20 per inspection × 250; 150) Marketing (0.03  $125  3,200; 0.03  $200  1,800) Total costs Total cost per unit ($272,325 ÷ 3,200 units; $302,075 ÷ 1,800 units)

$

Interior $ 96,000 76,800

Exterior $ 81,000 64,800

30,400 13,500 5,625 33,000 5,000 12,000 $272,325

64,600 31,500 19,375 27,000 3,000 10,800 $302,075

85.10

$ 167.82

3. Cost per unit Simple Costing System Activity-based Costing System Difference (Simple – ABC)

Interior $97.97 $85.10 $12.87

Exterior $144.95 $167.82 $(22.87)

Relative to the ABC system, the simple costing system overcosts interior doors and undercosts exterior doors. Under the simple costing system, the doors require a similar number of total machine hours (5,500 for interior and 4,500 for exterior), even though interior doors take fewer machine hours per unit. Under the simple costing system, the volume of the production of interior doors is driving the amount of overhead allocated to that product. The ABC study reveals that each exterior door requires more production runs, material moves, and setups. This is reflected in the higher indirect costs allocated to exterior doors in the ABC system. 4. Open Doors, Inc. can use the information revealed by the ABC system to change its pricing based on the ABC costs. Under the simple system, Open Doors was making an operating margin of 21.6% on each interior door (($125 – $97.97)  $125) and 27.5% on each exterior door (($200 – $144.95)  $200). But, the ABC system reveals that it is actually making an operating margin of about 32% (($125 – $85.10)  $125) on each interior door and about 16% (($200 – $167.82)  $200) on each exterior door. Open Doors, Inc. should consider decreasing the price of its interior doors to be more competitive. Open Doors should also consider increasing the price of its exterior doors, depending on the competition it faces in this market. Open Doors can also use the ABC information to improve its own operations. It could examine each of the indirect cost categories and analyze whether it would be possible to deliver the same level of service, but consume fewer indirect resources, or find a way to reduce the perunit-cost-driver cost of some of those indirect resources. Making these operational improvements can help Open Doors to reduce costs, become more competitive, and reduce prices to gain further market share while increasing its profits.


5-24

(30 min.) ABC, retail product-line profitability.

1.

The simple costing system (Panel A of Solution Exhibit 5-24) reports the following: Baked Milk & Frozen Goods Fruit Juice Products Total Revenues $57,000 $63,000 $52,000 $172,000 Costs Cost of goods sold 38,000 47,000 35,000 120,000 Store support (30% of COGS) 11,400 14,100 10,500 36,000 Total costs 49,400 61,100 45,500 156,000 Operating income $ 7,600 $ 1,900 $ 6,500 $ 16,000 Operating income ÷ Revenues

2.

13.33%

3.02%

12.50%

9.30%

The ABC system (Panel B of Solution Exhibit 5-24) reports the following: Baked Milk & Frozen Goods Fruit Juice Products Total Revenues $57,000 $63,000 $52,000 $172,000 Costs Cost of goods sold 38,000 47,000 35,000 120,000 Ordering ($100 × 30; 25; 13) 3,000 2,500 1,300 6,800 Delivery ($80 × 98; 36; 28) 7,840 2,880 2,240 12,960 Shelf-stocking ($20 × 183; 166; 24) 3,660 3,320 480 7,460 Customer support ($0.20 × 15,500; 20,500; 7,900) 3,100 4,100 1,580 8,780 Total costs 55,600 59,800 40,600 156,000 Operating income $ 1,400 $ 3,200 $11,400 $ 16,000 Operating income ÷ Revenues

2.46%

5.08%

21.92%

9.30%

These activity costs are based on the following: Activity Ordering Delivery Shelf-stocking Customer support

Cost Allocation Rate $100 per purchase order $80 per delivery $20 per hour $0.20 per item sold

Baked Milk & Goods Fruit Juice 30 25 98 36 183 166 15,500 20,500

Frozen Products 13 28 24 7,900


3.

The rankings of products in terms of relative profitability are: Simple Costing System ABC System 1. Baked goods 13.33% Frozen products 2. Frozen products 12.50 Milk & fruit juice 3. Milk & fruit juice 3.02 Baked goods

21.92% 5.08 2.46

The percentage revenue, COGS, and activity costs for each product line are:

Revenues COGS Activity areas: Ordering Delivery Shelf-stocking Customer support

Baked Goods 33.14 31.67

Milk & Frozen Fruit Juice Products Total 36.63 30.23 100.00 39.17 29.16 100.00

44.12 60.49 49.06 35.31

36.76 22.22 44.50 46.70

19.12 17.29 6.44 17.99

100.00 100.00 100.00 100.00

The baked goods line drops sizably in profitability when ABC is used. Although it constitutes 31.67% of COGS, it uses a higher percentage of total resources in each activity area, especially the high cost delivery activity area. In contrast, frozen products draws a much lower percentage of total resources used in each activity area than its percentage of total COGS. Hence, under ABC, frozen products is much more profitable. Family Supermarkets may want to explore ways to increase sales of frozen products. It may also want to explore price increases on baked goods.


SOLUTION EXHIBIT 5-24 Product-Costing Overviews of Family Supermarkets PANEL A: SIMPLE COSTING SYSTEM



INDIRECT COST POOL

Store Support




COGS

COST OBJECT: PRODUCT LINE




DIRECT COST



COGS

PANEL B: ABC SYSTEM INDIRECT COST POOL COST ALLOCATION BASE COST OBJECT: PRODUCT LINE

DIRECT COST

Ordering

Number of Purchase Order

Delivery

ShelfStocking

Customer Support

Number of Deliveries

Hours of Shelf-Stocking

Number of Items Sold


COGS


5-25

(15–20 min.) ABC, wholesale, customer profitability. Chain

1 Gross sales $55,000 Sales returns 11,000 Net sales 44,000 Cost of goods sold (70%) 30,800 Gross margin 13,200 Customer-related costs: Regular orders $25 × 45; 175; 52; 75 1,125 Rush orders $125 × 11; 48; 11; 32 1,375 Returned items $15 × 101; 25; 65; 35 1,515 Catalogs and customer support 1,100 Customer related costs 5,115 Contribution (loss) margin $ 8,085 Contribution (loss) margin as percentage of gross sales 14.7%

2 $25,000 3,500 21,500 15,050 6,450

3 $100,000 7,000 93,000 65,100 27,900

4 $75,000 6,500 68,500 47,950 20,550

4,375

1,300

1,875

6,000

1,375

4,000

375 975 1,100 1,100 11,850 4,750 $(5,400) $ 23,150

525 1,100 7,500 $13,050

(21.6%)

23.15%

17.4%

The analysis indicates that customers’ profitability (loss) contribution varies widely from (21.6%) to 23.15%. Immediate attention to Chain 2 is required which is currently showing a loss contribution. The chain has a disproportionate number of both regular orders and rush orders. Ramirez should work with the management of Chain 2 to find ways to reduce the number of orders, while maintaining or increasing the sales volume. If this is not possible, Ramirez should consider dropping Chain 2, if it can save the customer-related costs. Chain 1 has a disproportionate number of the items returned as well as sale returns. The causes of these should be investigated so that the profitability contribution of Chain 1 could be improved.


5-26

(50 min.) ABC, activity area cost-driver rates, product cross-subsidization.

1. Direct costs Direct materials Indirect costs Product support Total costs

$ 150,000 983,000 $1,133,000

Cost per pound of potato cuts 2.

Cost Pool Cleaning Cutting Packaging

Costs in Pool $120,000 $231,000 $444,000

=

$1,133,000 = $1.133 1,000 ,000

Number of Driver Units 1,200,000 raw pounds 3,850 hours* 37,000 hours**

Costs per Driver Unit $ 0.10 $60.00 $12.00

*(900,000 ÷ 250) + (100,000 ÷ 400) = 3,600 + 250 = 3,850 **(900,000 ÷ 25) + (100,000 ÷ 100) = 36,000 + 1,000 = 37,000

3.

Retail Potato Cuts Direct costs Direct materials $135,000 Packaging 180,000 Indirect costs Cleaning $0.10 × 90% × 1,200,000 108,000 $0.10 × 10% × 1,200,000 Cutting $60 × 3,600 hours 216,000 $60 × 250 hours Packaging $12 × 36,000; $12 × 1,000 432,000 Total costs Pounds produced Costs per pound

Institutional Potato Cuts

$ 315,000

$15,000 8,000

$23,000

12,000

15,000 756,000 $1,071,000 900,000 $ 1.19

12,000

39,000 $62,000 100,000 $ 0.62

Note: The total costs of $1,133,000 ($1,071,000 + $62,000) are the same as those in Requirement 1.


4.

There is much evidence of product-cost cross-subsidization. Cost per Pound Simple costing system ABC system

Retail $1.133 $1.190

Institutional $1.133 $0.620

Assuming the ABC numbers are more accurate, potato cuts sold to the retail market are undercosted while potato cuts sold to the institutional market are overcosted. The simple costing system assumes each product uses all the activity areas in a homogeneous way. This is not the case. Institutional sales use sizably less resources in the cutting area and the packaging area. The percentages of total costs for each cost category are as follows: Retail Institutional Total Direct costs Direct materials 90.0% 10.0% 100.0% Packaging 95.7 4.3 100.0 Indirect costs Cleaning 90.0 10.0 100.0 Cutting 93.5 6.5 100.0 Packaging 97.3 2.7 100.0 Units produced 90.0% 10.0% 100.0% Idaho can use the revised cost information for a variety of purposes: a. Pricing/product emphasis decisions. The sizable drop in the reported cost of potatoes sold in the institutional market makes it possible that Idaho was overpricing potato products in this market. It lost the bid for a large institutional contract with a bid 30% above the winning bid. With its revised product cost dropping from $1.133 to $0.620, Idaho could have bid much lower and still made a profit. An increased emphasis on the institutional market appears warranted. b. Product design decisions. ABC provides a road map as to how to reduce the costs of individual products. The relative components of costs are: Retail Direct costs Direct materials Packaging Indirect costs Cleaning Cutting Packaging Total costs

Institutional

12.6% 16.8

24.20% 12.90

10.1 20.2 40.3 100.0%

19.35 24.20 19.35 100.00%

Packaging-related costs constitute 57.1% (16.8% + 40.3%) of total costs of the retail product line. Design efforts that reduce packaging costs can have a big impact on reducing total unit costs for retail. c. Process improvements. Each activity area is now highlighted as a separate cost. The three indirect cost areas comprise over 60% of total costs for each product, indicating the upside from improvements in the efficiency of processes in these activity areas.


5-27

(20–25 min.) Activity-based costing, job-costing system.

1. Overhead allocation using a simple job-costing system, where overhead is allocated based on machine hours: Overhead allocation rate = $453,600  10,500 machine-hours = $43.20 per machine-hour

Overhead allocateda a

2.

Job 215

Job 325

$1,728

$2,592

$43.20 per machine-hour × 40 hours; 60 hours

Overhead allocation using an activity-based job-costing system:

Purchasing Material handling Machine maintenance Product inspection Packaging

Budgeted Overhead (1) $ 70,000 $ 87,500 $ 237,300 $ 18,900 $ 39,900 $ 453,600

Activity Driver (2) Purchase orders processed Material moves Machine hours Inspections Units produced

Overhead allocated Purchasing ($35  25; 8 orders) Material handling ($17.50  10; 4 moves) Machine maintenance ($22.60  40; 60 hours) Product inspection ($15.75  9; 3 inspections) Packaging ($10.50  15; 6 units) Total

Budgeted Activity Driver (3) 2,000

Activity Rate (4) = (1)  (3) $35.00

5,000 10,500 1,200 3,800

$17.50 $22.60 $15.75 $10.50

Job 215

Job 325

$ 875.00 175.00 904.00 141.75 157.50 $2,253.25

$ 280.00 70.00 1,356.00 47.25 63.00 $1,816.25

3. The manufacturing manager likely would find the ABC job-costing system more useful in cost management. Unlike direct manufacturing labor costs, the five indirect cost pools are systematically linked to the activity areas at the plant. The result is more accurate product costing. The manufacturing manager can seek to reduce both the level of activity (fewer purchase orders, less material handling) and the cost of each activity (such as the cost per inspection). Marketing managers can use ABC information to bid for jobs more competitively because ABC provides managers with a more accurate reflection of the resources used for and the costs of each job.


5-28

(30 min.) ABC, product-costing at banks, cross-subsidization.

1. Revenues Spread revenue on annual basis (3%  ; $1,100, $700, $24,600) Monthly fee charges ($22 ; 0, 12, 0) Total revenues Costs Deposit/withdrawal with teller $2.30  42; 48; 5 Deposit/withdrawal with ATM $0.70  7; 19; 17 Deposit/withdrawal on prearranged basis $0.40  0; 13; 62 Bank checks written $8.40  11; 1; 3 Foreign currency drafts $12.40  4; 2; 6 Inquiries $1.40  12; 20; 9 Total costs Operating income (loss)

Holt

Turner

Graham

$ 33.00

$ 21.00

$738.00

$ 792.00

0.00 33.00

264.00 285.00

0.00 738.00

264.00 1,056.00

96.60

110.40

11.50

218.50

4.90

13.30

11.90

30.10

0.00

5.20

24.80

30.00

92.40

8.40

25.20

126.00

49.60

24.80

74.40

148.80

28.00 190.10 $ 94.90

12.60 160.40 $577.60

57.40 610.80 $ 445.20

16.80 260.30 $(227.30)

Total

The assumption that the Holt and Graham accounts exceed $1,000 every month and the Turner account is less than $1,000 each month means the monthly charges apply only to Turner. One student with a banking background noted that in this solution 100% of the spread is attributed to the ―depositor side of the bank.‖ He noted that often the spread is divided between the ―depositor side‖ and the ―lending side‖ of the bank. 2. Cross-subsidization across individual Premier Accounts occurs when profits made on some accounts are offset by losses on other accounts. The aggregate profitability on the three customers is $445.20. The Graham account is highly profitable, $577.60, while the Holt account is sizably unprofitable. The Turner account shows a small profit but only because of the $264 monthly fees. It is unlikely that Turner will keep paying these high fees and that NSB would want Turner to pay such high fees from a customer relationship standpoint. The facts also suggest that the customers do not use the bank services uniformly. For example, Holt and Turner have a lot of transactions with the teller, and also inquire about their account balances more often than Graham. This suggests cross-subsidization. NSB should be very concerned about the cross-subsidization. Competition likely would ―understand‖ that highbalance low-activity type accounts (such as Graham) are highly profitable. Offering free services to these customers is not likely to retain these accounts if other banks offer higher interest rates. Competition likely will reduce the interest rate spread NSB can earn on the high-balance lowactivity accounts they are able to retain.


3.

Possible changes NSB could make are: a. Offer higher interest rates on high-balance accounts to increase NSB’s competitiveness in attracting and retaining these accounts. b. Introduce charges for individual services. The ABC study reports the cost of each service. NSB has to decide if it wants to price each service at cost, below cost, or above cost. If it prices above cost, it may use advertising and other means to encourage additional use of those services by customers. Of course, in determining its pricing strategy, NSB would need to consider how other competing banks are pricing their products and services.

5-29

(15 min.) Job costing with single direct-cost category, single indirect-cost pool, law firm.

1. Pricing decisions at Wigan Associates are heavily influenced by reported cost numbers. Suppose Wigan is bidding against another firm for a client with a job similar to that of Widnes Coal. If the costing system overstates the costs of these jobs, Wigan may bid too high and fail to land the client. If the costing system understates the costs of these jobs, Wigan may bid low, land the client, and then lose money in handling the case. 2. Direct professional labor, $70 × 104; $70 × 96 Indirect costs allocated, $105 × 104; $105 × 96 Total costs to be billed

Widnes Coal

St. Helen’s Glass

Total

$ 7,280

$ 6,720

$14,000

10,920 $18,200

10,080 $16,800

21,000 $35,000


5-30

1.

(20–25 min.) Job costing with multiple direct-cost categories, single indirect-cost pool, law firm (continuation of 5-29). Indirect costs = $7,000 Total professional labor-hours = 200 hours (104 hours on Widnes Coal + 96 hours on St. Helen’s Glass) Indirect cost allocated per professional labor-hour (revised) = $7,000 ÷ 200 = $35 per hour

2. Direct costs: Direct professional labor, $70 × 104; $70 × 96 Research support labor Computer time Travel and allowances Telephones/faxes Photocopying Total direct costs Indirect costs allocated, $35 × 104; $35 × 96 Total costs to be billed

Widnes Coal

St. Helen’s Glass

Total

$ 7,280 1,600 500 600 200 250 10,430

$ 6,720 3,400 1,300 4,400 1,000 750 17,570

$14,000 5,000 1,800 5,000 1,200 1,000 28,000

3,640 $14,070

3,360 $20,930

7,000 $35,000

Widnes Coal

St. Helen’s Glass

Total

$18,200 14,070

$16,800 20,930

$35,000 35,000

3.

Problem 5-29 Problem 5-30

The Problem 5-30 approach directly traces $14,000 of general support costs to the individual jobs. In Problem 5-29, these costs are allocated on the basis of direct professional labor-hours. The averaging assumption implicit in the Problem 5-29 approach appears incorrect—for example, the St. Helen’s Glass job has travel costs over seven times higher than the Widnes Coal case despite having lower direct professional labor-hours.


5-31

(30 min.) Job costing with multiple direct-cost categories, multiple indirect-cost pools, law firm (continuation of 5-29 and 5-30).

1.

Widnes Coal

St. Helen’s Glass

Total

$ 5,600

$ 8,000

2,000 3,400 1,300 4,400 1,000 750 18,450

6,000 5,000 1,800 5,000 1,200 1,000 28,000

3,220

4,600

800 4,020 $22,470

2,400 7,000 $35,000

St. Helen’s Glass

Total

$16,800

$35,000

$20,930

$35,000

$22,470

$35,000

Direct costs: Partner professional labor, $100 × 24; $100 × 56 $ 2,400 Associate professional labor, $50 × 80; $50 × 40 4,000 Research support labor 1,600 Computer time 500 Travel and allowances 600 Telephones/faxes 200 Photocopying 250 Total direct costs 9,550 Indirect costs allocated: Indirect costs for partners, $57.50 × 24; $57.50 × 56 1,380 Indirect costs for associates, $20 × 80; $20 × 40 1,600 Total indirect costs 2,980 Total costs to be billed $12,530 Widnes Comparison Coal Single direct cost/ Single indirect cost pool $18,200 Multiple direct costs/ Single indirect cost pool $14,070 Multiple direct costs/ Multiple indirect cost pools $12,530

The higher the percentage of costs directly traced to each case, and the greater the number of homogeneous indirect cost pools linked to the cost drivers of indirect costs, the more accurate the product cost of each individual case. The Widnes and St. Helen’s cases differ in how they use ―resource areas‖ of Wigan Associates:

Partner professional labor Associate professional labor Research support labor Computer time Travel and allowances Telephones/faxes Photocopying

Widnes Coal 30.0% 66.7 32.0 27.8 12.0 16.7 25.0

St. Helen’s Glass 70.0% 33.3 68.0 72.2 88.0 83.3 75.0


The Widnes Coal case makes relatively low use of the higher-cost partners but relatively higher use of the lower-cost associates than does St. Helen’s Glass. As a result, it also uses less of the higher indirect costs required to support partners compared to associates. The Widnes Coal case also makes relatively lower use of the support labor, computer time, travel, phones/faxes, and photocopying resource areas than does the St. Helen’s Glass case. 2. The specific areas where the multiple direct/multiple indirect (MD/MI) approach can provide better information for decisions at Wigan Associates include: Pricing and product (case) emphasis decisions. In a bidding situation using single direct/single indirect (SD/SI) or multiple direct/single indirect (MD/SI) data, Wigan may win bids for legal cases on which it will subsequently lose money. It may also not win bids on which it would make money with a lower-priced bid. From a strategic viewpoint, SD/SI or MD/SI exposes Wigan Associates to cherry-picking by competitors. Other law firms may focus exclusively on Widnes Coal-type cases and take sizable amounts of ―profitable‖ business from Wigan Associates. MD/MI reduces the likelihood of Wigan Associates losing cases on which it would have made money. Client relationships. MD/MI provides a better ―road map‖ for clients to understand how costs are accumulated at Wigan Associates. Wigan can use this road map when meeting with clients to plan the work to be done on a case before it commences. Clients can negotiate ways to get a lower-cost case from Wigan, given the information in MD/MI—for example, (a) use a higher proportion of associate labor time and a lower proportion of a partner time, and (b) use fax machines more and air travel less. If clients are informed in advance how costs will be accumulated, there is less likelihood of disputes about bills submitted to them after the work is done. Cost control. The MD/MI approach better highlights the individual cost areas at Wigan Associates than does the SD/SI or MD/SI approaches: MD/MI 7 2 9

Number of direct cost categories Number of indirect cost categories Total

SD/SI 1 1 2

MD/SI 7 1 8

MD/MI is likely to promote better cost-control practices than SD/SI or MD/SI, as the nine cost categories in MD/MI give Wigan a better handle on how to effectively manage different categories of both direct and indirect costs.


5-32 (50 min.)

Plantwide, department, and activity-cost rates.

1. Plant-wide costing rate Fighters Direct materials Assembly Painting Total Direct Labor Assembly Painting Total

Cargo

Total

$2.50 0.50 $3.00

$3.75 1.00 $4.75

$6.25 1.50 $7.75

$3.50

$2.00

$5.50

2.25 $5.75

1.50 $3.50

3.75 $9.25

Fighters Direct materials ($3.00 × 800 units; $4.75 × 740 units) Direct manufacturing labor ($5.75 × 800 units; $3.50 × 740 units) Total direct costs

Cargo

Total

$2,400

$3,515

$ 5,915

4,600 $7,000

2,590 $6,105

7,190 $13,105

Plant- wide overhead rate = $11,180  $13,105 = $0.85311 per direct cost dollar Total direct costs Overhead allocated (0.85311 × $7,000; $6,105) Total costs Divided by number of units Total cost per unit

$

Fighters $ 7,000.00 5,971.77 $12,971.77  800 16.21 $

Cargo $ 6,105.00 5,208.24 $11,313.24  740 15.29

2. Departmental costing Budgeted Budgeted Assembly Department overhead costs overhead rate  Budgeted Assembly Department direct manufacturing labor costs Assembly Dept. $7,030  $3.50  800 units + $2  740 units $7,030 $7, 030    $1.64252 per direct manuf. labor dollar $2,800 + $1,480 $4, 280


Budgeted overhead rate Painting Dept.



Budgeted Painting Department overhead costs Budgeted Painting Department direct costs



$4,150 $2.75 × 800 units + $2.50  740 units



$4,150 $4,150   $1.02469 per direct cost dollar $2, 200  $1,850 $4, 050

Direct materials Direct manufacturing labor Total direct costs Allocated overhead: Assembly Department (1.64252  $2,800a; $1,480a) Painting Department (1.02469  $2,200b; $1,850b) Total costs Divided by number of units

Fighters $ 2,400 4,600 7,000

Cargo $ 3,515 2,590 6,105

Total $ 5,915 7,190 13,105

4,599

2,431

7,030

2,254 $13,853  800 $ 17.32

1,896 $10,432  740 $ 14.10

4,150 $24,285

a

Direct manufacturing labor costs in Assembly Department calculated previously: Fighters, $3.50 × 800 units = $2,800; Cargo, $2 × 740 units = $1,480 b Direct costs of Painting Department calculated previously: Fighters, $2.75 × 800 units = $2,200; Cargo, $2.50 × 740 units = $1,850

3.

Activity-based Costing

Assembly Department Budgeted materials handling rate



$1,700  $8.58586 per batch 198 batches

Budgeted quality inspection rate




Budgeted utilities rate



$2,580  $0.602804 per direct manuf. labor dollar $4,280


Painting Department Budgeted materials handling rate



$900  $6.81818 per batch 132 batches

Budgeted quality inspection rate




Budgeted utilities rate

$2,100 $2.25  800 units + $1.50  740 units $2,100 $2,100    $0.72165 per direct manuf. labor dollar $1,800  $1,110 $2,910 

Direct materials Direct manufacturing labor Total direct costs Allocated Assembly Department Overhead: Materials handling ($8.58586  150; 48) Inspection ($13.88889  150; 48) Utilities (0.602804  $2,800; $1,480) Allocated Painting Department Overhead: Materials handling ($6.81818  100; 32) Inspection ($8.71212  100; 32) Utilities (0.72165  $1,800c; $1,110c) Total costs Divided by number of units c

Fighters $ 2,400 4,600 7,000

Cargo $3,515 2,590 6,105

Total $ 5,915 7,190 13,105

1,288

412

1,700

2,083

667

2,750

1,688

892

2,580

682

218

871

279

1,299 $14,911  800 $ 18.64

801 $9,374  740 $12.67

900 1,150 2,100 $24,285

Direct manufacturing labor costs in Painting Department calculated previously: Fighters, $2.25 × 800 units = $1,800; Cargo, $1.50 × 740 units = $1,110

4. Activity-based cost information can improve decisions by allowing managers to understand how different aspects of cost influence total cost per unit. Using ABC and determining the drivers of overhead costs help Allen’s Aero Toys understand that cargo planes were overcosted and fighter jets were undercosted. Managers can also understand the drivers of different cost categories and use this information for pricing and product-mix decisions, cost reduction and process-improvement decisions, design decisions, and to plan and manage activities. However, too much detail can overload managers 5-33 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

who don’t understand the data or what it means. Also, managers looking at per-unit data may be misled when considering costs that aren’t unit-level costs. 5-33 (30-40 min.) Department and activity-cost rates service sector. 1. Overhead costs = $19,000 + $260,000 + $267,900 + $121,200 = $668,100 Budgeted overhead rate =

$668,100  $1.70 per direct labor dollar $393, 000

Technician labor Depreciation Materials Allocated overhead* Total budgeted costs Budgeted number of procedures Budgeted cost per service

X-rays Ultrasound CT scan $ 64,000 $104,000 $119,000 136,800 231,000 400,200 22,400 16,500 23,900 108,800 176,800 202,300 $332,000 $528,300 $745,400 ÷ 2,555 ÷ 4,760 ÷ 3,290 $ 129.94 $ 110.99 $ 226.57 $

MRI $ 106,000 792,000 30,800 180,200 $1,109,000 ÷2,695 411.50

Total $ 393,000 1,560,000 93,600 668,100 $2,714,700

* Allocated overhead = Budgeted overhead rate × Technician labor costs = $1.70 × Technician labor costs 2. Budgeted Information Number of procedures Cleaning minutes per procedure Total cleaning minutes Number of procedures Minutes for each procedure Total procedure minutes

Activity Administration

Budgeted Cost (1) $ 19,000

Maintenance

$260,000

Sanitation

$267,900

Utilities

$121,200

X-rays Ultrasound 2,555 4,760 ×10 10 25,550 47,600 2,555 ×5 12,775

Cost Driver (2) Total number of procedures Total dollars of depreciation Total cleaning minutes Total procedure minutes

CT scan 3,290 ×20 65,800

MRI 2,695 ×40 107,800

Total 13,300

3,290 ×15 49,350

2,695 ×40 107,800

13,300

4,760 ×20 95,200 Units of Cost Driver (3) 13,300

246,750

265,125

Activity Rate (4) = (1) ÷ (3) $1.42857 per procedure

$1,560,000 $0.166667 per dollar of depreciation 246,750

$1.08571 per cleaning minute

265,125

$0.45714 per procedure minute


Technician labor Depreciation Materials Allocated activity costs: Administration ($1.42857 × 2,555; 4,760; 3,290; 2,695) Maintenance $0.166667 × $136,800; $231,000; $400, 200; $792,000) Sanitation ($1.08571 × 25,550; 47,600; 65,800; 107,800) Utilities ($0.45714 × 12,775; 95,200; 49,350; 107,800) Total budgeted cost Budgeted number of procedures Budgeted cost per service

X-rays $ 64,000 136,800 22,400

Ultrasound $104,000 231,000 16,500

CT Scan $119,000 400,200 23,900

MRI $ 106,000 792,000 30,800

Total $ 393,000 1,560,000 93,600

3,650

6,800

4,700

3,850

19,000

22,800

38,500

66,700

132,000

260,000

27,740

51,680

71,440

117,040

267,900

49,280 $1,230,970 ÷ 2,695 456.76

121,200 $2,714,700

5,840 43,520 22,560 $283,230 $492,000 $708,500 ÷ 2,555 ÷ 4,760 ÷ 3,290 $ 110.85 $ 103.36 $ 215.35 $

3. Using the disaggregated activity-based costing data, managers can see that the MRI actually costs substantially more and x-rays and ultrasounds substantially less than the traditional system indicated. In particular, the MRI activity generates a lot of maintenance activity and sanitation activity. Managers should examine the use of these two activities to search for ways to reduce the activity consumption and ultimately its cost.


5-34 1.

(30 min.) Choosing cost drivers, activity-based costing, activity-based management. Direct costs = Dance teacher salaries, Child care teacher salaries, Fitness instructor salaries Indirect costs = Supplies; Rent, maintenance, and utilities; Administration salaries; Marketing expenses

2. Indirect Cost Supplies Rent, maintenance, and utilities Administration salaries Marketing expenses

Cost Driver Number of participants Square footage Number of participants Number of advertisements

Budgeted Cost Driver Rate $21,984 ÷ 2,205 = $9.97 per participant $97,511÷ 11,650 = $8.37 per square foot $50,075 ÷ 2,205 = $22.71 per participant $21,000 ÷ 70 = $300 per advertisement

Supplies – Larger programs with more participants will require more supplies. For example, as the number of dance participants increases, so will the cost of dance accessories. Rent, maintenance and utilities are all building-related costs. Square-footage is the only spaceoriented cost driver available. Administration salaries – Larger programs require more time to enroll students and collect fees. Consequently, the number of participants appears to be a reasonable cost driver. Marketing expenses – Marketing expenses include the cost of advertising the studio. As the number of ads increases so do total marketing costs. 3. Salaries Allocated costs: Supplies ($9.97×1,485; 450; 270) Rent, maintenance, and utilities ($8.37×6,000; 3,150; 2,500) Administration salaries ($22.71×1,485; 450; 270) Marketing expenses ($300×26; 24; 20) Budgeted total costs ÷ Number of participants Budgeted cost per participant

Dance $ 62,100

Childcare $ 24,300

Fitness $ 39,060

Total $ 125,460

14,805

4,487

2,692

21,984

50,220

26,366

20,925

97,511

33,724

10,219

6,132

50,075

7,800 $ 168,649 ÷ 1,485 $ 113.57

7,200 $ 72,572 ÷450 $ 161.27

6,000 $ 74,809 ÷270 $ 277.07

21,000 $ 316,030

4. By dividing the full cost of each service line by the number of participants, Annie can see that fitness classes should be charged a higher price. Most of the higher unit cost is attributable to the cost of Aerobic instructors. Besides cost data, Annie should also consider a variety of other factors before setting the price for each service. Examples of other issues she should consider include the actions of competitors in her market, and the quality of her facilities and instructors.


5-35

(30–40 min.)

1.

Revenues Cost of goods sold Gross margin Other operating costs Operating income Gross margin %

Activity-based costing, merchandising. General Mom-and-Pop Supermarket Drugstore Single Chains Chains Stores Total $3,708,000 $3,150,000 $1,980,000 $8,838,000 3,600,000 3,000,000 1,800,000 8,400,000 $ 108,000 $ 150,000 $ 180,000 $ 438,000 301,080 $ 136,920 2.91%

4.76%

9.09%

The gross margin of Pharmacare, Inc., was 4.96% ($438,000 ÷ $8,838,000). The operating income margin of Pharmacare, Inc., was 1.55% ($136,920 ÷ $8,838,000). 2.

The per-unit cost driver rates are: 1. Customer purchase order processing, $80,000 ÷ 2,000 (140 + 360 + 1,500) orders 2. Line item ordering, $63,840 ÷ 21,280 (1,960 + 4,320 + 15,000) line items 3. Store delivery, $71,000 ÷ 1,480 (120 + 360 + 1,000) deliveries 4. Cartons shipped, $76,000 ÷ 76,000 (36,000 + 24,000 + 16,000) cartons 5. Shelf-stocking, $10,240 ÷ 640 (360 + 180 + 100) hours

3.

= $40 per order = $ 3 per line item = $47.973 per delivery = $ 1 per carton = $16 per hour

The activity-based costing of each distribution market for 2011 is: General Supermarket Chains

1. Customer purchase order processing ($40  140; 360; 1,500) 2. Line item ordering ($3  1,960; 4,320; 15,000) 3. Store delivery, ($47.973  120; 360; 1,000) 4. Cartons shipped ($1  36,000; 24,000; 16,000) 5. Shelf-stocking ($16  360; 180; 100)

Drugstore Chains

Mom-andPop Single Stores

Total

$ 5,600

$14,400

$ 60,000

$ 80,000

5,880

12,960

45,000

63 ,840

5,757

17,270

47,973

71,000

36,000

24,000

16,000

76,000

5,760 $58,997

2,880 $71,510

1,600 $170,573

10,240 $301,080


The revised operating income statement is: General Mom-and-Pop Supermarket Drugstore Single Chains Chains Stores Total Revenues $3,708,000 $3,150,000 $1,980,000 $8,838,000 Cost of goods sold 3,600,000 3,000,000 1,800,000 8,400,000 Gross margin 108,000 150,000 180,000 438,000 Operating costs 58,997 71,510 170,573 301,080 Operating income $ 49,003 $ 78,490 $ 9,427 $ 136,920 Operating income margin 1.32% 4.

2.49%

0.48%

1.55%

The ranking of the three markets are: Using Gross Margin

Using Operating Income

1. Mom-and-Pop Single Stores9.09% 2. Drugstore Chains 4.76% 3. General Supermarket Chains2.91%

1. Drugstore Chains 2.49% 2. General Supermarket Chains 1.32% 3. Mom-and-Pop Single Stores 0.48%

The activity-based analysis of costs highlights how the Mom-and-Pop Single Stores use a larger amount of Pharmacare’s resources per revenue dollar than do the other two markets. The ratio of the operating costs to revenues across the three markets is: General Supermarket Chains Drugstore Chains Mom-and-Pop Single Stores

1.59% 2.27% 8.61%

($58,997 ÷ $3,708,000) ($71,510 ÷ $3,150,000) ($170,573 ÷ $1,980,000)

This is a classic illustration of the maxim that ―all revenue dollars are not created equal.‖ The analysis indicates that the Mom-and-Pop Single Stores are the least profitable market. Pharmacare should work to increase profits in this market through: (1) a possible surcharge, (2) decreasing the number of orders, (3) offering discounts for quantity purchases, etc.


Other issues for Pharmacare to consider include a. Choosing the appropriate cost drivers for each area. The problem gives a cost driver for each chosen activity area. However, it is likely that over time further refinements in cost drivers would be necessary. For example, not all store deliveries are equally easy to make, depending on parking availability, accessibility of the storage/shelf space to the delivery point, etc. Similarly, not all cartons are equally easy to deliver–– their weight, size, or likely breakage component are factors that can vary across carton types. b. Developing a reliable data base on the chosen cost drivers. For some items, such as the number of orders and the number of line items, this information likely would be available in machine readable form at a high level of accuracy. Unless the delivery personnel have hand-held computers that they use in a systematic way, estimates of shelf-stocking time are likely to be unreliable. Advances in information technology likely will reduce problems in this area over time. c. Deciding how to handle costs that may be common across several activities. For example, (3) store delivery and (4) cartons shipped to stores have the common cost of the same trip. Some organizations may treat (3) as the primary activity and attribute only incremental costs to (4). Similarly, (1) order processing and (2) line item ordering may have common costs. d.

Behavioral factors are likely to be a challenge to Flair. He must now tell those salespeople who specialize in Mom-and-Pop accounts that they have been less profitable than previously thought.


5-36 (30-40 min.) Choosing cost drivers, activity-based costing, activity-based management. 1. Direct materials—purses Direct materials—backpacks Direct manufacturing labor—purses Direct manufacturing labor—backpacks Setup Shipping Design Plant utilities and administration

Output unit-level costs Output unit-level costs Output unit-level costs Output unit-level costs Batch-level costs Batch-level costs Product-sustaining costs Facility-sustaining costs

2. Direct materials—purses Direct materials—backpacks Direct manufacturing labor—purses Direct manufacturing labor—backpacks Setup Shipping Design Plant utilities and administration

Number of purses Number of backpacks Number of purses Number of backpacks Number of batches Number of batches Number of designs Hours of production

Direct material and direct manufacturing labor are costs that can be easily traced to output, which in this case is the number of purses or backpacks produced. Setup and shipping are both a function of the number of batches produced. Design is related to the number of designs created for each product. Plant utilities and administration result from general activity level in the plant. Thus, hours of production seems to be an appropriate cost driver. 3. Direct materials—purses Direct materials—backpacks Direct manufacturing labor—purses Direct manufacturing labor—backpacks Setup Shipping Design Plant utilities and administration

$379,290 ÷ 3,350 purses = $113.22 per purse $412,920 ÷ 6,050 backpacks = $68.25 per backpack $98,000 ÷ 3,350 purses = $29.25 per purse $120,000 ÷ 6,050 backpacks = $19.83 per backpack $65,930  190 batches = $347 per batch $73,910  190 batches = $389 per batch $166,000 ÷ 4 designs = $41,500 per design $243,000 ÷ 4,050 hours = $60 per hour


4. Direct materials Direct manufacturing labor Setup ($347 × 130; 60 batches) Shipping ($389 × 130; 60 batches) Design ($41,500 × 2; 2 designs) Plant utilities and administration ($60 × 1,450; 2,600 hours) Budgeted total costs Divided by number of backpacks/purses Budgeted cost per backpack/purse

Backpacks $412,920 120,000

Purses $379,290 98,000

Total $ 792,210 218,000

45,110

20,820

65,930

50,570

23,340

73,910

83,000

83,000

166,000

87,000 $798,600 ÷ 6,050 $ 132.00

156,000 $760,450 ÷ 3,350 $ 227.00

243,000 $1,559,050

5. Based on this analysis, over 50% of product cost relates to direct material. Managers should determine whether the material costs can be reduced. Producing in small lots increases the setup and shipping costs. While both are relatively small components of product cost, management may want to evaluate ways to reduce the number of setups and the cost per setup. Of the indirect costs, the product- and facility-sustaining costs are the highest. Management should review the design process for cost savings and examine why it takes so long to produce purses relative to backpacks.


5-37

(40 min.) ABC, health care.

1a. Medical supplies rate

= =

Medical supplies costs $220,000 = Total number of patient - years 110 $2,000 per patient-year

Rent and clinic, maintenance rate Rent and clinic maint. costs $126,000 = Total amount of square feet of space 21,000 = $6 per square foot Admin. cost rate for, patient-charts, food, and laundry Admin. costs to manage patient

=

=

charts, food, laundry $440,000 = 110 Total number of patient - years = $4,000 per patient-year Laboratory services rate = =

Laboratory services costs $84,000 = Total number of laboratory tests 2,100 $40 per test

These cost drivers are chosen as the ones that best match the descriptions of why the costs arise. Other answers are acceptable, provided that clear explanations are given. 1b. Activity-based costs for each program and cost per patient-year of the alcohol and drug program follow: Drug Direct labor Physicians at $150,000 × 4; 0 Psychologists at $75,000 × 4; 8 Nurses at $30,000 × 6; 10 Direct labor costs Medical supplies1 $2,000 × 50; 60 Rent and clinic maintenance2 $6 × 9,000; 12,000 Administrative costs to manage patient charts, food, and laundry3 $4,000 × 50; 60 Laboratory services4 $40 × 1,400; 700 Total costs

Cost per patient-year 1 2

$ 600,000 300,000 180,000 1,080,000 100,000

After-Care ––– $ 600,000 300,000 900,000 120,000

Total $ 600,000 900,000 480,000 1,980,000 220,000

54,000

72,000

126,000

200,000

240,000

440,000

56,000 $1,490,000

28,000 $1,360,000

84,000 $2,850,000

$1, 490, 000  $29,800 50

Allocated using patient-years Allocated using square feet of space


3 4

Allocated using patient-years Allocated using number of laboratory tests

1c. The ABC system more accurately allocates costs because it identifies better cost drivers. The ABC system chooses cost drivers for overhead costs that have a cause-and-effect relationship between the cost drivers and the costs. Of course, Clayton should continue to evaluate if better cost drivers can be found than the ones they have identified so far. By implementing the ABC system, Clayton can gain a more detailed understanding of costs and cost drivers. This is valuable information from a cost management perspective. The system can yield insight into the efficiencies with which various activities are performed. Clayton can then examine if redundant activities can be eliminated. Clayton can study trends and work toward improving the efficiency of the activities. In addition, the ABC system will help Clayton determine which programs are the most costly to operate. This will be useful in making long-run decisions as to which programs to offer or emphasize. The ABC system will also assist Clayton in setting prices for the programs that more accurately reflect the costs of each program. 2. The concern with using costs per patient-year as the rule to allocate resources among its programs is that it emphasizes ―input‖ to the exclusion of ―outputs‖ or effectiveness of the programs. After-all, Clayton’s goal is to cure patients while controlling costs, not minimize costs per-patient year. The problem, of course, is measuring outputs. Unlike many manufacturing companies, where the outputs are obvious because they are tangible and measurable, the outputs of service organizations are more difficult to measure. Examples are ―cured‖ patients as distinguished from ―processed‖ or ―discharged‖ patients, ―educated‖ as distinguished from ―partially educated‖ students, and so on.


5-38 (25 min.) Unused capacity, activity-based costing, activity-based management. 1. Number of batches Machine-hours

Basketballs 300 11,000

Volleyballs 400 12,500

Total 700 23,500

Setup cost per batch = $143,500 ÷ 700 batches = $205 per batch. Equipment and maintenance = $109,900 ÷ 23,500 machine-hours = $4.6766 per machine-hour.

Lease rent, insurance, utilities = $216,000 ÷ 12,000 sq. ft. of capacity = $18 per sq. ft. 2. Unused capacity  Total capacity 

Capacity used for Capacity used for  basketball production volleyball production

 12,000  3,360  5,040  3,600 sq. ft.

Cost of unused capacity = $18 per sq. ft × 3,600 sq. ft. = $64,800 3. Basketballs Volleyballs Direct materials $209,750 $358,290 Direct manufacturing labor 107,333 102,969 Setup ($205 × 300; 400) 61,500 82,000 Equipment and maintenance ($4.6766 × 11,000; 12,500) 51,443 58,457 Lease rent, etc. ($18 × 3,360; 5,040) 60,480 90,720 $490,506 Budgeted total costs $692,436 ÷ 66,000 Divided by number of units ÷100,000 $ 7.43 Budgeted cost per unit $ 6.92

Total $ 568,040 210,302 143,500 109,900 151,200 $1,182,942

4. Currently, Nivag only utilizes 70% of its available capacity. Managers should consider whether the excess capacity is sufficient to produce footballs. Other issues to consider include demand for the proposed product, the competition, capital investment needed to start and support this product line, and the availability of skilled and unskilled labor needed to manufacture footballs.


5-39

(4050 min.) Activity-based job costing, unit-cost comparisons.

An overview of the product-costing system is: INDIRECT COST POOL






Materials Handling

Lathe Work

Milling

Number of Parts

Number of Turns

Number of Machine-Hours

 

Number of Parts

Testing

Number of Units Tested

Indirect Costs

COST OBJECT: COMPONENTS

DIRECT COST

Grinding

Direct Costs


Direct Materials

1. Job Order 410 Direct manufacturing cost Direct materials Direct manufacturing labor $30  25; $30  375 Indirect manufacturing cost $115  25; $115  375 Total manufacturing cost Divided by number of units Manufacturing cost per unit

$9,700 750

Job Order 411 $59,900

$

10,450

11,250 $ 71,150

2,875 13,325 ÷ 10 $ 1,332.50

43,125 $114,275 ÷ 200 $571.375

$


2.

Job Order 410 Direct manufacturing cost Direct materials Direct manufacturing labor $30  25; $30  375 Indirect manufacturing cost Materials handling $0.40  500; $0.40  2,000 Lathe work $0.20  20,000; $0.20  59,250 Milling $20.00  150; $20.00  1,050 Grinding $0.80  500; $0.80  2,000 Testing $15.00  10; $15.00  200 Total manufacturing cost Divided by number of units Manufacturing cost per unit

$9,700 750

$59,900 $10,450

200 4,000

11,850

3,000

21,000 1,600

150 ÷

Number of units in job Costs per unit with prior costing system Costs per unit with activity-based costing

11,250 $ 71,150

800

400

3.

Job Order 411

7,750 3,000 $18,200 38,250 10 $109,400 $ 1,820 ÷ 200 $ 547

Job Order 410 10 $1,332.50 1,820.00

Job Order 411 200 $571.375 547

Job order 410 has an increase in reported unit cost of 36.6% [($1,820 – $1,332.50) ÷ $1,332.50], while job order 411 has a decrease in reported unit cost of 4.3% [($547 – $571.375) ÷ $571.375]. A common finding when activity-based costing is implemented is that low-volume products have increases in their reported costs while high-volume products have decreases in their reported cost. This result is also found in requirements 1 and 2 of this problem. Costs such as materials-handling costs vary with the number of parts handled (a function of batches and complexity of products) rather than with direct manufacturing labor-hours, an output-unit level cost driver, which was the only cost driver in the previous job-costing system. The product cost figures computed in requirements 1 and 2 differ because a. the job orders differ in the way they use each of five activity areas, and b. the activity areas differ in their indirect cost allocation bases (specifically, each area does not use the direct manufacturing labor-hours indirect cost allocation base).


The following table documents how the two job orders differ in the way they use each of the five activity areas included in indirect manufacturing costs:

Activity Area Materials handling Lathe work Milling Grinding Testing

Usage Based on Analysis of Activity Area Cost Drivers Job Order Job Order 410 411 20.0% 80.0% 25.2 74.8 12.5 87.5 20.0 80.0 4.8 95.2

Usage Assumed with Direct Manuf. Labor-Hours as Application Base Job Order Job Order 410 411 6.25% 93.75% 6.25 93.75 6.25 93.75 6.25 93.75 6.25 93.75

The differences in product cost figures might be important to Tracy Corporation for product pricing and product emphasis decisions. The activity-based accounting approach indicates that job order 410 is being undercosted while job order 411 is being overcosted. Tracy Corporation may erroneously push job order 410 and deemphasize job order 411. Moreover, by its actions, Tracy Corporation may encourage a competitor to enter the market for job order 411 and take market share away from it. 4. Information from the ABC system can also help Tracy manage its business better in several ways. a. Product design. Product designers at Tracy Corporation likely will find the numbers in the activity-based costing approach more believable and credible than those in the simple system. In a machine-paced manufacturing environment, it is unlikely that direct labor-hours would be the major cost driver. Activity-based costing provides more credible signals to product designers about the ways the costs of a product can be reduced––for example, use fewer parts, require fewer turns on the lathe, and reduce the number of machine-hours in the milling area. b. Cost management. Tracy can reduce the cost of jobs both by making process improvements that reduce the activities that need to be done to complete jobs and by reducing the costs of doing the activities. c. Cost planning. ABC provides a more refined model to forecast costs and to explain why actual costs differ from budgeted costs.


5-40

(50 min.) ABC, implementation, ethics.

1. Applewood Electronics should not emphasize the Regal model and should not phase out the Monarch model. Under activity-based costing, the Regal model has an operating income percentage of less than 3%, while the Monarch model has an operating income percentage of nearly 43%. Cost driver rates for the various activities identified in the activity-based costing (ABC) system are as follows: Soldering $ 942,000  1,570,000 = $ 0.60 per solder point Shipments 860,000  20,000 = 43.00 per shipment Quality control 1,240,000  77,500 = 16.00 per inspection Purchase orders 950,400  190,080 = 5.00 per order Machine power 57,600  192,000 = 0.30 per machine-hour Machine setups 750,000  30,000 = 25.00 per setup Applewood Electronics Calculation of Costs of Each Model under Activity-Based Costing Monarch Direct costs Direct materials ($208  22,000; $584  4,000) Direct manufacturing labor ($18  22,000; $42  4,000) Machine costs ($144  22,000; $72  4,000) Total direct costs Indirect costs Soldering ($0.60  1,185,000; $0.60  385,000) Shipments ($43  16,200; $43  3,800) Quality control ($16  56,200; $16  21,300) Purchase orders ($5  80,100; $5  109,980) Machine power ($0.30  176,000; $0.30  16,000) Machine setups ($25  16,000; $25  14,000) Total indirect costs Total costs

Regal

$ 4,576,000 396,000 3,168,000 8,140,000

$2,336,000 168,000 288,000 2,792,000

711,000 696,600 899,200 400,500 52,800 400,000 3,160,100 $11,300,100

231,000 163,400 340,800 549,900 4,800 350,000 1,639,900 $4,431,900


Profitability analysis

Revenues Cost of goods sold Gross margin Per-unit calculations: Units sold Selling price ($19,800,000  22,000; $4,560,000  4,000) Cost of goods sold ($11,300,100  22,000; $4,431,900  4,000) Gross margin Gross margin percentage

Monarch Regal Total $19,800,000 $4,560,000 $24,360,000 11,300,100 4,431,900 15,732,000 $ 8,499,900 $ 128,100 $ 8,628,000

22,000

4,000

$900.00

$1,140.00

513.64 $386.36 42.9%

$

1,107.98 32.02 2.8%

2. Applewood’s simple costing system allocates all manufacturing overhead other than machine costs on the basis of machine-hours, an output unit-level cost driver. Consequently, the more machine-hours per unit that a product needs, the greater the manufacturing overhead allocated to it. Because Monarch uses twice the number of machine-hours per unit compared to Regal, a large amount of manufacturing overhead is allocated to Monarch. The ABC analysis recognizes several batch-level cost drivers such as purchase orders, shipments, and setups. Regal uses these resources much more intensively than Monarch. The ABC system recognizes Regal’s use of these overhead resources. Consider, for example, purchase order costs. The simple system allocates these costs on the basis of machine-hours. As a result, each unit of Monarch is allocated twice the purchase order costs of each unit of Regal. The ABC system allocates $400,500 of purchase order costs to Monarch (equal to $18.20 ($400,500  22,000) per unit) and $549,900 of purchase order costs to Regal (equal to $137.48 ($549,900  4,000) per unit). Each unit of Regal uses 7.55 ($137.48  $18.20) times the purchases order costs of each unit of Monarch. Recognizing Regal’s more intensive use of manufacturing overhead results in Regal showing a much lower profitability under the ABC system. By the same token, the ABC analysis shows that Monarch is quite profitable. The simple costing system overcosted Monarch, and so made it appear less profitable. 3. Duval’s comments about ABC implementation are valid. When designing and implementing ABC systems, managers and management accountants need to trade off the costs of the system against its benefits. Adding more activities would make the system harder to understand and more costly to implement but it would probably improve the accuracy of cost information, which, in turn, would help Applewood make better decisions. Similarly, using inspection-hours and setup-hours as allocation bases would also probably lead to more accurate cost information, but it would increase measurement costs.


4. Activity-based management (ABM) is the use of information from activity-based costing to make improvements in a firm. For example, a firm could revise product prices on the basis of revised cost information. For the long term, activity-based costing can assist management in making decisions regarding the viability of product lines, distribution channels, marketing strategies, etc. ABM highlights possible improvements, including reduction or elimination of non-value-added activities, selecting lower cost activities, sharing activities with other products, and eliminating waste. ABM is an integrated approach that focuses management’s attention on activities with the ultimate aim of continuous improvement. As a whole-company philosophy, ABM focuses on strategic, as well as tactical and operational activities of the company. 5. Incorrect reporting of ABC costs with the goal of retaining both the Monarch and Regal product lines is unethical. In assessing the situation, the specific ―Standards of Ethical Conduct for Management Accountants‖ (described in Exhibit 1-7) that the management accountant should consider are listed below. Competence Clear reports using relevant and reliable information should be prepared. Preparing reports on the basis of incorrect costs in order to retain product lines violates competence standards. It is unethical for Benzo to change the ABC system with the specific goal of reporting different product cost numbers that Duval favors. Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Benzo may be tempted to change the product cost numbers to please Duval, the division president. This action, however, would violate the responsibility for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. Credibility The management accountant’s standards of ethical conduct require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, adjusting the product cost numbers to make both the Monarch and Regal lines look profitable would violate the standard of objectivity. Benzo should indicate to Duval that the product cost calculations are, indeed, appropriate. If Duval still insists on modifying the product cost numbers, Benzo should raise the matter with one of Duval’s superiors. If, after taking all these steps, there is continued pressure to modify product cost numbers, Benzo should consider resigning from the company, rather than engage in unethical behavior.


5-41

(30-40 mins.) Activity-based costing, cost hierarchy.

1.

Revenues Cost of Merchandise Cost of Café Cleaning Allocated Selling, General and Administration Costsa (0.300986 × $2,656,727; $1,722,311; $556,685) Operating income a

Super Bookstore Income Statement For the Year Ended 31 December, 2010 Books CDs Café Total $3,720,480 $2,315,360 $736,216 $6,772,056 2,656,727 1,722,311 556,685 4,935,723 18,250 18,250 799,638 $ 264,115

518,392 $ 74,657

167,554 $ (6,273)

1,485,584 $ 332,499

Overhead rate = $1,485,584 ÷ $4,935,723 = 0.300986 per cost of merchandise dollar

2. Selling, general and administration (S,G & A) is comprised of a variety of costs that are unlikely to be consumed uniformly across product lines based on the cost of merchandise. Super Bookstore should consider an activity-based costing system to clarify how each product line uses these S, G & A resources.

Number of purchase orders Number of deliveries received Hours of shelf-stocking time Items sold

Purchasing Receiving Stocking Customer support

Books 2,800 1,400 15,000 124,016

CDs 2,500 1,700 14,000 115,768

Café 2,000 1,600 10,000 368,108

Total 7,300 4,700 39,000 607,892

$474,500 ÷ 7,300 orders placed = $65 per purchase order $432,400 ÷ 4,700 deliveries = $92 per delivery $487,500 ÷ 39,000 hours = $12.50 per stocking hour $91, 184 ÷ 607,892 items sold = $0.15 per item sold

Revenues Cost of Merchandise Gross margin Cost of Café Cleaning Purchasing ($65 × 2,800; 2,500; 2,000) Receiving ($92 × 1,400; 1,700; 1,600) Shelf-stocking ($12.50 × 15,000; 14,000; 10,000) Customer support ($0.15 × 124,016; 115,768; 368,108 Total S, G & A costs Operating income

Books $3,720,480 2,656,727 1,063,753

CDs $2,315,360 1,722,311 593,049

Café $ 736,216 556,685 179,531 18,250

Total $6,772,056 4,935,723 1,836,333 18,250

182,000

162,500

130,000

474,500

128,800

156,400

147,200

432,400

187,500

175,000

125,000

487,500

18,603 516,903 $ 546,850

17,365 511,265 $ 81,784

55,216 475,666 $(296,135)

91,184 1,503,834 $ 332,499


Comparing product line income statements in requirements 1 and 2, it appears that books are much more profitable and café loses a lot more money under the ABC system compared to the simple system. The reason is that books use far fewer S,G & A resources relative to its merchandise costs and café uses far greater S, G & A resources relative to its merchandise costs. 3. To: Super Bookstore Management Team From: Cost Analyst Re: Costing System The current accounting system allocates indirect costs (S,G & A) to product lines based on the Cost of Merchandise sold. Using this method, the S, G & A costs are assigned 54%, 35%, 11%, to the Books, CDs, and Café product lines, respectively. I recommend that the organization switch to an activity-based costing (ABC) method. With ABC, the product lines are assigned indirect costs based on their consumption of the activities that give rise to the costs. An ABC analysis reveals that the Café consumes considerably more than 11% of indirect costs. Instead, the café generally requires 25-35% of the purchasing, receiving and stocking activity and 60% of the customer support. The current accounting technique masks the losses being produced by the café because it assumes all indirect costs are driven by the dollar amount of merchandise sold. By adopting ABC, management can evaluate the costs of operating the three product lines and make more informed pricing and product mix decisions. For example, management may want to consider increasing prices of the food and drinks served in the café. Before deciding whether to increase prices or to close the café, management must consider the beneficial effect that having a cafe has on the other product lines. An ABC analysis can also help Super Bookstore manage its costs by reducing the number of activities that each product line demands and by reducing the cost of each activity. These actions will improve the profitability of each product line. ABC analysis can also be used to plan and manage the various activities.


CHAPTER 6 MASTER BUDGET AND RESPONSIBILITY ACCOUNTING 6-1 a. b. c. d.

The budgeting cycle includes the following elements: Planning the performance of the company as a whole as well as planning the performance of its subunits. Management agrees on what is expected. Providing a frame of reference, a set of specific expectations against which actual results can be compared. Investigating variations from plans. If necessary, corrective action follows investigation. Planning again, in light of feedback and changed conditions.

6-2 The master budget expresses management’s operating and financial plans for a specified period (usually a fiscal year) and includes a set of budgeted financial statements. It is the initial plan of what the company intends to accomplish in the period. 6-3 Strategy, plans, and budgets are interrelated and affect one another. Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives. Strategic analysis underlies both long-run and short-run planning. In turn, these plans lead to the formulation of budgets. Budgets provide feedback to managers about the likely effects of their strategic plans. Managers use this feedback to revise their strategic plans. 6-4 We agree that budgeted performance is a better criterion than past performance for judging managers, because inefficiencies included in past results can be detected and eliminated in budgeting. Also, future conditions may be expected to differ from the past, and these can also be factored into budgets. 6-5 Production and marketing traditionally have operated as relatively independent business functions. Budgets can assist in reducing conflicts between these two functions in two ways. Consider a beverage company such as Coca-Cola or Pepsi-Cola: Communication. Marketing could share information about seasonal demand with production. Coordination. Production could ensure that output is sufficient to meet, for example, high seasonal demand in the summer. 6-6 In many organizations, budgets impel managers to plan. Without budgets, managers drift from crisis to crisis. Research also shows that budgets can motivate managers to meet targets and improve their performance. Thus, many top managers believe that budgets meet the cost-benefit test. 6-7 A rolling budget, also called a continuous budget, is a budget or plan that is always available for a specified future period, by continually adding a period (month, quarter, or year) to the period that just ended. A four-quarter rolling budget for 2011 is superseded by a four-quarter rolling budget for April 2011 to March 2012, and so on.


6-8

The steps in preparing an operating budget are as follows: 1. Prepare the revenues budget 2. Prepare the production budget (in units) 3. Prepare the direct material usage budget and direct material purchases budget 4. Prepare the direct manufacturing labor budget 5. Prepare the manufacturing overhead budget 6. Prepare the ending inventories budget 7. Prepare the cost of goods sold budget 8. Prepare the nonmanufacturing costs budget 9. Prepare the budgeted income statement

6-9 The sales forecast is typically the cornerstone for budgeting, because production (and, hence, costs) and inventory levels generally depend on the forecasted level of sales. 6-10 Sensitivity analysis adds an extra dimension to budgeting. It enables managers to examine how budgeted amounts change with changes in the underlying assumptions. This assists managers in monitoring those assumptions that are most critical to a company in attaining its budget and allows them to make timely adjustments to plans when appropriate. 6-11 Kaizen budgeting explicitly incorporates continuous improvement anticipated during the budget period into the budget numbers. 6-12 Nonoutput-based cost drivers can be incorporated into budgeting by the use of activitybased budgeting (ABB). ABB focuses on the budgeted cost of activities necessary to produce and sell products and services. Nonoutput-based cost drivers, such as the number of parts, number of batches, and number of new products can be used with ABB. 6-13 The choice of the type of responsibility center determines what the manager is accountable for and thereby affects the manager’s behavior. For example, if a revenue center is chosen, the manager will focus on revenues, not on costs or investments. The choice of a responsibility center type guides the variables to be included in the budgeting exercise. 6-14 Budgeting in multinational companies may involve budgeting in several different foreign currencies. Further, management accountants must translate operating performance into a single currency for reporting to shareholders, by budgeting for exchange rates. Managers and accountants must understand the factors that impact exchange rates, and where possible, plan financial strategies to limit the downside of unexpected unfavorable moves in currency valuations. In developing budgets for operations in different countries, they must also have good understanding of political, legal and economic issues in those countries. 6-15 No. Cash budgets and operating income budgets must be prepared simultaneously. In preparing their operating income budgets, companies want to avoid unnecessary idle cash and unexpected cash deficiencies. The cash budget, unlike the operating income budget, highlights periods of idle cash and periods of cash shortage, and it allows the accountant to plan cost effective ways of either using excess cash or raising cash from outside to achieve the company’s operating income goals.


6-16

(15 min.) Sales budget, service setting.

1. 2011 Volume 12,200 16,400

Rouse & Sons Radon Tests Lead Tests

At 2011 Selling Prices $290 $240

Expected 2012 Change in Volume +6% -10%

Expected 2012 Volume 12,932 14,760

Rouse & Sons Sales Budget For the Year Ended December 31, 2012

Radon Tests Lead Tests

Selling Price $290 $240

Units Sold 12,932 14,760

Total Revenues $3,750,280 3,542,400 $7,292,680

2. Rouse & Sons Radon Tests Lead Tests

2011 Volume 12,200 16,400

Planned 2012 Selling Prices $290 $230

Expected 2012 Change in Volume +6% -7%

Expected 2012 Volume 12,932 15,252

Rouse & Sons Sales Budget For the Year Ended December 31, 2012

Radon Tests Lead Tests

Selling Price $290 $230

Units Sold 12,932 15,252

Total Revenues $3,750,280 3,507,960 $7,258,240

Expected revenues at the new 2012 prices are $7,258,240, which is lower than the expected 2012 revenues of $7,292,680 if the prices are unchanged. So, if the goal is to maximize sales revenue and if Jim Rouse’s forecasts are reliable, the company should not lower its price for a lead test in 2012.


6-17

(5 min.)

Sales and production budget.

Budgeted sales in units Add target ending finished goods inventory Total requirements Deduct beginning finished goods inventory Units to be produced 6-18

(5 min.)

200,000 25,000 225,000 15,000 210,000

Direct materials purchases budget.

Direct materials to be used in production (bottles) Add target ending direct materials inventory (bottles) Total requirements (bottles) Deduct beginning direct materials inventory (bottles) Direct materials to be purchased (bottles)

2,500,000 80,000 2,580,000 50,000 2,530,000

6-19 (10 min.) Budgeting material purchases. Production Budget: Finished Goods (units) 45,000 18,000 63,000 16,000 47,000

Budgeted sales Add target ending finished goods inventory Total requirements Deduct beginning finished goods inventory Units to be produced Direct Materials Purchases Budget:

Direct materials needed for production (47,000 Add target ending direct materials inventory Total requirements Deduct beginning direct materials inventory Direct materials to be purchased

3)

Direct Materials (in gallons) 141,000 50,000 191,000 60,000 131,000


6-20

(30 min.) Revenues and production budget.

1.

12-ounce bottles 4-gallon units a b

Selling Price $0.25 1.50

Units Sold 4,800,000a 1,200,000b

Total Revenues $1,200,000 1,800,000 $3,000,000

400,000 × 12 months = 4,800,000 100,000 × 12 months = 1,200,000

2.

Budgeted unit sales (12-ounce bottles) Add target ending finished goods inventory Total requirements Deduct beginning finished goods inventory Units to be produced

4,800,000 600,000 5,400,000 900,000 4,500,000

3.

Beginning = Budgeted + Target Budgeted inventory sales ending inventory production = 1,200,000 + 200,000 1,300,000 = 100,000 4-gallon units

6-21 (30 min.) Budgeting: direct material usage, manufacturing cost and gross margin. 1. Direct Material Usage Budget in Quantity and Dollars Material Wool Physical Units Budget Direct materials required for Blue Rugs (200,000 rugs × 36 skeins and 0.8 gal.)

7,200,000 skeins

Cost Budget Available from beginning direct materials inventory: (a) Wool: 458,000 skeins $ 961,800 Dye: 4,000 gallons To be purchased this period: (b) Wool: (7,200,000 - 458,000) skeins × $2 per skein 13,484,000 Dye: (160,000 – 4,000) gal. × $6 per gal. _________ Direct materials to be used this period: (a) + (b) $14,445,800

Dye

Total

160,000 gal.

$ 23,680

936,000 $ 959,680

$15,405,480


2. $31, 620, 000 Weaving budgeted = = $2.55 per DMLH overhead rate 12, 400, 000 DMLH Dyeing budgeted = $17, 280, 000 = $12 per MH overhead rate 1, 440, 000 MH

3. Budgeted Unit Cost of Blue Rug

Cost per Unit of Input $2 6 13 12 2.55

Wool Dye Direct manufacturing labor Dyeing overhead Weaving overhead Total 1

Input per Unit of Output 36 skeins 0.8 gal. 62 hrs. 7.21 mach-hrs. 62 DMLH

Total $ 72.00 4.80 806.00 86.40 158.10 $1127.30

0.2 machine hour per skein 36 skeins per rug = 7.2 machine-hrs. per rug.

4. Revenue Budget

Blue Rugs Blue Rugs

Selling Units Price Total Revenues 200,000 $2,000 $400,000,000 185,000 $2,000 $370,000,000

5a. Sales = 200,000 rugs Cost of Goods Sold Budget From Schedule Beginning finished goods inventory Direct materials used Direct manufacturing labor ($806 × 200,000) Dyeing overhead ($86.40 × 200,000) Weaving overhead ($158.10 × 200,000) Cost of goods available for sale Deduct ending finished goods inventory Cost of goods sold

Total $

$15,405,480 161,200,000 17,280,000 31,620,000

0

225,505,480 225,505,480 0 $225,505,480


5b. Sales = 185,000 rugs Cost of Goods Sold Budget From Schedule Beginning finished goods inventory Direct materials used Direct manufacturing labor ($806 × 200,000) Dyeing overhead ($86.40 × 200,000) Weaving overhead ($158.10 × 200,000) Cost of goods available for sale Deduct ending finished goods inventory ($1,127.30 × 15,000) Cost of goods sold

Total $

$ 15,405,480 161,200,000 17,280,000 31,620,000

0

225,505,480 225,505,480 16,909,500 $208,595,980

6. Revenue Less: Cost of goods sold Gross margin

200,000 rugs sold $400,000,000 225,505,480 $ 174,494,520

185,000 rugs sold $370,000,000 208,595,980 $ 161,404,020

6-22

(15–20 min.) Revenues, production, and purchases budget.

1.

900,000 motorcycles

2.

Budgeted sales (motorcycles) Add target ending finished goods inventory Total requirements Deduct beginning finished goods inventory Units to be produced

3.

Direct materials to be used in production, 880,000 × 2 (wheels) Add target ending direct materials inventory Total requirements Deduct beginning direct materials inventory Direct materials to be purchased (wheels) Cost per wheel in yen Direct materials purchase cost in yen

400,000 yen = 360,000,000,000 yen 900,000 80,000 980,000 100,000 880,000

1,760,000 60,000 1,820,000 50,000 1,770,000 16,000 28,320,000,000

Note the relatively small inventory of wheels. In Japan, suppliers tend to be located very close to the major manufacturer. Inventories are controlled by just-in-time and similar systems. Indeed, some direct materials inventories are almost nonexistent.


6-23

(15-25 min.) Budgets for production and direct manufacturing labor. Roletter Company Budget for Production and Direct Manufacturing Labor for the Quarter Ended March 31, 2013

Budgeted sales (units) Add target ending finished goods inventorya (units) Total requirements (units) Deduct beginning finished goods inventory (units) Units to be produced Direct manufacturing labor-hours (DMLH) per unit Total hours of direct manufacturing labor time needed Direct manufacturing labor costs: Wages ($10.00 per DMLH) Pension contributions ($0.50 per DMLH) Workers’ compensation insurance ($0.15 per DMLH) Employee medical insurance ($0.40 per DMLH) Social Security tax (employer’s share) ($10.00 0.075 = $0.75 per DMLH) Total direct manufacturing labor costs

January 10,000

February 12,000

March 8,000

Quarter 30,000

16,000 26,000

12,500 24,500

13,500 21,500

13,500 43,500

16,000 10,000

16,000 8,500

12,500 9,000

16,000 27,500

× 2.0

× 2.0

1.5

20,000

17,000

13,500

50,500

$200,000

$170,000

$135,000

$505,000

10,000

8,500

6,750

25,250

3,000

2,550

2,025

7,575

8,000

6,800

5,400

20,200

15,000

12,750

10,125

37,875

$236,000

$200,600

$159,300

$595,900

a

100% of the first following month’s sales plus 50% of the second following month’s sales. Note that the employee Social Security tax of 7.5% is irrelevant. Such taxes are withheld from employees’ wages and paid to the government by the employer on behalf of the employees; therefore, the 7.5% amounts are not additional costs to the employer.


6-24

(20–30 min.) Activity-based budgeting.

1. This question links to the ABC example used in the Problem for Self-Study in Chapter 5 and to Question 5-24 (ABC, retail product-line profitability). Cost Hierarchy

Activity Ordering $90 14; 24; 14 Delivery $82 12; 62; 19 Shelf-stocking $21 16; 172; 94 Customer support $0.18 4,600; 34,200; 10,750 Total budgeted indirect costs

Soft Drinks

Batch-level

Fresh Produce

$1,260

Batch-level Output-unitlevel Output-unitlevel

Total

$ 2,160

$1,260

$ 4,680

984

5,084

1,558

7,626

336

3,612

1,974

5,922

6,156 $17,012

1,935 $6,727

8,919 $27,147

828 $3,408 12.5%

Percentage of total indirect costs

Packaged Food

62.7%

24.8%

2. Refer to the last row of the table in requirement 1. Fresh produce, which probably represents the smallest portion of COGS, is the product category that consumes the largest share (62.7%) of the indirect resources. Fresh produce demands the highest level of ordering, delivery, shelf-stocking and customer support resources of all three product categories—it has to be ordered, delivered and stocked in small, perishable batches, and supermarket customers often ask for a lot of guidance on fresh produce items. 3. An ABB approach recognizes how different products require different mixes of support activities. The relative percentage of how each product area uses the cost driver at each activity area is:

Activity Ordering Delivery Shelf-stocking Customer support

Cost Hierarchy Batch-level Batch-level Output-unit-level Output-unit-level

Soft Drinks 27% 13 6 9

Fresh Packaged Produce Food 46% 27% 67 20 61 33 69 22

Total 100% 100 100 100

By recognizing these differences, FS managers are better able to budget for different unit sales levels and different mixes of individual product-line items sold. Using a single cost driver (such as COGS) assumes homogeneity in the use of indirect costs (support activities) across product lines which does not occur at FS. Other benefits cited by managers include: (1) better identification of resource needs, (2) clearer linking of costs with staff responsibilities, and (3) identification of budgetary slack.


6-25

(20–30 min.) Kaizen approach to activity-based budgeting (continuation of 6-24).

1. Activity Ordering Delivery Shelf-stocking Customer support

Cost Hierarchy Batch-level Batch-level Output-unit-level Output-unit-level

Budgeted Cost-Driver Rates January February March $90.00 $89.6400 $89.2814 82.00 81.6720 81.3453 21.00 20.9160 20.8323 0.18 0.1793 0.1786

The March 2011 rates can be used to compute the total budgeted cost for each activity area in March 2011: Activity Ordering $89.2814 14; 24; 14 Delivery $81.3453 12; 62; 19 Shelf-stocking $20.8323 16; 172; 94 Customer support $0.1786 4,600; 34,200; 10,750 Total

Cost Hierarchy

Soft Drinks

Batch-level

$1,250

Batch-level

Fresh Produce

Packaged Food

Total

$ 2,143

$1,250

$ 4,643

976

5,043

1,546

7,565

Output-unit-level

333

3,583

1,958

5,874

Output-unit-level

821 $3,380

6,108 $16,877

1,920 $6,674

8,849 $26,931

2. A kaizen budgeting approach signals management’s commitment to systematic cost reduction. Compare the budgeted costs from Question 6-24 and 6-25.

Question 6-24 Question 6-25 (Kaizen)

Ordering $4,680 4,643

Delivery $7,626 7,565

ShelfStocking $5,922 5,874

Customer Support $8,919 8,849

The kaizen budget number will show unfavorable variances for managers whose activities do not meet the required monthly cost reductions. This likely will put more pressure on managers to creatively seek out cost reductions by working ―smarter‖ within FS or by having ―better‖ interactions with suppliers or customers. One limitation of kaizen budgeting, as illustrated in this question, is that it assumes small incremental improvements each month. It is possible that some cost improvements arise from large discontinuous changes in operating processes, supplier networks, or customer interactions. Companies need to highlight the importance of seeking these large discontinuous improvements as well as the small incremental improvements.


6-26

(15 min.) Responsibility and controllability.

1. (a) Production manager (b) Purchasing Manager The purchasing manager has control of the cost to the extent that he/she is doing the purchasing and can seek or contract for the best price. The production manager should work with the purchasing manager from the warehouse. They can, together, possibly find a combination of better engine and better price for the engine than the production manager has found. 2. (a) Production Manager (b) External Forces In the case of the utility rate hike the production manager would be responsible for the costs, but they are hard to control. The rates are fixed by the utility company, and there is usually no choice in which utility company is used. The production manager can try to reduce waste (turn off lights when not in use, turn of machines when not running, don’t leave water running, etch) but other than conservation measures, the manager has no say in the utility rates. The manager might consider purchasing more energy-efficient machines. 3. (a) Van 3 driver (b) Service manager The driver of each van has the responsibility to stay within budget for the costs of the service vehicle. The service manager should set policies to which the drivers must adhere, including not using the van for personal use. Although costly, the service manager could install GPS in the vans to make sure they are where they are supposed to be, and can also fire the driver of Van 3 for misusing company property. (Using the van for personal driving affects the tax deductibility of the van for the firm as well). 4. (a) Anderson’s service manager (b) Bigstore Warehouse manager Since Bigstore Warehouse has a maintenance contract with Anderson, both the warehouse manager and Anderson’s service manager should work together to make sure routine maintenance is scheduled for the Bigstore Warehouse forklifts. This will decrease the number and cost of the repair emergencies. The manager should also consider the average cost of these service calls over the months where there were no calls. 5. (a) Service manager (b) This depends… The answer to this question really depends on why Fred Snert works so slowly. If it is because Fred is chatting with the customers (which may be why they like him) then the service manage should tell him to only bill for actual time worked. If it is because Fred works intentionally slowly to get the overtime, then the service manager should consider disciplining him unless he is too valuable in other ways. If it is because he does not have adequate training, then HR should 6-11 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

be involved, and the service manager should work with Fred to get him more training and with HR to make sure future hires are adequately trained. 6. (a) Service manager (b) External forces Like the cost of utilities, the cost of gasoline is determined externally. However, unlike the case of utilities, it is possible that the service manager can contract with a gasoline company to buy gas at a fixed price over a period of time. The advantage for Anderson is that the price is set, and the advantage for the gasoline company is that they are certain to have a long term customer even if the price is lower than for a random customer.


6-27

(30 min.) Cash flow analysis, chapter appendix.

1.

The cash that Game Guys can expect to collect during May and June is calculated below. Cash collected in From service revenue May ($1,400 x .97) June ($2,600 x .97) From sales revenue Cash sales From credit card sales May (.5 x $6,200 x .97) June (.5 x $9,700 x .97) From cash sales May (0.1 x $6,200) June (0.1 x $9,700) Credit sale collections From April (.4 x $5,500 x .9) (.4 x $5,500 x .08) From May (.4 x $6.200 x .9) Total collections

2.

May

June

$1,358.00 $2,522.00

3,007.00 4,704.50 620.00 970.00 1,980.00

$6,965.00

176.00 2,232.00 $10,604.50

(a) Budgeted expenditures for May are as follows. Costs $4,350 1,400 1,000 $6,750

Inventory purchases Rent, utilities, etc. Wages TOTAL

Yes, Game Guys will be able to cover its May costs since receipts are $6,965 and expenditures are only $6,750. (b) Original numbers

Beginning cash Collections Cash Costs Total a b

$100.00 6,965.00 6,750.00 $315.00

May Revenues decrease 10% $100.00 6,466.50a 6,750.00 $(183.50)

May Revenues decrease 5% $100.00 6,715.75b 6,750.00 $ 65.75

May Costs increase 8% $100.00 6,965.00 7,290.00 $(225.00)

From requirement 1, this is 0.90 × (1,358 + 3,007 + 620) + 1,980 = $6,466.50 From requirement 1, this is 0.95 × (1,358 + 3,007 + 620) + 1,980 = $6,715.75


3.

The cost of inventory purchases without the discount is $4,350, which Game Guys would not have to pay until June if they buy the inventory on account in May. However, if they take the discount and pay in May, the cost will be $4,350 x (100% - 2%) = $4,263. This means they will save $87. This makes total expenditures for May Costs $4,263.00 1,400.00 1,000.00 $6,663.00

Inventory purchases Rent, utilities, etc. Wages TOTAL

Game Guys total cash available is $100 (cash balance) + $6,200 (cash receipts) so they will have to borrow $363 at a rate of 24% (or 2% per month.) Based on the information from #1, they will be able to pay this back in June (assuming cash expenditures don’t increase dramatically), so they will incur interest costs of $363 x .02 = $7.26 (rounded up). Since it will cost them less than $8 to save $87, it makes sense to go ahead and take the short-term loan to pay the account payable early.


6-28

(40 min.)

Budget schedules for a manufacturer.

1a.

Revenues Budget Units sold Selling price Budgeted revenues

b.

Knights Blankets 120 $150 $18,000

Raiders Blankets 180 $175 $31,500

$49,500

Production Budget in Units Knights Blankets 120 20 140 10 130

Budgeted unit sales Add budgeted ending fin. goods inventory Total requirements Deduct beginning fin. goods inventory Budgeted production

c.

Total

Raiders Blankets 180 25 205 15 190

Direct Materials Usage Budget (units) Red wool Knights blankets: 1. Budgeted input per f.g. unit 2. Budgeted production 3. Budgeted usage (1 × 2) Raiders blankets: 4. Budgeted input per f.g. unit 5. Budgeted production 6. Budgeted usage (4 × 5) 7. Total direct materials usage (3 + 6) Direct Materials Cost Budget 8. Beginning inventory 9. Unit price (FIFO) 10. Cost of DM used from beginning inventory (8 × 9) 11. Materials to be used from purchases (7 – 8) 12. Cost of DM in March 13. Cost of DM purchased and used in March (11 × 12) 14. Direct materials to be used (10 + 13)

Black wool

3 130 390 – – –

Knights logo patches

– – –

1 130 130

3.3 190 627

– – –

Raiders logo patches

Total

– – –

1 190 190

390

627

130

190

30

10

40

55

$8

$10

$6

$5

$240

$100

$240

$275

360 $9

617 $9

90 $6

135 $7

$3,240

$5,553

$540

$945

$3,480

$5,653

$780

$855

$10,278

$1,220 $11,133


Direct Materials Purchases Budget Black wool

Red wool Budgeted usage (from line 7) Add target ending inventory Total requirements Deduct beginning inventory Total DM purchases Purchase price (March) Total purchases

d.

627 20 647 10 637 $9 $5,733

130 20 150 40 110 $6 $660

Raiders logos 190 20 210 55 155 $7 $1,085

Total

______ $10,898

Direct Manufacturing Labor Budget

Knights blankets Raiders blankets

e.

390 20 410 30 380 $9 $3,420

Knights logos

Budgeted Units Produced 130 190

Direct Manuf. LaborHours per Output Unit 1.5 2.0

Total Hours 195 380 575

Hourly Rate $26 $26

Total $5,070 $9,880 $14,950

Manufacturing Overhead Budget Variable manufacturing overhead costs (575 × $15) Fixed manufacturing overhead costs Total manufacturing overhead costs

$8,625 9,200 $17,825

Total manuf. overhead cost per hour = $17,825 / 575 = $31 per direct manufacturing labor-hour Fixed manuf. overhead cost per hour = $ 9,200 / 575 = $16 per direct manufacturing labor-hour f.

Computation of unit costs of ending inventory of finished goods Knights Raiders Blankets Blankets Direct materials Red wool ($9 × 3, 0) $ 27.0 $ 0.0 Black wool ($9 x 0, 3.3) 0.0 29.7 Knights logos ($6 x 1, 0) 6.0 0.0 Raiders logos ($7 x 0, 1) 0.0 7.0 Direct manufacturing labor ($26 ×1.5, 2) 39.0 52.0 Manufacturing overhead Variable ($15 ×1.5, 2) 22.5 30.0 Fixed ($16 ×1.5, 2) 24.0 32.0 Total manufacturing cost $118.5 $150.7


Ending Inventories Budget Cost per Unit Direct Materials Red wool Black wool Knight logo patches Raider logo patches

Units

Total

$9.0 9.0 6.0

20 20 20

$ 180.0 180.0 120.0

7.0

20

140.0 620.0

Finished Goods Knight blankets Raider blankets

118.5 150.7

20 25

Total g.

2.

2,370.0 3,767.5 6,137.5 $6,757.5

Cost of goods sold budget Beginning fin. goods inventory, March 1, 2012 ($1,210 + $2,235) Direct materials used (from Dir. materials cost budget) $11,133.0 Direct manufacturing labor (Dir. manuf. labor budget) 14,950.0 Manufacturing overhead (Manuf. overhead budget) 17,825.0 Cost of goods manufactured Cost of goods available for sale Deduct ending fin. goods inventory, March 31, 2012 (Inventories budget) Cost of goods sold

$ 3,445.0

43,908.0 47,353.0 6,137.5 $41,215.5

Areas where continuous improvement might be incorporated into the budgeting process: (a) Direct materials. Either an improvement in usage or price could be budgeted. For example, the budgeted usage amounts for the fabric could be related to the maximum improvement (current usage – minimum possible usage) of yards of fabric for either blanket. It may also be feasible to decrease the price paid, particularly with quantity discounts on things like the logo patches. (b) Direct manufacturing labor. The budgeted usage of 1.5 hours/2 hours could be continuously revised on a monthly basis. Similarly, the manufacturing labor cost per hour of $26 could be continuously revised down. The former appears more feasible than the latter. (c) Variable manufacturing overhead. By budgeting more efficient use of the allocation base, a signal is given for continuous improvement. A second approach is to budget continuous improvement in the budgeted variable overhead cost per unit of the allocation base. (d ) Fixed manufacturing overhead. The approach here is to budget for reductions in the year-to-year amounts of fixed overhead. If these costs are appropriately classified as fixed, then they are more difficult to adjust down on a monthly basis.


6-29 (45 min.) Activity-based budget: kaizen improvements.

1. Increase in Costs for the Year Assume DryPool uses New Dye Units to dye Cost differential ($1-$.20) per ounce x 3 ounces Increase in costs

60,000 x $2.40 $144,000

Since the fine is only $102,000, they would be financially better off by not switching. 2.

If DryPool switches to the new dye, costs will increase by $144,000. If DryPool implements kaizen costing, costs will be reduced as follows: Original monthly costs Input Fabric Labor Total *

Unit cost $6 $3

Number of units 6,000* 6,000*

Total cost $36,000 $18,000 $54,000

Annual cost $432,000 $216,000 $648,000

(12,000 + 60,000)/12 months = 6,000 units

Monthly decrease in costs Fabric Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12

$36,000 35,640 35,284 34,931 34,581 34,235 33,893 33,554 33,218 32,886 32,557 32,231 $409,010

Labor cost Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12

$18,000 17,820 17,642 17,466 17,291 17,118 16,947 16,778 16,610 16,444 16,280 16,117 $204,513

TOTAL Diff between costs with and without Kaizen improvements

$613,523 $34,477

This means costs increase a net ($144,000 – 34,477) = $109,523


Since DryPool would otherwise have to spend $102,000 to pay the fine, their net costs would only be $7,523 higher than if they did not switch to the new dye or implement kaizen costing. 3. Reduction in materials can be accomplished by reducing waste and scrap. Reduction in direct labor can be accomplished by improving the efficiency of operations and decreasing down time. Employees who make and dye the T-shirts may have suggestions for ways to do their jobs more efficiently. For instance, employees may recommend process changes that reduce idle time, setup time, and scrap. To motivate workers to improve efficiency, many companies have set up programs that share productivity gains with the workers. DryPool must be careful that productivity improvements and cost reductions do not in any way compromise product quality.


6-30

(30–40 min.) Revenue and production budgets.

This is a routine budgeting problem. The key to its solution is to compute the correct quantities of finished goods and direct materials. Use the following general formula:

(Budgeted,production,or purchases) = (Target,ending,inventory) + (Budgeted,sales or,materials used) – (Beginning,inventory) 1.

Scarborough Corporation Revenue Budget for 2012

Thingone Thingtwo Budgeted revenues 2.

Units 60,000 40,000

Total $ 9,900,000 10,000,000 $19,900,000

Scarborough Corporation Production Budget (in units) for 2012

Budgeted sales in units Add target finished goods inventories, December 31, 2012 Total requirements Deduct finished goods inventories, January 1, 2012 Units to be produced 3.

Price $165 250

Thingone 60,000

Thingtwo 40,000

25,000 85,000

9,000 49,000

20,000 65,000

8,000 41,000

Scarborough Corporation Direct Materials Purchases Budget (in quantities) for 2012 A Direct materials to be used in production • Thingone (budgeted production of 65,000 units times 4 lbs. of A, 2 lbs. of B) • Thingtwo (budgeted production of 41,000 units times 5 lbs. of A, 3 lbs. of B, 1 lb. of C) Total Add target ending inventories, December 31, 2012 Total requirements in units Deduct beginning inventories, January 1, 2012 Direct materials to be purchased (units)

Direct Materials B

260,000

130,000

205,000 465,000 36,000 501,000 32,000 469,000

123,000 253,000 32,000 285,000 29,000 256,000

C

-41,000 41,000 7,000 48,000 6,000 42,000


4.

Scarborough Corporation Direct Materials Purchases Budget (in dollars) for 2012

Direct material A Direct material B Direct material C Budgeted purchases 5.

Expected Purchase Price per unit $12 5 3

Total $5,628,000 1,280,000 126,000 $7,034,000

Scarborough Corporation Direct Manufacturing Labor Budget (in dollars) for 2012

Thingone Thingtwo Total 6.

Budgeted Purchases (Units) 469,000 256,000 42,000

Direct Budgeted Manufacturing Production Labor-Hours (Units) per Unit 65,000 2 41,000 3

Total Hours 130,000 123,000

Rate per Hour $12 16

Total $1,560,000 1,968,000 $3,528,000

Scarborough Corporation Budgeted Finished Goods Inventory at December 31, 2012 Thingone: Direct materials costs: A, 4 pounds × $12 $48 B, 2 pounds × $5 10 Direct manufacturing labor costs, 2 hours × $12 Manufacturing overhead costs at $20 per direct manufacturing labor-hour (2 hours × $20) Budgeted manufacturing costs per unit Finished goods inventory of Thingone $122 × 25,000 units Thingtwo: Direct materials costs: A, 5 pounds × $12 $60 B, 3 pounds × $5 15 C, 1 each × $3 3 Direct manufacturing labor costs, 3 hours × $16 Manufacturing overhead costs at $20 per direct manufacturing labor-hour (3 hours × $20) Budgeted manufacturing costs per unit Finished goods inventory of Thingtwo $186 × 9,000 units Budgeted finished goods inventory, December 31, 2012

$ 58 24 40 $122 $3,050,000

$ 78 48 60 $186 1,674,000 $4,724,000


6-31

(30 min.) Budgeted income statement. Easecom Company Budgeted Income Statement for 2012 (in thousands) Revenues Equipment ($6,000 × 1.06 × 1.10) Maintenance contracts ($1,800 × 1.06) Total revenues Cost of goods sold ($4,600 × 1.03 × 1.06) Gross margin Operating costs: Marketing costs ($600 + $250) Distribution costs ($150 × 1.06) Customer maintenance costs ($1,000 + $130) Administrative costs Total operating costs Operating income

6-32

$6,996 1,908 $8,904 5,022 3,882 850 159 1,130 900 3,039 $ 843

(15 min.) Responsibility of purchasing agent.

The cost of the biscuits is usually the responsibility of the purchasing agent, and usually controllable by the Central Warehouse. However, in this scenario, Janet the cook has taken the responsibility for the cost of the replacement biscuits from the purchasing agent by making a purchasing decision. Since Barney holds the purchasing agent responsible for biscuit costs, and presuming that Janet knew this, Janet should have discussed her decision with the purchasing agent before sending the kitchen helper to the store. Barney should not be angry because his employees acted to satisfy the customers on a short term emergency basis. Presuming the Central Warehouse does not consistently have problems with their freezer, there is no way the purchasing agent could foresee the biscuit shortage and plan accordingly. Also, the problem only lasted three days, which, in the course of the year (or even the month) will not seriously harm the profits of a restaurant that sells a variety of foods. However, had they run out of biscuits for three days, this could have long term implications for customer satisfaction and customer loyalty, and in the long run could harm profits as customers find other restaurants in which to eat breakfast.


6-33

(60 min.) Comprehensive problem with ABC costing

1. Revenue Budget For the Month of April

Cat-allac Dog-eriffic Total

Units Selling Price Total Revenues 580 $190 $ 110,200 240 275 66,000 $176,200

2. Production Budget For the Month of April

Budgeted unit sales Add target ending finished goods inventory Total required units Deduct beginning finished goods inventory Units of finished goods to be produced

Product Cat-allac Dog-eriffic 580 240 45 25 625 265 25 40 600 225

3a. Direct Material Usage Budget in Quantity and Dollars For the Month of April Material Plastic Metal Physical Units Budget Direct materials required for Cat-allac (600 units × 3 lbs. and 0.5 lb.) Dog-errific (225 units × 5 lbs. and 1 lb.) Total quantity of direct material to be used

1,800 lbs. 1,125 lbs. 2,925 lbs.

Cost Budget Available from beginning direct materials inventory (under a FIFO cost-flow assumption) Plastic: 230 lbs. × $3.80 per lb. $ 874 Metal: 70 lbs. × $3.20 per lb. To be purchased this period . Plastic: (2,925 – 230) lbs. $4 per lb. 10,780 Metal: (525 – 70) lbs. $3 per lb. __ ____ Direct materials to be used this period $11,654

Total

300 lbs. 225 lbs. 525 lbs.

$ 224

1,365 $ 1,589

$13,243


Direct Material Purchases Budget For the Month of April Material Plastic Metal Physical Units Budget To be used in production (requirement 3) Add target ending inventory Total requirements Deduct beginning inventory Purchases to be made Cost Budget Plastic: 3,095 lbs. $4 Metal: 520 lbs. $3 Purchases

2,925 lbs. 400 lbs. 3,325 lbs. 230 lbs. 3,095 lbs.

Total

525 lbs. 65 lbs. 590 lbs. 70 lbs. 520 lbs.

$12,380 ______ $12,380

$ 1,560 $ 1,560

$ 13,940

4. Direct Manufacturing Labor Costs Budget For the Month of April

Cat-allac Dog-errific Total

Output Units Produced (requirement 2) 600 225

DMLH per Unit 3 5

Hourly Wage Rate $14 14

Total Hours 1,800 1,125

Total $25,200 15,750 $40,950

5. Machine Setup Overhead Units to be produced Units per batch Number of batches Setup time per batch Total setup time

Cat-allac 600 ÷ 25 24 1.25 hrs. 30 hrs.

Budgeted machine setup costs = $130 per setup hour = $8,580

Dog-errific 225 ÷13 18 2.00 hrs. 36 hrs.

Total

66 hrs.

66 hours

Processing Overhead Budgeted machine-hours (MH) = (13 MH per unit × 600 units) + (20 MH per unit × 225 units) = 7,800 MH + 4,500 MH = 12,300 MH Budgeted processing costs = $5 per MH × 12,300 MH = $61,500 Inspection Overhead Budgeted inspection-hours = (0.5 24 batches) + (0.6 18 batches) = 12 + 10.8 = 22.8 inspection hrs. Budgeted inspection costs = $20 per inspection hr. 22.8 inspection hours = $456 6-24 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Manufacturing Overhead Budget For the Month of April Machine setup costs $ 8,580 Processing costs 61,500 Inspection costs 456 Total costs $70,536 6. Unit Costs of Ending Finished Goods Inventory April 30, 20xx Product Cat-allac Dog-errific Cost per Input per Input per Unit of Unit of Unit of Input Output Total Output Total Plastic $ 4 3 lbs. $ 12.00 5 lbs. $ 20.00 Metal 3 0.5 lbs. 1.50 1 lb. 3.00 Direct manufacturing labor 14 3 hrs. 42.00 5 hrs. 70.00 Machine setup 130 0.05 hrs. 1 6.50 0.16 hr1 20.80 Processing 5 13 MH 65.00 20 MH 100.00 Inspection 20 0.02 hr2 0.40 0.048 hr.2 0.96 Total $127.40 $214.76 1 2

30 setup-hours ÷ 600 units = 0.05 hours per unit; 36 setup-hours ÷ 225 units = 0.16 hours per unit 12 inspection hours ÷ 600 units = 0.02 hours per unit; 10.8 inspection hours ÷ 225 units = 0.048 hours per unit

Ending Inventories Budget April 30, 20xx Quantity Direct Materials Plastic Metals Finished goods Cat-allac Dog-errific Total ending inventory

Cost per unit

Total

400 65

$4 3

$1,600 195

45 25

$127.40 214.76

$5,733 5,369

$1,795

11,102 $12,897


7. Cost of Goods Sold Budget For the Month of April, 20xx Beginning finished goods inventory, April, 1 ($2,500 + $7,440) Direct materials used (requirement 3) Direct manufacturing labor (requirement 4) Manufacturing overhead (requirement 5) Cost of goods manufactured Cost of goods available for sale Deduct: Ending finished goods inventory, April 30 (reqmt. 6) Cost of goods sold

$

9,940

$13,243 40,950 70,536 124,729 134,669 11,102 $123,567

8. Nonmanufacturing Costs Budget For the Month of April, 20xx Salaries ($32,000 ÷ 2 1.05) $16,800 Other fixed costs ($32,000 ÷ 2) 16,000 Sales commissions ($176,200 1%) 1,762 Total nonmanufacturing costs $34,562 9. Budgeted Income Statement For the Month of April, 20xx Revenues $176,200 Cost of goods sold 123,567 Gross margin 52,633 Operating (nonmanufacturing) costs 34,562 Operating income $ 18,071


6-34 (25 min.) (Continuation of 6-33) Cash budget (Appendix) Cash Budget April 30, 20xx Cash balance, April 1, 20xx Add receipts Cash sales ($176,200 × 10%) Credit card sales ($176,200 × 90% × 98%) Total cash available for needs (x) Deduct cash disbursements Direct materials ($8,400 + $13,940 × 50%) Direct manufacturing labor Manufacturing overhead ($70,536 ─ $22,500 depreciation) Nonmanufacturing salaries Sales commissions Other nonmanufacturing fixed costs ($16,000 ─ $12,500 deprn) Machinery purchase Income taxes Total disbursements (y) Financing Repayment of loan 1 Interest at 24% ($2,600 24% ) 12 Total effects of financing (z) Ending cash balance, April 30 (x) ─ (y) ─ (z)

$

5,200

17,620 155,408 $178,228 $ 15,370 40,950 48,036 16,800 1,762 3,500 13,800 5,400 $145,618 $

2,600 52

$ 2,652 $ 29,958


6-35 1.

(60 min.)

Comprehensive operating budget, budgeted balance sheet.

Schedule 1: Revenues Budget for the Year Ended December 31, 2012 Snowboards

2.

Units 1,000

Selling Price $450

Schedule 2: Production Budget (in Units) for the Year Ended December 31, 2012 Snowboards 1,000 200 1,200 100 1,100

Budgeted unit sales (Schedule 1) Add target ending finished goods inventory Total requirements Deduct beginning finished goods inventory Units to be produced 3.

Total Revenues $450,000

Schedule 3A: Direct Materials Usage Budget for the Year Ended December 31, 2012 Wood

Fiberglass

Total

Physical Units Budget Wood: 1,100 × 5.00 b.f. Fiberglass: 1,100 × 6.00 yards To be used in production Cost Budget Available from beginning inventory Wood: 2,000 b.f. × $28.00 Fiberglass: 1,000 b.f. × $4.80 To be used from purchases this period Wood: (5,500 – 2,000) × $30.00 Fiberglass: (6,600 – 1,000) × $5.00 Total cost of direct materials to be used

5,500 5,500

6,600 6,600

$ 56,000 $ 4,800 105,000 $161,000

28,000 $32,800

$193,800

Schedule 3B: Direct Materials Purchases Budget for the Year Ended December 31, 2012 Wood Physical Units Budget Production usage (from Schedule 3A) Add target ending inventory Total requirements Deduct beginning inventory Purchases Cost Budget Wood: 5,000 × $30.00 Fiberglass: 7,600 × $5.00 Purchases

5,500 1,500 7,000 2,000 5,000

Fiberglass

Total

6,600 2,000 8,600 1,000 7,600

$150,000 $150,000

$38,000 $38,000

$188,000


4.

Schedule 4: Direct Manufacturing Labor Budget for the Year Ended December 31, 2012 Labor Category Manufacturing labor

5.

Cost Driver Units 1,100

DML Hours per Driver Unit 5.00

Total Hours 5,500

Wage Rate $25.00

Total $137,500

Schedule 5: Manufacturing Overhead Budget for the Year Ended December 31, 2012 At Budgeted Level of 5,500 Direct Manufacturing Labor-Hours Variable manufacturing overhead costs ($7.00 × 5,500) Fixed manufacturing overhead costs Total manufacturing overhead costs

6. 7. 8.

$104,500 = $19.00 per hour 5,500 $104,500 Budgeted manufacturing overhead cost per output unit: = $95.00 per output unit 1,100 Schedule 6A: Computation of Unit Costs of Manufacturing Finished Goods in 2012

Budgeted manufacturing overhead rate:

Direct materials Wood Fiberglass Direct manufacturing labor Total manufacturing overhead a

$ 38,500 66,000 $104,500

Cost per Unit of Inputa

Inputsb

$30.00 5.00 25.00

5.00 6.00 5.00

Total $150.00 30.00 125.00 95.00 $400.00

cost is per board foot, yard or per hour inputs is the amount of each input per board

b

9.

Schedule 6B: Ending Inventories Budget, December 31, 2012

Direct materials Wood Fiberglass Finished goods Snowboards Total Ending Inventory

Units

Cost per Unit

1,500 2,000

$ 30.00 5.00

$ 45,000 10,000

200

400.00

80,000 $135,000

Total


10. Schedule 7: Cost of Goods Sold Budget for the Year Ended December 31, 2012 From Schedule Beginning finished goods inventory January 1, 2010, $374.80 × 100 Direct materials used Direct manufacturing labor Manufacturing overhead Cost of goods manufactured Cost of goods available for sale Deduct ending finished goods inventory, December 31, 2012 Cost of goods sold

Given 3A 4 5

Total $ 37,480 $193,800 137,500 104,500 435,800 473,280

6B

80,000 $393,280

11. Budgeted Income Statement for Slopes for the Year Ended December 31, 2012 Revenues Schedule 1 $450,000 Cost of goods sold Schedule 7 393,280 Gross margin 56,720 Operating costs Variable marketing costs ($250 × 30) $ 7,500 Fixed nonmanufacturing costs 30,000 37,500 Operating income $ 19,220 12. Budgeted Balance Sheet for Slopes as of December 31, 2012 Cash Inventory Schedule 6B Property, plant, and equipment (net) Total assets Current liabilities Long-term liabilities Stockholders’ equity Total liabilities and stockholders’ equity

$ 10,000 135,000 850,000 $995,000 $ 17,000 178,000 800,000 $995,000


6-36

(30 min.) Cash budgeting, chapter appendix.

1.

Projected Sales May

Sales in units Revenues (Sales in units × $450)

June

July

August

September

80

120

200

100

60

$36,000

$54,000

$90,000

$45,000

$27,000

May

June

July

August

September

October 40

Collections of Receivables From sales in: May (30% $36,000) June (50%; 30% $54,000) July (20%; 50%; 30% $90,000) August (20%; 50% $45,000) September (20% $27,000) Total

$10,800 27,000 18,000

$16,200 45,000 9,000

$55,800

$70,200

$ 27,000 22,500 5,400 $54,900

July

August

September

October

Calculation of Payables May Material and Labor Use, Units Budgeted production Direct materials Wood (board feet) Fiberglass (yards) Direct manuf. labor (hours)

June 200

100

60

40

1,000 1,200 1,000

500 600 500

300 360 300

200 240 200

$30,000

$15,000

$9,000

6,000

3,000

1,800

12,500

7,500

5,000

150

150

150

Disbursement of Payments Direct materials Wood (1,000; 500; 300 $30) Fiberglass (1,200; 600; 360 $5) Direct manuf. labor (500; 300; 200 $25) Interest payment (6% $30,000 ÷12) Variable Overhead Calculation Variable overhead rate Overhead driver (direct manuf. labor-hours) Variable overhead expense

$

7

500 $ 3,500

$

7

300 $ 2,100

$

October

7

200 $1,400


Cash Budget for the months of July, August, September 2012 July August Beginning cash balance $10,000 $ 5,650

September $40,100

Add receipts: Collection of receivables Total cash available

55,800 $65,800

70,200 $75,850

54,900 $95,000

Deduct disbursements: Material purchases Direct manufacturing labor Variable costs Fixed costs Interest payments Total disbursements Ending cash balance

$36,000 12,500 3,500 8,000 150 60,150 $ 5,650

$18,000 7,500 2,100 8,000 150 35,750 $40,100

$10,800 5,000 1,400 8,000 150 25,350 $69,650

2. Yes. Slopes has a budgeted cash balance of $69,650 on 10/1/2012 and so it will be in a position to pay off the $30,000 1-year note on October 1, 2012. 3. No. Slopes does not maintain a $10,000 minimum cash balance in July. To maintain a $10,000 cash balance in each of the three months, it could perhaps encourage its customers to pay earlier by offering a discount. Alternatively, Slopes could seek short-term credit from a bank.


6-37 (40–50 min.)

Cash budgeting.

Itami Wholesale Co. Statement of Budgeted Cash Receipts and Disbursements For the Months of December 2011 and January 2012

Cash balance, beginning Add receipts: Collections of receivables (Schedule 1) (a) Total cash available for needs Deduct disbursements: For merchandise purchases (Schedule 2) For variable costs (Schedule 3) For fixed costs (Schedule 3) (b) Total disbursements Cash balance, end of month (a – b)

December 2011 January 2012 $ 88,000 $ 18,470 295,250 383,250

265,050 283,520

$291,280 66,000 7,500 364,780 $ 18,470

$223,040 50,000 7,500 280,540 $ 2,980

Under the current projections, the cash balance as of January 31, 2012, is $2,980, which is not sufficient to enable repayment of the $100,000 note.

Schedule 1: Collections of Receivables Collections in

Oct. Sales

December

$39,200a

January a d

0.14 × $280,000 0.14 × $320,000

b e

Nov. Sales

Dec. Sales

Jan. Sales

Total

$96,000b

$160,050c

----

$295,250

$44,800d

$ 99,000e

$121,250f

$265,050

0.30 × $320,000 c 0.50 × $330,000 × .97 0.30 × $330,000 f 0.50 × $250,000 × .97


Schedule 2: Payments for Merchandise December January 750a 740c 3,300 2,500 4,050 3,240 b 815 750 3,235 2,490 $258,800 $199,200

Target ending inventory (in units) Add units sold (sales ÷ $100) Total requirements Deduct beginning inventory (in units) Purchases (in units) Purchases in dollars (units × $80)

Cash disbursements: For December: accounts payable; 60% of current month’s purchases For January: 40% of December’s purchases

December

January

$136,000 $155,280 _______ $291,280

$119,520 103,520 $223,040

a

500 units + 0.10 ($250,000 ÷ $100) $65,200 ÷ $80 c 500 units + 0.10($240,000 ÷ $100) b

Schedule 3: Marketing, Distribution, and Customer-Service Costs Total annual fixed costs, $120,000, minus $30,000 depreciation Monthly fixed cost requiring cash outlay $600,000 $120,000 Variable cost ratio to sales = = 0.2 $2,400,000 December variable costs: 0.2 × $330,000 sales $66,000 January variable costs: 0.2 × $250,000 sales $50,000

$90,000 $ 7,500


6-38

(60 min.) Comprehensive problem; ABC manufacturing, two products.

1. Revenues Budget For the Year Ending December 31, 2011

Combs Brushes Total

Units 12,000 14.000

Selling Price Total Revenues $ 6 $72,000 $20 $280,000 $352,000

2a. Total budgeted marketing costs = Budgeted variable marketing costs + Budgeted fixed marketing costs = $14,100 + $60,000 = $74,100 Marketing allocation rate = $74,100 / $352,000 = $0.21 per sales dollar 2b. Total budgeted distribution costs = Budgeted variable distribution costs + Budgeted fixed distribution costs = $0 + $780 = $780 Combs: Brushes: Total

12,000 units ÷ 1,000 units per delivery 14,000 units ÷ 1,000 units per delivery

12 deliveries 14 deliveries 26 deliveries

Delivery allocation rate = $780 / 26 deliveries = $30 per delivery 3. Production Budget (in Units) For the Year Ending December 31, 2011 Product Combs Brushes Budgeted unit sales 12,000 14,000 Add target ending finished goods inventory 1,200 1,400 Total required units 13,200 15,400 Deduct beginning finished goods inventory 600 1,200 Units of finished goods to be produced 12,600 14,200


4a. Combs

Brushes

Total

12,600 ÷200 63 ×1/3 21

14,200 ÷100 142 ×1 142

163

Machine setup overhead Units to be produced Units per batch Number of setups Hours to setup per batch Total setup hours

Total budgeted setup costs = Budgeted variable setup costs + Budgeted fixed setup costs = $6,830 + $11,100 = $17,930 Machine setup = $17,930 / 163 setup hours = $110 per setup hour allocation rate

b. Combs: Brushes: Total

12,600 units × .025 MH per unit 14,200 units × 0.1 MH per unit

315 MH 1,420 MH 1,735 MH

Total budgeted processing costs = Budgeted variable processing costs + Budgeted fixed processing costs = $7,760 + $20,000 = $27,760 Processing allocation rate = $27,760 / 1,735 MH = $16 per MH c. Total budgeted inspection costs = Budgeted variable inspection costs + Budgeted fixed inspection costs = $7,000 + $1,040 = $8,040 Inspection allocation rate = $8,040 / 26,800 units = $0.30 per unit 5. Direct Material Usage Budget in Quantity and Dollars For the Year Ending December 31, 2011 Material Plastic Bristles Physical Units Budget Direct materials required for Combs (12,600 units × 5 oz and 0 bunches) Brushes (14,200 units × 8 oz and 16 bunches) Total quantity of direct materials to be used

Total

63,000 oz. 113,600 oz. 227,200 bunches 176,600 oz. 227,200 bunches


Cost Budget Available from beginning direct materials inventory (under a FIFO cost-flow assumption) To be purchased this period Plastic: (176,600 oz. ─ 1,600 oz) × $0.20 per oz. Bristles: (227,200 bunches ─ 1,820) × $0.5 per bunch Direct materials to be used this period

$ 304 35,000 ______ $35,304

$

946

112,690 $ 113,636

$148,940

Direct Materials Purchases Budget For the Year Ending December 31, 2011 Material Plastic Bristles

Total

Physical Units Budget To be used in production (requirement 5) Add: Target ending direct material inventory Total requirements Deduct: Beginning direct material inventory Purchases to be made

176,600 oz. 1,766 178,366 oz. 1,600 oz. 176,766 oz.

227,200 bunches 2,272 229,472 bunches 1,820 bunches 227,652 bunches

Cost Budget Plastic: 176,766 oz. $0.20 per oz Bristles : 227,652 bunches $0.5 per bunch Purchases

$ 35,353 _______ $ 35,353

$ 113,826 $ 113,826

$149,179

Total budgeted materials handling costs = Budgeted variable Materials handling costs + Budgeted fixed materials handling costs = $11,490 + $15,000 = $26,490 Materials handling = $26,490 / 176,600 oz = $0.15 per oz. of plastic allocation rate

7. Direct Manufacturing Labor Costs Budget For the Year Ending December 31, 2011

Combs Brushes Total

Output Units Produced 12,600 14,200

Direct Manufacturing Labor-Hours per Unit 0.05 0.2

Total Hourly Wage Hours Rate 630 $12 2,840 12

Total $ 7,560 34,080 $41,640


8. Manufacturing Overhead Cost Budget For the Year Ending December 31, 2011

Materials handling Machine setup Processing Inspection TOTALS

Variable $ 11,490 6,830 7,760 7,000 $ 33,080

Fixed $ 15,000 11,100 20,000 1,040 $ 47,140

Total $ 26,490 17,930 27,760 8,040 $ 80,220


9. Unit Costs of Ending Finished Goods Inventory For the Year Ending December 31, 2011

Plastic Bristles Direct manufacturing labor Materials handling Machine setup Processing Inspection Totals 1

Cost per Unit of Input $0.20 0.50 12 0.15 110 16 0.30

Combs Input per Unit of Output 5 oz. ─ .05 hrs. 5 oz. 0.00167 hrs.1 .025 MH 1 unit

Brushes

Total $1.00 ─ 0.60 0.75 0.18 0.40 0.30 $3.23

Input per Unit of Output 8 oz 16 bunches 0.2 hour 8 oz 0.01 setup-hr1 0.1 MH 1 unit

Total $ 1.60 8.00 2.40 1.20 1.10 1.60 0.30 $16.20

21 setup-hours ÷ 12,600 units = 0.00167 hours per unit; 142 setup hours ÷ 14,200 units = 0.01 hours per unit

Ending Inventories Budget December 31, 2011 Quantity Direct Materials Plastic Bristles Finished goods Combs Brushes Total ending inventory

Cost per unit

1,766 oz 2,272 bunches

1,200 1,400

Total

$0.20 0.50

$353.20 1,136.00

$3.23 16.20

$3,876.00 22,680.00

$1,489.20

26,556.00 $28,045.20

10. Cost of Goods Sold Budget For the Year Ending December 31, 2011 Beginning finished goods inventory, Jan. 1 ($1,800 + $18,120) Direct materials used (requirement 5) $148,940 Direct manufacturing labor (requirement 7) 41,640 Manufacturing overhead (requirement 8) 80,220 Cost of goods manufactured Cost of goods available for sale Deduct: Ending finished goods inventory, December 31 (reqmt. 9) Cost of goods sold


$ 19,920

270,800 290,720 26,556 $264,164

11. Nonmanufacturing Costs Budget For the Year Ending December 31, 2011

Marketing Distribution Total

Variable $14,100 0 $14,100

Fixed $60,000 780 $60,780

Total $74,100 780 $74,880

12. Budgeted Income Statement For the Year Ending December 31, 2011 Revenue $352,000 Cost of goods sold 264,164 Gross margin 87,836 Operating (nonmanufacturing) costs 74,880 Operating income $12,956


6-39 (15 min.) Budgeting and ethics. 1. The standards proposed by Wert are not challenging. In fact, he set the target at the level his department currently achieves. DM 3.95 lbs. 100 units = 395 lbs. DL 14.5 min. 100 units = 1,450 min ÷ 60 = 24 hrs. approx MT 11.8 min. 100 units = 1,180 min. ÷ 60 = 20 hrs. approx 2. Wert probably chose these standards so that his department would be able to make the goal and receive any resulting reward. With a little effort, his department can likely beat these goals. 3. As discussed in the chapter, benchmarking might be used to highlight the easy targets set by Wert. Perhaps the organization has multiple plant locations that could be used as comparisons. Alternatively, management could use industry averages. Also, management should work with Wert to better understand his department and encourage him to set more realistic targets. Finally, the reward structure should be designed to encourage increasing productivity, not beating the budget. 6-40 (45 min.) Human Aspects of Budgeting in a Service Firm 1.

The manager of Hair Suite III has the best style, because this manager is involving the workers in a decision that directly affects their work.

2. The workers will most likely be upset or even angry with the manager of Hair Suite I. The manager is not a stylist, and yet is changing the schedule for the stylists, assuming they can work faster and need less rest between customers, without discussing this change with them or asking for input or suggestions. To indicate displeasure, the stylists at Hair Suite I could quit, or they could perform a work slowdown. This means that the manager will schedule a customer for a 40 minute appointment, but the stylist will spend more than 40 minutes with each customer anyway. The result is that the appointments will get backed up, some customers may not get served, and overall the customers will be unhappy. Most of the workers in Hair Suite II are not likely to volunteer to work an extra hour a day. Although it would mean additional revenue for each stylist, it will make each work day longer and the idea was not presented to the workers in a way that appears beneficial to the workers. To indicate displeasure with this plan, the stylist will simply not volunteer to work an extra hour a day. 3. Of course the manager of Hair Suite III could implement one of the plans of the other salons. That is, workers could shorten their appointment times per customer, or lengthen their work days, or a combination of both. Alternately, workers could work six days per week rather than five. However, in the case of salon III, the manager has invited the stylists to help solve the problem rather than the manager telling them what changes to 6-41 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

make, so they will be more likely to agree to make changes since they are involved in the decision. Other things they may do: The manager may let individual stylists set their own schedules. It is possible that not all customers need an hour each, and the stylists can individually book customers in a way that works in an extra customer per day. They could agree to shorter lunch breaks They could implement a monthly contest to see who can service the most customers (but still have satisfied customers) and earn rewards, including o A name on a plaque for employee of the month (virtually no cost to the salon) o Gift certificates to local businesses (low cost to the salon) o Reduction in one month’s rental revenue (some cost to the salon, depending on the amount of the reduction) o If the salon is in an area where parking is hard to find or costly, a month of free parking or an assigned parking space 4. A stretch target is supposed to be challenging but achievable. The manager of Hair Suite I is asking the stylists to reduce per customer service time by 20 minutes, or a 20/60 = 33% reduction in service time. Even if this reduction is achievable, the other part of the issue is whether the customers will believe they are still getting the same quality service. In a hair salon this is particularly important because the customers expect to look good when they come out, and they will not if the stylist has to rush or cut corners to meet the 40 minute deadline. Also, as mentioned before, the stretch target should motivate employees but if the manager simply imposes the time constraint on the stylists without their input, this will have the opposite effect.


6-41 (60 min.) Comprehensive budgeting problem; activity-based costing, operating and financial budgets. 1a. Revenues Budget For the Month of June, 2012

Regular Deluxe Total

Units Selling Price Total Revenues 2,000 $80 $160,000 3,000 130 390,000 $550,000

b. Production Budget For the Month of June, 2012

Budgeted unit sales Add: target ending finished goods inventory Total required units Deduct: beginning finished goods inventory Units of finished goods to be produced

Product Regular Deluxe 2,000 3,000 400 600 2,400 3,600 250 650 2,150 2,950

c. Direct Material Usage Budget in Quantity and Dollars For the Month of June, 2012 Material Cloth Wood Physical Units Budget Direct materials required for Regular (2,150 units × 1.3 yd.; 0 bd-ft) Deluxe (2,950 units × 1.5 yds.; 2 bd-ft) Total quantity of direct materials to be used

2,795 yds. 4,425 yds. 7,720 yds.

Total

0 5,900 5,900

Cost Budget Available from beginning direct materials inventory (under a FIFO cost-flow assumption) To be purchased this period Cloth: (7720 yd. – 610 yd.) × $3.50 per yd. Wood: (5,900 – 800) × $5 per bd-ft Direct materials to be used this period

$ 2,146

$ 4,040

24,885 _ ___ $27,031

25,500 $29,540

$56,571


Direct Materials Purchases Budget For the Month of June, 2012 Material Cloth Wood Physical Units Budget To be used in production Add: Target ending direct material inventory Total requirements Deduct: beginning direct material inventory Purchases to be made Cost Budget Cloth: (7,496 yds. × $3.50 per yd.) Wood: (5,395 ft × $5 per bd-ft) Total

7,720 yds. 386 yds. 8,106 yds. 610 yds. 7,496 yds.

$26,236 ___ _ $26,236

Total

5,900 ft 295 ft 6,195 ft 800 ft 5,395 ft

$26,975 $26,975

$53,211

d. Direct Manufacturing Labor Costs Budget For the Month of June, 2012

Regular Deluxe Total

Output Units Produced 2,150 2,950

Direct Manufacturing Labor-Hours per Unit 5 7

Total Hourly Wage Hours Rate 10,750 $10 20,650 10 31,400

Total $107,500 206,500 $314,000

e. Manufacturing Overhead Costs Budget For the Month of June 2012 Total Machine setup (Regular 43 batches1 2 hrs./batch + Deluxe 59 batches2 3 hrs./batch) $12/hour Processing (31,400 DMLH $1.20) Inspection (5100 pairs x $0.90 per pair) Total 1

$ 3,156 37,680 4,590 $45,426

Regular: 2,150 pairs ÷ 50 pairs per batch = 43; 2Giant: 2,950 pairs ÷ 50 pairs per batch = 59


f.

Cloth Wood Direct manufacturing labor Machine setup Processing Inspection Total 1

Unit Costs of Ending Finished Goods Inventory For the Month of June, 2012 Regular Deluxe Cost per Input per Input per Unit of Input Unit of Output Total Unit of Output $ 3.50 1.3 yd $ 4.55 1.5 yd 5.00 0 0 2 bd-ft 10.00 5 hr. 50.00 7 hrs 12.00 0.04 hr. 1 0.48 0.06 hr1 1.20 5 hrs 6.00 7 hrs 0.90 1 pair 0.90 1 pair $61.93

Total $ 5.25 10.00 70.00 0.72 8.40 0.90 $95.27

2 hours per setup ÷ 50 pairs per batch = 0.04 hr. per unit; 3 hours per setup ÷ 50 pairs per batch = 0.06 hr. per unit.

Ending Inventories Budget June, 2012

Direct Materials Cloth Wood Finished goods Regular Deluxe Total ending inventory

Quantity

Cost per unit

Total

386 yards 295 bd-ft

$3.50 5.00

$1,351 1,475

400 600

$61.93 95.27

$24,772 57,162

$ 2,826

81,934 $84,760

g. Cost of Goods Sold Budget For the Month of June, 2012 Beginning finished goods inventory, June 1 ($15,500 + $61,750) Direct materials used (requirement c) Direct manufacturing labor (requirement d) Manufacturing overhead (requirement e) Cost of goods manufactured Cost of goods available for sale Deduct ending finished goods inventory, June 30 (requirement f) Cost of goods sold

$ 77,250 $56,571 314,000 45,426 415,997 493,247 81,934 $411,313


h. Nonmanufacturing Costs Budget For the Month of June, 2012 Total Marketing and general administration 8% 550,000 $44,000 Shipping (5,000 pairs / 40 pairs per shipmt) x $10 1,250 Total $45,250

2. Cash Budget June 30, 2012 Cash balance, June 1 (from Balance Sheet) Add receipts Collections from May accounts receivable Collections from June accounts receivable ($550,000 60%) Total collection from customers Total cash available for needs (x) Deduct cash disbursements Direct material purchases in May Direct material purchases in June ( $53,211 80%) Direct manufacturing labor Manufacturing overhead ( $45,426 70% because 30% is depreciation) Nonmanufacturing costs ( $45,250 90% because 10% is depreciation) Taxes Dividends Total disbursements (y) Financing Interest at 6% ($100,000 6% 1 ÷ 12) (z) Ending cash balance, June 30 (x) ─ (y) ─ (z)

$

6,290 205,200 330,000

535,200 $541,490 $

10,400 42,569 314,000

31,798

40,725 7,200 10,000 $456,692 $ $

500 84,298


3. Budgeted Income Statement For the Month of June, 2012 Revenues Cost of goods sold Gross margin Operating (nonmanufacturing) costs Bad debt expense ($550,000 2%) Interest expense (for June) Net income

$550,000 411,313 $138,687 $45,250 11,000 500

56,750 $ 81,937

Budgeted Balance Sheet June 30, 2012 Assets Cash Accounts receivable ($550,000 40%) Less: allowance for doubtful accounts Inventories Direct materials Finished goods

$

$

Fixed assets Less: accumulated depreciation ($90,890 + 45,426 30% + 45,250 10%)) Total assets Liabilities and Equity Accounts payable ($53,211 20%) Interest payable Long-term debt Common stock Retained earnings (465,936 + 81,937-10,000)) Total liabilities and equity

84,298

$220,000 11,000

209,000

2,826 81,934

84,760

$580,000 109,043

470,957 $849,015

$ 10,642 500 100,000 200,000 537,873 $849,015


CHAPTER 7 FLEXIBLE BUDGETS, DIRECT-COST VARIANCES, AND MANAGEMENT CONTROL 7-1 Management by exception is the practice of concentrating on areas not operating as expected and giving less attention to areas operating as expected. Variance analysis helps managers identify areas not operating as expected. The larger the variance, the more likely an area is not operating as expected. 7-2 Two sources of information about budgeted amounts are (a) past amounts and (b) detailed engineering studies. 7-3 A favorable variance––denoted F––is a variance that has the effect of increasing operating income relative to the budgeted amount. An unfavorable variance––denoted U––is a variance that has the effect of decreasing operating income relative to the budgeted amount. 7-4 The key difference is the output level used to set the budget. A static budget is based on the level of output planned at the start of the budget period. A flexible budget is developed using budgeted revenues or cost amounts based on the actual output level in the budget period. The actual level of output is not known until the end of the budget period. 7-5 A flexible-budget analysis enables a manager to distinguish how much of the difference between an actual result and a budgeted amount is due to (a) the difference between actual and budgeted output levels, and (b) the difference between actual and budgeted selling prices, variable costs, and fixed costs. 7-6

The steps in developing a flexible budget are: Step 1: Identify the actual quantity of output. Step 2: Calculate the flexible budget for revenues based on budgeted selling price and actual quantity of output. Step 3: Calculate the flexible budget for costs based on budgeted variable cost per output unit, actual quantity of output, and budgeted fixed costs.

7-7

Four reasons for using standard costs are: (i) cost management, (ii) pricing decisions, (iii) budgetary planning and control, and (iv) financial statement preparation.

7-8 A manager should subdivide the flexible-budget variance for direct materials into a price variance (that reflects the difference between actual and budgeted prices of direct materials) and an efficiency variance (that reflects the difference between the actual and budgeted quantities of direct materials used to produce actual output). The individual causes of these variances can then be investigated, recognizing possible interdependencies across these individual causes.


7-9

Possible causes of a favorable direct materials price variance are: purchasing officer negotiated more skillfully than was planned in the budget, purchasing manager bought in larger lot sizes than budgeted, thus obtaining quantity discounts, materials prices decreased unexpectedly due to, say, industry oversupply, budgeted purchase prices were set without careful analysis of the market, and purchasing manager received unfavorable terms on nonpurchase price factors (such as lower quality materials).

7-10 Some possible reasons for an unfavorable direct manufacturing labor efficiency variance are the hiring and use of underskilled workers; inefficient scheduling of work so that the workforce was not optimally occupied; poor maintenance of machines resulting in a high proportion of non-value-added labor; unrealistic time standards. Each of these factors would result in actual direct manufacturing labor-hours being higher than indicated by the standard work rate. 7-11 Variance analysis, by providing information about actual performance relative to standards, can form the basis of continuous operational improvement. The underlying causes of unfavorable variances are identified and corrective action taken where possible. Favorable variances can also provide information if the organization can identify why a favorable variance occurred. Steps can often be taken to replicate those conditions more often. As the easier changes are made, and perhaps some standards tightened, the harder issues will be revealed for the organization to act on—this is continuous improvement. 7-12 An individual business function, such as production, is interdependent with other business functions. Factors outside of production can explain why variances arise in the production area. For example: poor design of products or processes can lead to a sizable number of defects, marketing personnel making promises for delivery times that require a large number of rush orders can create production-scheduling difficulties, and purchase of poor-quality materials by the purchasing manager can result in defects and waste. 7-13 The plant supervisor likely has good grounds for complaint if the plant accountant puts excessive emphasis on using variances to pin blame. The key value of variances is to help understand why actual results differ from budgeted amounts and then to use that knowledge to promote learning and continuous improvement. 7-14 The sales-volume variance can be decomposed into two parts: a market-share variance that reflects the difference in budgeted contribution margin due to the actual market share being different from the budgeted share; and a market-size variance, which captures the impact of actual size of the market as a while differing from the budgeted market size. 7-15 Evidence on the costs of other companies is one input managers can use in setting the performance measure for next year. However, caution should be taken before choosing such an amount as next year's performance measure. It is important to understand why cost differences across companies exist and whether these differences can be eliminated. It is also important to examine when planned changes (in, say, technology) next year make even the current low-cost producer not a demanding enough hurdle. 7-2 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

7-16

(20–30 min.) Flexible budget. Variance Analysis for Brabham Enterprises for August 2012

Units (tires) sold Revenues Variable costs Contribution margin Fixed costs Operating income

Actual Results (1) g 2,800 a $313,600 d 229,600 84,000 g 50,000

FlexibleBudget Variances (2) = (1) – (3) 0 $ 5,600 F 22,400 U 16,800 U 4,000 F

Flexible Budget (3) 2,800 b $308,000 e 207,200 100,800 g 54,000

Sales-Volume Variances (4) = (3) – (5) 200 U $22,000 U 14,800 F 7,200 U 0

Static Budget (5) g 3,000 c $330,000 f 222,000 108,000 g 54,000

$ 34,000

$12,800 U

$ 46,800

$ 7,200 U

$ 54,000

$12,800 U $ 7,200 U Total flexible-budget variance Total sales-volume variance $20,000 U Total static-budget variance a

$112 × 2,800 = $313,600 $110 × 2,800 = $308,000 c $110 × 3,000 = $330,000 d Given. Unit variable cost = $229,600 ÷ 2,800 = $82 per tire e $74 × 2,800 = $207,200 f $74 × 3,000 = $222,000 g Given b

2.

The key information items are:

Units Unit selling price Unit variable cost Fixed costs

Actual 2,800 $ 112 $ 82 $50,000

Budgeted 3,000 $ 110 $ 74 $54,000

The total static-budget variance in operating income is $20,000 U. There is both an unfavorable total flexible-budget variance ($12,800) and an unfavorable sales-volume variance ($7,200). The unfavorable sales-volume variance arises solely because actual units manufactured and sold were 200 less than the budgeted 3,000 units. The unfavorable flexible-budget variance of $12,800 in operating income is due primarily to the $8 increase in unit variable costs. This increase in unit variable costs is only partially offset by the $2 increase in unit selling price and the $4,000 decrease in fixed costs.


7-17

(15 min.) Flexible budget.

The existing performance report is a Level 1 analysis, based on a static budget. It makes no adjustment for changes in output levels. The budgeted output level is 10,000 units––direct materials of $400,000 in the static budget ÷ budgeted direct materials cost per attaché case of $40. The following is a Level 2 analysis that presents a flexible-budget variance and a salesvolume variance of each direct cost category. Variance Analysis for Connor Company

Output units Direct materials Direct manufacturing labor Direct marketing labor Total direct costs

FlexibleSalesActual Budget Flexible Volume Results Variances Budget Variances (1) (2) = (1) – (3) (3) (4) = (3) – (5) 8,800 0 8,800 1,200 U $364,000 $12,000 U $352,000 $48,000 F 78,000 7,600 U 70,400 9,600 F 110,000 4,400 U 105,600 14,400 F $552,000 $24,000 U $528,000 $72,000 F

Static Budget (5) 10,000 $400,000 80,000 120,000 $600,000

$24,000 U $72,000 F Flexible-budget variance Sales-volume variance $48,000 F Static-budget variance

The Level 1 analysis shows total direct costs have a $48,000 favorable variance. However, the Level 2 analysis reveals that this favorable variance is due to the reduction in output of 1,200 units from the budgeted 10,000 units. Once this reduction in output is taken into account (via a flexible budget), the flexible-budget variance shows each direct cost category to have an unfavorable variance indicating less efficient use of each direct cost item than was budgeted, or the use of more costly direct cost items than was budgeted, or both. Each direct cost category has an actual unit variable cost that exceeds its budgeted unit cost: Actual Budgeted Units 8,800 10,000 Direct materials $ 41.36 $ 40.00 Direct manufacturing labor $ 8.86 $ 8.00 Direct marketing labor $ 12.50 $ 12.00 Analysis of price and efficiency variances for each cost category could assist in further the identifying causes of these more aggregated (Level 2) variances.


7-18 1.

(25–30 min.) Flexible-budget preparation and analysis. Variance Analysis for Bank Management Printers for September 2012 Level 1 Analysis Actual Static-Budget Results Variances (1) (2) = (1) – (3) 12,000 3,000 U a $252,000 $48,000 U d 84,000 36,000 F 168,000 12,000 U 150,000 5,000 U $ 18,000 $17,000 U

Units sold Revenue Variable costs Contribution margin Fixed costs Operating income

Static Budget (3) 15,000 c $300,000 f 120,000 180,000 145,000 $ 35,000

$17,000 U Total static-budget variance

2.

Level 2 Analysis

Units sold Revenue Variable costs Contribution margin Fixed costs Operating income

FlexibleActual Budget Results Variances (1) (2) = (1) – (3) 12,000 0 a $252,000 $12,000 F d 84,000 12,000 F 168,000 24,000 F 150,000 5,000 U $ 18,000

$19,000 F

Sales Flexible Volume Static Budget Variances Budget (3) (4) = (3) – (5) (5) 12,000 3,000 U 15,000 b c $240,000 $60,000 U $300,000 e f 96,000 24,000 F 120,000 144,000 36,000 U 180,000 145,000 0 145,000 $ (1,000)

$36,000 U

$ 35,000

$19,000 F $36,000 U Total flexible-budget Total sales-volume variance variance $17,000 U Total static-budget variance a

d

b

e

12,000 × $21 = $252,000 12,000 × $20 = $240,000 c 15,000 × $20 = $300,000

12,000 × $7 = $ 84,000 12,000 × $8 = $ 96,000 f 15,000 × $8 = $120,000

3. Level 2 analysis breaks down the static-budget variance into a flexible-budget variance and a sales-volume variance. The primary reason for the static-budget variance being unfavorable ($17,000 U) is the reduction in unit volume from the budgeted 15,000 to an actual 12,000. One explanation for this reduction is the increase in selling price from a budgeted $20 to an actual $21. Operating management was able to reduce variable costs by $12,000 relative to the flexible budget. This reduction could be a sign of efficient management. Alternatively, it could be due to using lower quality materials (which in turn adversely affected unit volume).


7-19

(30 min.) Flexible budget, working backward.

1. Variance Analysis for The Clarkson Company for the year ended December 31, 2012

Units sold Revenues Variable costs Contribution margin Fixed costs Operating income

FlexibleBudget Variances (2)=(1) (3) 0 $260,000 F 255,000 U 5,000 F 20,000 U $ 15,000 U

Actual Results (1) 130,000 $715,000 515,000 200,000 140,000 $ 60,000

Flexible Budget (3) 130,000 $455,000a 260,000b 195,000 120,000 $ 75,000

$15,000 U Total flexible-budget variance

Sales-Volume Variances (4)=(3) (5) 10,000 F $35,000 F 20,000 U 15,000 F 0 $15,000 F

Static Budget (5) 120,000 $420,000 240,000 180,000 120,000 $ 60,000

$15,000 F Total sales volume variance

$0 Total static-budget variance a b

130,000 × $3.50 = $455,000; $420,000 130,000 × $2.00 = $260,000; $240,000

2.

120,000 = $3.50 120,000 = $2.00

Actual selling price: Budgeted selling price: Actual variable cost per unit: Budgeted variable cost per unit:

$715,000 420,000 515,000 240,000

130,000 = ÷ 120,000 = ÷ 130,000 = ÷ 120,000 =

$5.50 $3.50 $3.96 $2.00

3. A zero total static-budget variance may be due to offsetting total flexible-budget and total sales-volume variances. In this case, these two variances exactly offset each other: Total flexible-budget variance Total sales-volume variance

$15,000 Unfavorable $15,000 Favorable

A closer look at the variance components reveals some major deviations from plan. Actual variable costs increased from $2.00 to $3.96, causing an unfavorable flexible-budget variable cost variance of $255,000. Such an increase could be a result of, for example, a jump in direct material prices. Clarkson was able to pass most of the increase in costs onto their customers—actual selling price increased by 57% [($5.50 – $3.50) $3.50], bringing about an offsetting favorable flexible-budget revenue variance in the amount of $260,000. An increase in the actual number of units sold also contributed to more favorable results. The company should examine why the units sold increased despite an increase in direct material prices. For example, Clarkson’s customers may have stocked up, anticipating future increases in direct material prices. Alternatively, Clarkson’s selling price increases may have been lower than competitors’ price increases. Understanding the reasons why actual results differ from budgeted amounts can help Clarkson better manage its costs and pricing decisions in the future. The important lesson learned here is that a superficial examination of summary level data (Levels 0 and 1) may be insufficient. It is imperative to scrutinize data at a more detailed level (Level 2). Had Clarkson not been able to pass costs on to customers, losses would have been considerable.


7-20

(30-40 min.) Flexible budget and sales volume variances, market-share and market-size variances.

1. and 2. Performance Report for Marron, Inc., June 2012

Units (pounds) Revenues Variable mfg. costs Contribution margin

Actual (1) 355,000 $1,917,000 1,260,250 $ 656,750

Flexible Budget Variances (2) = (1) – (3) -$17,750 U 17,750 U $35,500 U

Flexible Budget (3) 355,000 $1,934,750a 1,242,500b $ 692,250

$35,500 U Flexible-budget variance

Sales Volume Variances (4) = (3) – (5) 10,000 $54,500 35,000 $19,500

F F U F

Static Budget (5) 345,000 $1,880,250 1,207,500 $ 672,750

$ 19,500 F Sales-volume variance

$16,000 U Static-budget variance a

Budgeted selling price = $1,880,250 345,000 lbs = $5.45 per lb. Flexible-budget revenues = $5.45 per lb. 355,000 lbs. = $1,934,750

b

Budgeted variable mfg. cost per unit = $1,207,500 Flexible-budget variable mfg. costs = $3.50 per lb.

345,000 lbs. = $3.50 355,000 lbs. = $1,242,500


Static Budget Variance (6) = (1) – (5) 10,000 F $36,750 F 52,750 U $16,000 U

Static Budg Variance a % of Stati Budget (7) = (6) (5 2.90% 1.95% 4.37% 2.38%

3. The selling price variance, caused solely by the difference in actual and budgeted selling price, is the flexible-budget variance in revenues = $17,750 U. 4. Budgeted market share = 345,000 ÷ 1,150,000 = 30% Actual market share = 355,000 ÷ 1,109,375 = 32% Static Budget: Actual Market Size Actual Market Size Budgeted Market Size × Actual Market Share × Budgeted Market Share × Budgeted Market Share × Budgeted Contribution × Budgeted Contribution × Budgeted Contribution Margin per Unit Margin per Unit Margin per Unit (1,109,375 × 32% × $1.95) (1,109,375 × 30% × $1.95) (1,150,000 × 30% × $1.95) $692,250 $648,984 $672,750 $43,266 F Market-share variance

$23,766 U Market-size variance

$19,500 F Sales-volume variance

5. The flexible-budget variances show that for the actual sales volume of 355,000 pounds, selling prices were lower and costs per pound were higher. The favorable sales volume variance in revenues (because more pounds of ice cream were sold than budgeted) helped offset the unfavorable variable cost variance and shored up the results in June 2012. Levine should be more concerned because the small static-budget variance in contribution margin of $16,000 U is actually made up of a favorable sales-volume variance in contribution margin of $19,500, an unfavorable selling-price variance of $17,750 and an unfavorable variable manufacturing costs variance of $17,750. Levine should analyze why each of these variances occurred and the relationships among them. Could the efficiency of variable manufacturing costs be improved? The sales volume appears to have increased due to the lower sales price or a better quality product since the overall total market size decreased. The company increased its market share even in the face of an overall decrease in the market for ice-cream products. This could be due to increased efforts in marketing or actions by competitors that are driving more customers to the company.


7-21

(20–30 min.) Price and efficiency variances.

1.

The key information items are:

Output units (scones) Input units (pounds of pumpkin) Cost per input unit

Actual 60,800 16,000 $ 0.82

Budgeted 60,000 15,000 $ 0.89

Peterson budgets to obtain 4 pumpkin scones from each pound of pumpkin. The flexible-budget variance is $408 F.

Pumpkin costs

FlexibleActual Budget Results Variance (1) (2) = (1) – (3) a $13,120 $408 F

Flexible Budget (3) b $13,528

Sales-Volume Static Variance Budget (4) = (3) – (5) (5) c $178 U $13,350

a

16,000 × $0.82 = $13,120 60,800 × 0.25 × $0.89 = $13,528 c 60,000 × 0.25 × $0.89 = $13,350 b

2.

Actual Costs Incurred (Actual Input Quantity × Actual Price) a $13,120

Actual Input Quantity × Budgeted Price b $14,240

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) c $13,528

$1,120 F $712 U Price variance Efficiency variance $408 F Flexible-budget variance a

16,000 × $0.82 = $13,120 16,000 × $0.89 = $14,240 c 60,800 × 0.25 × $0.89 = $13,528 b

3.

The favorable flexible-budget variance of $408 has two offsetting components: (a) favorable price variance of $1,120––reflects the $0.82 actual purchase cost being lower than the $0.89 budgeted purchase cost per pound. (b) unfavorable efficiency variance of $712––reflects the actual materials yield of 3.80 scones per pound of pumpkin (60,800 ÷ 16,000 = 3.80) being less than the budgeted yield of 4.00 (60,000 ÷ 15,000 = 4.00). The company used more pumpkins (materials) to make the scones than was budgeted.

One explanation may be that Peterson purchased lower quality pumpkins at a lower cost per pound.


7-22 (15 min.) Materials and manufacturing labor variances. Actual Costs Incurred (Actual Input Quantity × Actual Price) Direct Materials

Flexible Budget (Budgeted Input Actual Input Quantity Allowed for Quantity Actual Output × Budgeted Price × Budgeted Price)

$200,000

$214,000

$225,000

$14,000 F $11,000 F Price variance Efficiency variance $25,000 F Flexible-budget variance Direct Mfg. Labor

$90,000

$86,000

$80,000

$4,000 U $6,000 U Price variance Efficiency variance $10,000 U Flexible-budget variance

7-23 (30 min.) Direct materials and direct manufacturing labor variances. 1.

May 2011 Units Direct materials Direct labor Total price variance Total efficiency variance

Actual Results (1) 550 $12,705.00 $ 8,464.50

Price Variance (2) = (1)–(3) $1,815.00 U $ 104.50 U $1,919.50 U

Actual Quantity Budgeted Price (3) $10,890.00a $ 8,360.00c

Efficiency Variance (4) = (3) – (5) $990.00 U $440.00 F

Flexible Budget (5) 550 $9,900.00b $8,800.00d

$550.00 U

a

7,260 meters $1.50 per meter = $10,890 550 lots 12 meters per lot $1.50 per meter = $9,900 c 1,045 hours $8.00 per hour = $8,360 d 550 lots 2 hours per lot $8 per hour = $8,800 b

Total flexible-budget variance for both inputs = $1,919.50U + $550U = $2,469.50U Total flexible-budget cost of direct materials and direct labor = $9,900 + $8,800 = $18,700 Total flexible-budget variance as % of total flexible-budget costs = $2,469.50 $18,700 = 13.21%


2. May 2012 Units Direct materials Direct manuf. labor Total price variance Total efficiency variance

Actual Results (1) 550 $11,828.36a $ 8,295.21d

Price Variance (2) = (1) – (3) $1,156.16 U $ 102.41 U $1,258.57 U

Actual Quantity Budgeted Price (3) $10,672.20b $ 8,192.80e

Efficiency Variance (4) = (3) – (5) $772.20 U $607.20 F

Flexible Budget (5) 550 $9,900.00c $8,800.00c

$165.00 U

a

Actual dir. mat. cost, May 2012 = Actual dir. mat. cost, May 2011 0.98 0.95 = $12,705 0.98 0.95 = $11.828.36 Alternatively, actual dir. mat. cost, May 2012 = (Actual dir. mat. quantity used in May 2011 0.98) (Actual dir. mat. price in May 2011 0.95) = (7,260 meters 0.98) ($1.75/meter 0.95) = 7,114.80 $1.6625 = $11,828.36 b (7,260 meters 0.98) $1.50 per meter = $10,672.20 c Unchanged from 2011. d Actual dir. labor cost, May 2012 = Actual dir. manuf. cost May 2011 0.98 = $8,464.50 0.98 = $8,295.21 Alternatively, actual dir. labor cost, May 2012 = (Actual dir. manuf. labor quantity used in May 2011 0.98) Actual dir. labor price in 2011 = (1,045 hours 0.98) $8.10 per hour = 1,024.10 hours $8.10 per hour = $8,295.21 e (1,045 hours 0.98) $8.00 per hour = $8,192.80

Total flexible-budget variance for both inputs = $1,258.57U + $165U = $1,423.57U Total flexible-budget cost of direct materials and direct labor = $9,900 + $8,800 = $18,700 Total flexible-budget variance as % of total flexible-budget costs = $1,423.57 $18,700 = 7.61% 3. Efficiencies have improved in the direction indicated by the production manager—but, it is unclear whether they are a trend or a one-time occurrence. Also, overall, variances are still 7.6% of flexible input budget. GloriaDee should continue to use the new material, especially in light of its superior quality and feel, but it may want to keep the following points in mind: The new material costs substantially more than the old ($1.75 in 2011 and $1.6625 in 2012 vs. $1.50 per meter). Its price is unlikely to come down even more within the coming year. Standard material price should be re-examined and possibly changed. GloriaDee should continue to work to reduce direct materials and direct manufacturing labor content. The reductions from May 2011 to May 2012 are a good development and should be encouraged.


7-24

(30 min.) Price and efficiency variances, journal entries.

1. Direct materials and direct manufacturing labor are analyzed in turn: Actual Costs Incurred (Actual Input Quantity × Actual Price)

Direct Materials

(100,000 × $4.65a) $465,000

Actual Input Quantity × Budgeted Price Purchases Usage (100,000 × $4.50) $450,000

(98,055 × $4.50) $441,248

$15,000 U Price variance Direct Manufacturing Labor

b

(4,900 × $31.5 ) $154,350

b

(9,850 × 10 × $4.50) $443,250

$2,002 F Efficiency variance (9,850 × 0.5 × $30) or (4,925 × $30) $147,750

(4,900 × $30) $147,000 $7,350 U Price variance

a

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price)

$750 F Efficiency variance

$465,000 ÷ 100,000 = $4.65 $154,350 ÷ 4,900 = $31.5

2.

Direct Materials Control Direct Materials Price Variance Accounts Payable or Cash Control

450,000 15,000

Work-in-Process Control Direct Materials Control Direct Materials Efficiency Variance

443,250

Work-in-Process Control Direct Manuf. Labor Price Variance Wages Payable Control Direct Manuf. Labor Efficiency Variance

147,750 7,350

465,000

441,248 2,002

154,350 750

3. Some students’ comments will be immersed in conjecture about higher prices for materials, better quality materials, higher grade labor, better efficiency in use of materials, and so forth. A possibility is that approximately the same labor force, paid somewhat more, is taking slightly less time with better materials and causing less waste and spoilage. A key point in this problem is that all of these efficiency variances are likely to be insignificant. They are so small as to be nearly meaningless. Fluctuations about standards are bound to occur in a random fashion. Practically, from a control viewpoint, a standard is a band or range of acceptable performance rather than a single-figure measure. 4. The purchasing point is where responsibility for price variances is found most often. The production point is where responsibility for efficiency variances is found most often. The Monroe Corporation may calculate variances at different points in time to tie in with these different responsibility areas. 7-12 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

7-25

(20 min.)

Continuous improvement (continuation of 7-24).

1.

Standard quantity input amounts per output unit are: Direct Direct Materials Manufacturing Labor (pounds) (hours) January 10.000 0.500 February (Jan. × 0.98) 9.800 0.490 March (Feb. × 0.99) 9.702 0.485

2. The answer is the same as that for requirement 1 of Question 7-24, except for the flexible-budget amount. Actual Costs Incurred (Actual Input Quantity × Actual Price) Direct Materials

(100,000 × $4.65a) $465,000

Actual Input Quantity × Budgeted Price Purchases Usage (100,000 × $4.50) (98,055 × $4.50) $450,000 $441,248

$15,000 U Price variance Direct Manuf. Labor

(4,900 × $31.5b) $154,350

b

(9,850 × 9.702 × $4.50) $430,041

$11,207 U Efficiency variance (4,900 × $30) $147,000

$7,350 U Price variance a


(9,850 × 0.485 × $30) $143,318 $3,682 U Efficiency variance

$465,000 ÷ 100,000 = $4.65 $154,350 ÷ 4,900 = $31.5

Using continuous improvement standards sets a tougher benchmark. The efficiency variances for January (from Exercise 7-24) and March (from Exercise 7-25) are:

Direct materials Direct manufacturing labor

January $2,002 F $ 750 F

March $11,207 U $3,682 U

Note that the question assumes the continuous improvement applies only to quantity inputs. An alternative approach is to have continuous improvement apply to the total budgeted input cost per output unit ($45 for direct materials in January and $15 for direct manufacturing labor in January).


7-26

(20 30 min.) Materials and manufacturing labor variances, standard costs.

1.

Direct Materials

Actual Costs Incurred (Actual Input Quantity × Actual Price)

Actual Input Quantity × Budgeted Price

(3,700 sq. yds. × $5.10) $18,870

(3,700 sq. yds. × $5.00) $18,500

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (2,000 × 2 × $5.00) (4,000 sq. yds. × $5.00) $20,000

$370 U Price variance

$1,500 F Efficiency variance $1,130 F Flexible-budget variance

The unfavorable materials price variance may be unrelated to the favorable materials efficiency variance. For example, (a) the purchasing officer may be less skillful than assumed in the budget, or (b) there was an unexpected increase in materials price per square yard due to reduced competition. Similarly, the favorable materials efficiency variance may be unrelated to the unfavorable materials price variance. For example, (a) the production manager may have been able to employ higher-skilled workers, or (b) the budgeted materials standards were set too loosely. It is also possible that the two variances are interrelated. The higher materials input price may be due to higher quality materials being purchased. Less material was used than budgeted due to the high quality of the materials. Direct Manufacturing Labor Actual Costs Incurred (Actual Input Quantity Actual Input Quantity × Actual Price) × Budgeted Price (900 hrs. × $9.80) $8,820

(900 hrs. × $10.00) $9,000 $180 F Price variance

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (2000 × 0.5 × $10.00) (1,000 hrs. × $10.00) $10,000

$1,000 F Efficiency variance

$1,180 F Flexible-budget variance

The favorable labor price variance may be due to, say, (a) a reduction in labor rates due to a recession, or (b) the standard being set without detailed analysis of labor compensation. The favorable labor efficiency variance may be due to, say, (a) more efficient workers being employed, (b) a redesign in the plant enabling labor to be more productive, or (c) the use of higher quality materials.


2.

Control Point Purchasing

Actual Costs Incurred (Actual Input Quantity × Actual Price) (6,000 sq. yds.× $5.10) $30,600

Actual Input Quantity × Budgeted Price (6,000 sq. yds. × $5.00) $30,000



Production

(3,700 sq. yds.× $5.00) $18,500

(2,000 × 2 × $5.00) $20,000


Direct manufacturing labor variances are the same as in requirement 1.


7-27

(15 25 min.) Journal entries and T-accounts (continuation of 7-26).

For requirement 1 from Exercise 7-26: a. Direct Materials Control Direct Materials Price Variance Accounts Payable Control To record purchase of direct materials.

18,500 370 18,870

b. Work-in-Process Control Direct Materials Efficiency Variance Direct Materials Control To record direct materials used.

20,000 1,500 18,500

c. Work-in-Process Control 10,000 Direct Manufacturing Labor Price Variance Direct Manufacturing Labor Efficiency Variance Wages Payable Control To record liability for and allocation of direct labor costs. Direct Materials Control (a) 18,500 (b) 18,500

Work-in-Process Control (b) 20,000 (c) 10,000 Wages Payable Control (c) 8,820

Direct Materials Price Variance (a) 370

180 1,000 8,820

Direct Materials Efficiency Variance (b) 1,500

Direct Manufacturing Labor Price Variance (c) 180

Direct Manuf. Labor Efficiency Variance (c) 1,000

Accounts Payable Control (a) 18,870

For requirement 2 from Exercise 7-26: The following journal entries pertain to the measurement of price and efficiency variances when 6,000 sq. yds. of direct materials are purchased: a1. Direct Materials Control Direct Materials Price Variance Accounts Payable Control To record direct materials purchased.

30,000 600 30,600

a2. Work-in-Process Control Direct Materials Control Direct Materials Efficiency Variance To record direct materials used.

20,000 18,500 1,500


Direct Materials Control (a1) 30,000 (a2) 18,500

Accounts Payable Control (a1) 30,600

Direct Materials Price Variance (a1) 600

Work-in-Process Control (a2) 20,000

Direct Materials Efficiency Variance (a2) 1,500

The T-account entries related to direct manufacturing labor are the same as in requirement 1. The difference between standard costing and normal costing for direct cost items is:

Direct Costs

Standard Costs Standard price(s) × Standard input allowed for actual outputs achieved

Normal Costs Actual price(s) × Actual input

These journal entries differ from the normal costing entries because Work-in-Process Control is no longer carried at ―actual‖ costs. Furthermore, Direct Materials Control is carried at standard unit prices rather than actual unit prices. Finally, variances appear for direct materials and direct manufacturing labor under standard costing but not under normal costing.


7-28 (25 min.)

Flexible budget (Refer to data in Exercise 7-26).

A more detailed analysis underscores the fact that the world of variances may be divided into three general parts: price, efficiency, and what is labeled here as a sales-volume variance. Failure to pinpoint these three categories muddies the analytical task. The clearer analysis follows (in dollars):

Direct Materials

Actual Costs Incurred (Actual Input Quantity × Actual Price) $18,870



Static Budget

$18,500

$20,000

$25,000

(a) $370 U Direct Manuf. Labor

$8,820

(b) $1,500 F

$9,000 (a) $180 F

(c) $5,000 F

$10,000 (b) $1,000 F

$12,500

(c) $2,500 F

(a) Price variance (b) Efficiency variance (c) Sales-volume variance The sales-volume variances are favorable here in the sense that less cost would be expected solely because the output level is less than budgeted. However, this is an example of how variances must be interpreted cautiously. Managers may be incensed at the failure to reach scheduled production (it may mean fewer sales) even though the 2,000 units were turned out with supreme efficiency. Sometimes this phenomenon is called being efficient but ineffective, where effectiveness is defined as the ability to reach original targets and efficiency is the optimal relationship of inputs to any given outputs. Note that a target can be reached in an efficient or inefficient way; similarly, as this problem illustrates, a target can be missed but the given output can be attained efficiently.


7-29

(20 min.)

Sales volume, market share and market size variances.

1. Sales volume variance. Budgeted contribution margin per unit = ($3,300,000 ÷ 220,000) × (1 – 64%) = $5.40 per unit Sales volume variance = Budgeted contribution margin per unit × (Actual units sold – budgeted units sold) = $5.40 × (230,550 – 220,000) = $56,970 F 2. Market share and market size variances Budgeted market share = 220,000 ÷ 4,400,000 = 5% Actual market share = 230,550 ÷ 4,350,000 = 5.30%

Static Budget: Actual Market Size Actual Market Size Budgeted Market Size × Actual Market Share × Budgeted Market Share × Budgeted Market Share × Budgeted Contribution × Budgeted Contribution × Budgeted Contribution Margin per Unit Margin per Unit Margin per Unit (4,350,000 × 5.3% × $5.40) (4,350,000 × 5% × $5.40) (4,400,000 × 5% × $5.40 $1,244,970 $1,174,500 $1,188,000 $70,470 F Market-share variance

$13,500 U Market-size variance


3. The market share variance is favorable indicating that the company increased its percentage of the market. Since the total market decreased, this could be due to providing a higher quality product or more after-sale services than competitors, a decrease in sales price, or due to negative actions by competitors.


7-30 1.

(30 min.) Flexible budget, direct materials and direct manufacturing labor variances. Variance Analysis for Tuscany Statuary for 2011

Flexible Sales Actual Budget Flexible Volume Static Results Variances Budget Variances Budget (1) (2) = (1) – (3) (3) (4) = (3) – (5) (5) Units sold 5,500a 0 5,500 500 U 6,000a b Direct materials $ 668,800 $ 8,800 U $ 660,000 $ 60,000 F $ 720,000c Direct manufacturing labor 952,750a 9,750 F 962,500d 87,500 F 1,050,000e a a Fixed costs 1,180,000 20,000 F 1,200,000 0 1,200,000a Total costs $2,801,550 $20,950 F $2,822,500 $147,500 F $2,970,000 $20,950 F $147,500 F Flexible-budget variance Sales-volume variance $168,450 F Static-budget variance a

Given $120/unit × 5,500 units = $660,000 c $120/unit × 6,000 units = $720,000 d $175/unit × 5,500 units = $962,500 e $175/unit × 6,000 units = $1,050,000 b

2.

Direct materials

Actual Incurred (Actual Input Quantity Actual Price) $668,800a

Actual Input Quantity Budgeted Price $704,000b

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output Budgeted Price) $660,000c

$35,200 F Price variance

$44,000 U Efficiency variance $8,800 U Flexible-budget variance

Direct manufacturing labor

$952,750d

$925,000e

$962,500f

$27,750 U $37,500 F Price variance Efficiency variance $9,750 F Flexible-budget variance a

70,400 pounds × $9.5/pound = $668,800 70,400 pounds × $10/pound = $704,000 c 5,500 statues × 12 pounds/statue × $10/pound = 66,000 pounds × $10/pound = $660,000 d 18,500 hours × $51.50/hour = $952,750 e 18,500 hours × $50/hour = $925,000 f 5,500 statues × 3.5 hours/statue × $50/hour = 19,250 hours × $50/hour = $962,500 b


7-31

(30 min.) Variance analysis, nonmanufacturing setting

1. This is a problem of two equations & two unknowns. The two equations relate to the number of cars detailed and the labor costs (the wages paid to the employees). X = number of cars detailed by the experienced employee Y = number of cars detailed by the less experienced employees (combined) Budget: X + Y = 200 $40X + $20Y = $5,600

Actual: X + Y = 225 $40X + $20Y = $6,000

Substitution: 40X + 20(200-X) = 5,600 20X = 1,600 X= 80 cars Y=120 cars

Substitution: 40X + 20(225-X) = 6,000 20X = 1,500 X = 75 cars Y=150 cars

Budget: The experienced employee is budgeted to detail 80 cars (and earn $3,200), and the less experienced employees are budgeted to detail 60 cars each and earn $1,200 apiece. Actual: The experienced employee details 75 cars (and grosses $3,000 for the month), and the other two wash 75 each and gross $1,500 apiece. 2.

Units sold Revenues Variable costs Supplies Labor – Experienced Labor – Less experienced Total variable costs Contribution Margin Fixed costs Operating income

Actual Results (1) 225

FlexibleBudget Variances (2)=(1)-(3)

Flexible Budget (3) 225

Sales Volume Variance (4)=(3)-(5)

Static Budget (5) 200

$39,375

$5,625 F

$33,750a

$3,750 F

$30,000

2,250 3,000 3,000 8,250 31,125 9,500 $21,625

562 U 600 F 300 U 262 U 5,363 F 0 $5,363 F

1,688b 3,600c 2,700d 7,988 25,762 9,500 $16,262

188 U 400 U 300 U 888 U 2,862 F 0 $2,862 F

1,500 3,200 2,400 7,100 22,900 9,500 $13,400

a

225 × ($30,000/200) 225 × ($1,500/200) c 225 × ($3,200/200) d 225 × ($2,400/200) b


3. Actual sales price = $39,375 ÷ 225 = $175 Sales Price Variance = (Actual sales price – Budgeted sales price) × Actual number of cars detailed: = ($175 – $150) × 225 = $5,625 Favorable Labor efficiency for experienced worker: Standard cars expected to be completed by experienced worker based on actual number of cars detailed = (80 ÷ 200) × 225 = 90 cars Labor efficiency variance = Budgeted wage rate per car × (Actual cars detailed – budgeted cars detailed) = $40 × (75 – 90) = $600 Favorable Labor efficiency for less experienced workers: Standard cars expected to be completed by less experienced workers based on actual number of cars detailed = (120 ÷ 200) × 225 = 135 cars Labor efficiency variance = Budgeted wage rate per car × (Actual cars detailed – budgeted cars detailed) = $20 × (150 – 135) = $300 Unfavorable 4. In addition to understanding the variances computed above, Stevie should attempt to keep track of the number of cars worked on by each employee, as well as the number of hours actually spent on each car. In addition, Stevie should look at the prices charged for detailing, in relation to the hours spent on each job. It should also be considered whether the experienced worker should be asked to take time per car, given his prior years at work and the fact that he is paid twice the wage rate of the less experienced employees.


7-32

(60 min.) Comprehensive variance analysis, responsibility issues.

1a.

Actual selling price = $82.00 Budgeted selling price = $80.00 Actual sales volume = 7,275 units Selling price variance = (Actual sales price Budgeted sales price) × Actual sales volume = ($82 $80) × 7,275 = $14,550 Favorable

1b.

Development of Flexible Budget

Revenues Variable costs DM Frames $2.20/oz. × 3.00 oz. DM Lenses $3.10/oz. × 6.00 oz. Direct manuf. labor $15.00/hr. × 1.20 hrs. Total variable manufacturing costs Fixed manufacturing costs Total manufacturing costs

Budgeted Unit Amounts $80.00 a

6.60 b 18.60 c 18.00

Actual Volume 7,275

Flexible Budget Amount $582,000

7,275 7,275 7,275

48,015 135,315 130,950 314,280 112,500 426,780

Gross margin a

$155,220

b c $49,500 ÷ 7,500 units; $139,500 ÷ 7,500 units; $135,000 ÷ 7,500 units

Units sold Revenues Variable costs DM Frames DM Lenses Direct manuf. labor Total variable costs Fixed manuf. costs Total costs Gross margin Level 2

Actual Results (1) 7,275

FlexibleBudget Variances (2)=(1)-(3)

Flexible Budget (3) 7,275

Sales Volume Variance (4)=(3)-(5)

Static Budget (5) 7,500

$596,550

$14,550F

$582,000

$18,000 U

$600,000

55,872 150,738 145,355 351,965 108,398 460,363 $136,187

7,857U 15,423U 14,405U 37,685U 4,102F 33,583U $19,033U

48,015 135,315 130,950 314,280 112,500 426,780 $155,220

1,485 F 4,185 F 4,050 F 9,720 F 0 9,720 F $ 8,280 U

49,500 139,500 135,000 324,000 112,500 436,500 $163,500


Level 1

$ 8,280 U Sales-volume variance

$27,313 U Static-budget variance


1c.

Price and Efficiency Variances DM Frames Actual ounces used = 3.20 per unit × 7,275 units = 23,280 oz. Price per oz. = $55,872 23,280 = $2.40 DM Lenses Actual ounces used = 7.00 per unit × 7,275 units = 50,925 oz. Price per oz. = $150,738 50,925 = $2.96 Direct Labor Actual labor hours = $145,355 14.80 = 9,821.3 hours Labor hours per unit = 9,821.3 7,275 units = 1.35 hours per unit

Direct Materials: Frames

Actual Costs Incurred (Actual Input Quantity × Actual Price) (1) (7,275 × 3.2 × $2.40) $55,872

Actual Input Quantity × Budgeted Price (2) (7,275 × 3.2 × $2.20) $51,216

$4,656 U Price variance

Direct Materials: Lenses

(7,275 × 7.0 × $2.96) $150,738

$3,201 U Efficiency variance

(7,275 × 7.0 × $3.10) $157,868


Direct Manuf. Labor

(7,275 × 1.35 × $14.80) $145,355

(7,275 × 6.00 × $3.10) $135,315


(7,275 × 1.35 × $15.00) $147,319


2.

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (3) (7,275 × 3.00 × $2.20) $48,015

(7,275 × 1.20 × $15.00) $130,950


Possible explanations for the price variances are: (a) Unexpected outcomes from purchasing and labor negotiations during the year. (b) Higher quality of frames and/or lower quality of lenses purchased. (c) Standards set incorrectly at the start of the year. Possible explanations for the uniformly unfavorable efficiency variances are: (a) Substantially higher usage of lenses due to poor quality lenses purchased at lower price. (b) Lesser trained workers hired at lower rates result in higher materials usage (for both frames and lenses), as well as lower levels of labor efficiency. (c) Standards set incorrectly at the start of the year.


7-33

(20 min.) Possible causes for price and efficiency variances

1.

Actual Costs Incurred (Actual Input Quantity × Actual Price) (1) Direct Materials: Bottles

Pesos 2,275,500

Actual Input Quantity × Budgeted Price (2) (6,150,000 × Peso 0.36) Pesos 2,214,000

Pesos 61,500 U Price variance


Pesos 784,420

Pesos 378,000 U Efficiency variance

(26,000 × Peso 29.25) Pesos 760,500

Pesos 23,920 U Price variance

2.

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (3) (340,000 × 15 × Peso 0.36) Pesos 1,836,000

(340,000 × (2/60) × Peso 29.25) Pesos 331,500

Pesos 429,000 U Efficiency variance

If union organizers are targeting our plant, it could suggest employee dissatisfaction with our wage and benefits policies. During this time of targeting, we might expect employees to work more slowly and they may be less careful with the materials that they are using. These tactics might be seen as helpful in either organizing the union or in receiving increases in wages and/or benefits. We should expect unfavorable efficiency variances for both wages and materials. We may see an unfavorable wage variance, if we need to pay overtime due to work slowdowns. We do, in fact, see a substantial unfavorable materials quantity variance, representing a serious overuse of materials. While we may not expect each bottle to use exactly 15 oz. of materials, we do expect the shrinkage to be much less than this. Similarly, we see well over double the number of hours used relative to what we expect to make and fill this number of bottles. They are able to produce just over 13 bottles per hour, instead of the standard 30 bottles per hour. It is plausible that this waste & inefficiency are either caused by, or are reflective of the reasons behind the attempt to organize the union at this plant.


7-34

(35 min.) Material cost variances, use of variances for performance evaluation

1. Materials Variances Actual Costs Incurred (Actual Input Quantity × Actual Price) Direct Materials

(8,400 × $19a) $159,600

Actual Input Quantity × Budgeted Price Purchases Usage (8,400 × $22) (7,900 × $22) $184,800 $173,800

$25,200 F Price variance a

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (800 × 8 × $22) (6,400 × $22) $140,800


$159,600 ÷8,400 = $19

2. The favorable price variance is due to the $3 difference ($22 – $19) between the standard price based on the previous suppliers and the actual price paid through the on-line marketplace. The unfavorable efficiency variance could be due to several factors including inexperienced workers and machine malfunctions. But the likely cause here is that the lower-priced titanium was lower quality or less refined, which led to more waste. The labor efficiency variance could be affected if the lower quality titanium caused the workers to use more time. 3. Switching suppliers was not a good idea. The $25,200 savings in the cost of titanium was outweighed by the $33,000 extra material usage. In addition, the $33,000U efficiency variance does not recognize the total impact of the lower quality titanium because, of the 8,400 pounds purchased, only 7,900 pounds were used. If the quantity of materials used in production is relatively the same, Better Bikes could expect the remaining 500 lbs to produce approximately 50 more units. At standard, 50 more units should take 50 × 8 = 400 lbs. There could be an additional unfavorable efficiency variance of (500 $22) $11,000

(50 × 8 × $22) $8,800 $2,200U

4. The purchasing manager’s performance evaluation should not be based solely on the price variance. The short-run reduction in purchase costs was more than offset by higher usage rates. His evaluation should be based on the total costs of the company as a whole. In addition, the production manager’s performance evaluation should not be based solely on the efficiency variances. In this case, the production manager was not responsible for the purchase of the lower-quality titanium, which led to the unfavorable efficiency scores. In general, it is important for Stanley to understand that not all favorable material price variances are ―good news,‖ because of the negative effects that can arise in the production process from the purchase of inferior inputs. They can lead to unfavorable efficiency variances for both materials and labor. Stanley should also that understand


efficiency variances may arise for many different reasons and she needs to know these reasons before evaluating performance. 5. Variances should be used to help Better Bikes understand what led to the current set of financial results, as well as how to perform better in the future. They are a way to facilitate the continuous improvement efforts of the company. Rather than focusing solely on the price of titanium, Scott can balance price and quality in future purchase decisions. 6. Future problems can arise in the supply chain. Scott may need to go back to the previous suppliers. But Better Bikes’ relationship with them may have been damaged and they may now be selling all their available titanium to other manufacturers. Lower quality bicycles could also affect Better Bikes’ reputation with the distributors, the bike shops and customers, leading to higher warranty claims and customer dissatisfaction, and decreased sales in the future.


7-35

(30 min.) Direct manufacturing labor and direct materials variances, missing data.

1. Actual Costs Incurred (Actual Input Quantity Actual Price) $739,900a

Direct mfg. labor

Actual Input Quantity Budgeted Price $735,000b


Flexible Budget (Budgeted Input Quantity Allowed for Actual Output Budgeted Price) $742,500c


$2,600 F Flexible-budget variance a

Given (or 49,000 hours × $15.10/hour) 49,000 hours × $15/hour = $735,000 c 5,500 units × 9 hours/unit × $15/hour = $742,500 b

2. Unfavorable direct materials efficiency variance of $1,500 indicates that fewer pounds of direct materials were actually used than the budgeted quantity allowed for actual output. =

$1, 500 efficiency variance $3 per pound budgeted price

= 500 pounds Budgeted pounds allowed for the output achieved = 5,500 30 = 165,000 pounds Actual pounds of direct materials used = 165,000 500 = 164,500 pounds 3. Actual price paid per pound = 579,500/190,000 = $3.05 per pound 4.

Actual Costs Incurred (Actual Input × Actual Price) $579,500a

Actual Input × Budgeted Price $570,000b

$9,500 U Price variance a b

Given 190,000 pounds × $3/pound = $570,000


7-36

(20–30 min.) Direct materials and manufacturing labor variances, solving unknowns. All given items are designated by an asterisk.


Actual Costs Incurred (Actual Input Quantity × Actual Price)



(1,900 × $21) $39,900

(1,900 × $20*) $38,000

(4,000* × 0.5* × $20*) $40,000

$1,900 U* Price variance

Direct Materials

(13,000 × $5.25) $68,250*

$2,000 F* Efficiency variance

Purchases (13,000 × $5*) $65,000

$3,250 U* Price variance

Usage (12,500 × $5*) $62,500

(4,000* × 3* × $5*) $60,000

$2,500 U* Efficiency variance

1. 4,000 units × 0.5 hours/unit = 2,000 hours 2. Flexible budget – Efficiency variance = $40,000 – $2,000 = $38,000 Actual dir. manuf. labor hours = $38,000 ÷ Budgeted price of $20/hour = 1,900 hours 3. $38,000 + Price variance, $1,900 = $39,900, the actual direct manuf. labor cost Actual rate = Actual cost ÷ Actual hours = $39,000 ÷ 1,900 hours = $21/hour (rounded) 4. Standard quantity of direct materials = 4,000 units × 3 pounds/unit = 12,000 pounds 5. Flexible budget + Dir. matls. effcy. var. = $60,000 + $2,500 = $62,500 Actual quantity of dir. matls. used = $62,500 ÷ Budgeted price per lb = $62,500 ÷ $5/lb = 12,500 lbs 6. Actual cost of direct materials, $68,250 – Price variance, $3,250 = $65,000 Actual quantity of direct materials purchased = $65,000 ÷ Budgeted price, $5/lb = 13,000 lbs. 7. Actual direct materials price = $68,250 ÷ 13,000 lbs = $5.25 per lb.


7-37

(20 min.)

Direct materials and manufacturing labor variances, journal entries.

1. Direct Materials:

Wool

Actual Costs Incurred (Actual Input Quantity × Actual Price) (given)

Actual Input Quantity × Budgeted Price 3,040 $3.50

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) 235 12 $3.50

$10,336

$10,640

$9,870

$304 F $770 U Price variance Efficiency variance $466 U Flexible-budget variance Direct Manufacturing Labor: Actual Costs Incurred (Actual Input Quantity × Actual Price) (given)

Actual Input Quantity × Budgeted Price 925 $10

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) 235 4 $10

$9,620

$9,250

$9,400

$370 U $150 F Price variance Efficiency variance $220 U Flexible-budget variance


2.

Direct Materials Price Variance (time of purchase = time of use) Direct Materials Control 10,640 Direct Materials Price Variance 304 Accounts Payable Control or Cash 10,336

Direct Materials Efficiency Variance Work in Process Control Direct Materials Efficiency Variance Direct Materials Control

9,870 770 10,640

Direct Manufacturing Labor Variances Work in Process Control Direct Mfg. Labor Price Variance Direct Mfg. Labor Efficiency Variance Wages Payable or Cash

9,400 370 150 9,620

3. Plausible explanations for the above variances include: Shayna paid a little less for the wool, but the wool was lower quality (more knots in the yarn that had to be cut out) and workers had to use more of it. Shayna used more experienced workers in April than she usually does. This resulted in payment of higher wages per hour, but the new workers were more efficient and took less hours than normal. However, overall the higher wage rates resulted in Shayna’s total wage bill being higher than expected.


7-38

(30 min.) Use of materials and manufacturing labor variances for benchmarking.

1.

Unit variable cost (dollars) and component percentages for each firm:

Firm A DM DL VOH Total 2.

$ 9.80 16.50 9.90 $36.20

Firm B

27.1% 45.6% 27.3% 100.0%

$10.92 17.83 15.53 $44.28

Firm C

24.7% 40.2% 35.1% 100.0%

$10.75 15.68 7.13 $33.56

Firm D

32.1% 46.7% 21.2% 100.0%

$11.25 15.90 11.25 $38.40

29.3% 41.4% 29.3% 100.0%

Variances and percentage over/under standard for each firm relative to the Industry Benchmark: Firm A Firm B Firm C Firm D % over % over % over % over Variance standard Variance standard Variance standard Variance standard

DM Price Variance DM Efficiency Variance DL Price Variance DL Efficiency Variance

$0.20 F

-2.00%

$1.17 U

12.00%

--

--

$1.25 F

-10.00%

--

--

$0.25 F

-2.50%

$0.75 U

7.50%

$2.50 U

25.00%

$2.20 U

15.38%

$2.88 U

19.23%

$3.33 U

26.92%

$2.90 U

22.31%

$1.30 U

10.00%

$1.95 U

15.00%

$0.65 F

-5.00%

--

--

We illustrate these calculations for Firm A. The DM Price Variance is computed as:

= =

(Firm A Price – Benchmark Price) × Firm A Usage ($4.90 – $5.00) × 2.00 oz. $0.20 F

The DM Efficiency Variance is computed as follows:

= =

(Firm A Usage – Benchmark Usage) (2.00 oz. – 2.00 oz.) $5.00 $0

Benchmark Price

The DL Price Variance is computed as:

= =

(Firm A Rate – Benchmark Rate) ($15.00 – $13.00) 1.10 $2.20 U

Firm A Hours


The DL Efficiency Variance is computed as follows:

= =

(Firm A Usage – Benchmark Usage) (1.10 hrs. – 1.00 hrs.) $13.00 $1.30 U

Benchmark Rate

The % over standard is the percentage difference in prices relative to the Industry Benchmark. Again using the DM Price Variance calculation for Firm A, the % over standard is given by: (Firm A Price – Benchmark Price) ÷ Benchmark Price = ($4.90 – $5.00) ÷ $5.00 = 2% under standard.

3. To: Boss From: Junior Accountant Re: Benchmarking & productivity improvements Date: March 15, 2011 Benchmarking advantages – we can see how productive we are relative to our competition and the industry benchmark – we can see the specific areas in which there may be opportunities for us to reduce costs Benchmarking disadvantages – some of our competitors are targeting the market for high-end and custom-made lenses. I'm not sure that looking at their costs helps with understanding ours better – we may focus too much on cost differentials and not enough on differentiating ourselves, maintaining our competitive advantages, and growing our margins Areas to discuss – we may want to find out whether we can get the same lower price for glass as Firm D – we may want to re-evaluate the training our employees receive given our level of unfavorable labor efficiency variance compared to the benchmark. –

can we use Firm B’s materials efficiency and Firm C’s variable overhead consumption levels as our standards for the coming year?

– It is unclear why the trade association is still using $13 for the labor rate benchmark. Given the difficulty of hiring qualified workers, real wage rates are now substantially higher. We pay our workers $2 more per hour, and our competitors pay even higher wages than we do!


7-39

(60 min.) Comprehensive variance analysis review. Actual Results Units sold (95% × 1,500,000) Selling price per unit Revenues (1,425,000 × $6.10) Direct materials purchased and used: Direct materials per unit Total direct materials cost (1,425,000 × $1.60) Direct manufacturing labor: Actual manufacturing rate per hour Labor productivity per hour in units Manufacturing labor-hours of input (1,425,000 ÷ 250) Total direct manufacturing labor costs (5,700 × $12.20) Direct marketing costs: Direct marketing cost per unit Total direct marketing costs (1,425,000 × $0.25) Fixed overhead costs ($800,000 + $10,000) Static Budgeted Amounts Units sold Selling price per unit Revenues (1,500,000 × $6.00) Direct materials purchased and used: Direct materials per unit Total direct materials costs (1,500,000 × $1.50) Direct manufacturing labor: Direct manufacturing rate per hour Labor productivity per hour in units Manufacturing labor-hours of input (1,500,000 ÷ 300) Total direct manufacturing labor cost (5,000 × $12.00) Direct marketing costs: Direct marketing cost per unit Total direct marketing cost (1,500,000 × $0.30) Fixed overhead costs

1. Revenues Variable costs Direct materials Direct manufacturing labor Direct marketing costs Total variable costs Contribution margin Fixed costs Operating income 2. Actual operating income Static-budget operating income Total static-budget variance

1,425,000 $ 6.10 $8,692,500 $ 1.60 $2,280,000 $

$

12.20 250 5,700 69,540

$ 0.25 $ 356,250 $ 810,000

1,500,000 $ 6.00 $9,000,000 $ 1.50 $2,250,000 $

$

12.00 300 5,000 60,000

$ 0.30 $ 450,000 $ 800,000

Actual Results $8,692,500

Static-Budget Amounts $9,000,000

2,280,000 69,540 356,250 2,705,790 5,986,710 810,000 $5,176,710

2,250,000 60,000 450,000 2,760,000 6,240,000 800,000 $5,440,000

$5,176,710 5,440,000 $ 263,290 U


Flexible-budget-based variance analysis for Sonnet, Inc. for March 2011 Actual Results Units (diskettes) sold

Flexible-Budget Variances

1,425,000

0

Flexible Budget

SalesVolume Variances

1,425,000

Static Budget

75,000

1,500,000

Revenues Variable costs Direct materials Direct manuf. labor Direct marketing costs Total variable costs Contribution margin Fixed costs

$8,692,500

$142,500 F

$8,550,000

$450,000 U $9,000,000

2,280,000 69,540 356,250 2,705,790 5,986,710 810,000

142,500 U 12,540 U 71,250 F 83,790 U 58,710 F 10,000 U

2,137,500 57,000 427,500 2,622,000 5,928,000 800,000

112,500 F 3,000 F 22,500 F 138,000 F 312,000 U 0

2,250,000 60,000 450,000 2,760,000 6,240,000 800,000

Operating income

$5,176,710

$ 48,710 F

$5,128,000

$312,000 U

$5,440,000

$263,290 U Total static-budget variance $48,710 F Total flexible-budget variance

$312,000 U Total sales-volume variance

3.

Flexible-budget operating income = $5,128,000.

4.

Flexible-budget variance for operating income = $48,710 F.

5.

Sales-volume variance for operating income = $312,000 U.

6.

Budgeted market share = 1,500,000 ÷ 7,500,000 = 20% Actual market share = 1,425,000 ÷ 8,906,250 = 16% Budgeted contribution margin per unit = $6,240,000 ÷ 1,500,000 = $4.16 per unit

Actual Market Size × Actual Market Share × Budgeted Contribution Margin per Unit (8,906,250 × 16% × $4.16) $5,928,000

Static Budget: Actual Market Size Budgeted Market Size × Budgeted Market Share × Budgeted Market Share × Budgeted Contribution × Budgeted Contribution Margin per Unit Margin per Unit (8,906,250 × 20% × $4.16) (7,500,000 × 20% × $4.16) $7,410,000 $6,240,000

$1,482,000 U Market-share variance

$1,170,000 F Market-size variance

$312,000 U Sales-volume variance


Analysis of direct mfg. labor flexible-budget variance for Sonnet, Inc. for March 2011

Direct. Mfg. Labor

Actual Costs Incurred (Actual Input Quantity × Actual Price) (5,700 × $12.20) $69,540

Actual Input Quantity × Budgeted Price (5,700 × $12.00) $68,400


Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (*4,750 × $12.00) $57,000


$12,540 U Flexible-budget variance * 1,425,000 units ÷ 300 direct manufacturing labor standard productivity rate per hour.

7.

DML price variance = $1,140 U; DML efficiency variance = $11,400 U

8.

DML flexible-budget variance = $12,540U


7-40

(30 min.) Comprehensive variance analysis.

1.

Computing unit selling prices and unit costs of inputs: Actual selling price = $2,502,500 ÷ 275,000 = $9.10 Budgeting selling price = $2,700,000 ÷ 300,000 = $9.00 Actual Selling-price,variance = × Actual selling price units sold = ($9.10/unit – $9.00/unit) × 275,000 units = $27,500 F

2., 3., and 4. The actual and budgeted unit costs are: Actual Direct materials Cream Vanilla Extract Cherry Direct manufacturing labor Preparing Stirring

Budgeted

$0.04 ($124,800 ÷ 3,120,000) 0.15 ($184,500 ÷ 1,230,000) 0.41 ($133,250 ÷ 325,000)

$0.03 0.12 0.45

15.00 ($77,500 ÷ 310,000) × 60 18.00 ($154,500 ÷ 515,000) × 60

14.40 18.00

The actual output achieved is 275,000 pounds of Cherry Star. The direct cost price and efficiency variances are: Actual Costs Incurred (Actual Input Quantity × Actual Price) (1) Direct materials Cream Vanilla Extract Cherry

Direct manuf. labor costs Preparing Stirring

Actual Input Quantity × Budgeted Price (3)

Price Variance (2)=(1)–(3)

Efficiency Variance (4)=(3)–(5)

Flex. Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (5)

$ 124,800 184,500 133,250 $442,550

$ 31,200 U 36,900 U 13,000 F $55,100 U

$ 93,600a 147,600b 146,250c $387,450

$ 5,400 F 15,600 U 22,500 U $32,700 U

$ 99,000f 132,000g 123,750h $354,750

$ 77,500 154,500 $232,000

$ 3,100 U 0 $ 3,100 U

$ 74,400d 154,500e $228,900

$ 4,800 F 6,000 U $ 1,200 U

$ 79,200 148,500j $227,700

a

f

b

g

$0.03 × 3,120,000 = $93,600 $0.12 × 1,230,000 = $147,600 c $0.45 × 325,000 = $146,250 d $14.40/hr. × (310,000 min. ÷ 60 min./hr.) = $74,400 e $18.00/hr. × (515,000 min. ÷ 60 min./hr.) = $154,500

$0.03 × 12 × 275,000 = $99,000 $0.12 × 4 × 275,000 = $132,000 h $0.45 × 1 × 275,000 = $123,750 i $14.40 × ((275,000× 1.2) 60) = $79,200 j $18.00 × ((275,000 × 1.8) 60) = $148,500


i

Comments on the variances include Selling price variance. This may arise from a general increase in input prices (cream and vanilla). The sales price increase could be an effort to maintain a target margin. It could also arise from an overall industry increase in sales prices. Material price variance. The increase in the price per ounce of cream and vanilla extract could arise from uncontrollable market factors or from poor contract negotiations by Iceland. The decrease in the price per ounce of cherry could arise from good negotiations, a quantity discount or a lower quality input. Material efficiency variance. For vanilla extract and cherry, usage is greater than budgeted. Possible reasons include lower quality inputs, use of lower quality workers, and the preparing and stirring equipment not being maintained in a fully operational mode. The favorable efficiency variance for cream could arise due to higher quality inputs (related to the unfavorable price variance) where less waste is experienced in the production process. Labor rate variance. The actual wage rate was higher for preparing than was budgeted. This could arise due to hiring more experienced workers or unexpected overtime. The use of experienced workers is not supported by the material efficiency variance unless the machines are in very poor condition. Labor efficiency variance. The favorable efficiency variance for preparing could be due to workers eliminating nonvalue-added steps in production or more experienced workers being more efficient. The unfavorable efficiency variance for stirring could be due to inadequate training on new equipment or processes, or less experienced workers.


7-41

(30 min.) Price and efficiency variances, problems in standard-setting, benchmarking.

1. Actual cost of aluminum per sq ft = $283,023 ÷ 95,940 sq ft = $2.95 per sq ft Actual aluminum per drum = 95,940 sq ft ÷ 4,920 drums= 19.50 sq ft Actual cost of plastic per sq ft = $50,184 ÷ 33,456 sq ft = $1.50 per sq ft Actual plastic per lid = 33,456 sq ft ÷ 4,920 drums= 6.80 sq ft Actual direct labor rate = $118,572 ÷ 9,840 hours = $12.05 per hour Actual labor hours per unit = 9,840 hours ÷ 4,920 = 2 hours per unit

Actual Costs Incurred (Actual Input Quantity × Actual Price) Direct Materials Aluminum

$283,023

Actual Input Quantity × Budgeted Price (95,940 × $3) $287,820


Actual Costs Incurred (Actual Input Quantity × Actual Price) Direct Materials Plastic

$50,184


Actual Input Quantity × Budgeted Price (33,456 × $1.50) $50,184

$ -Price variance


Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (4,920 × 7 × $1.5) $51,660


(9,840 × $12) $118,080

$118,572

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (4,920 × 20 × $3) $295,200


(4,920 × 2.30 × $12) $135,792 $17,712 F Efficiency variance

2. Actions employees may have taken include: (a) Adding steps that are not necessary in working on a drum or lid. (b) Taking more time on each step than is necessary. (c) Creating problem situations so that the budgeted amount of average downtime will be overstated. (d) Creating defects in drums and/or lids so that the budgeted amount of average rework will be overstated. Employees may take these actions for several possible reasons.


(a) They may be paid on a piece-rate basis with incentives for production levels above budget. (b) They may want to create a relaxed work atmosphere, and a less demanding standard can reduce stress. (c) They have a ―them vs. us‖ mentality rather than a partnership perspective. (d) They may want to gain all the benefits that ensue from superior performance (job security, wage rate increases) without putting in the extra effort required. This behavior is unethical if it is deliberately designed to undermine the credibility of the standards used at Stuckey. 3.

If Jorgenson does nothing about standard costs, his behavior will violate the ―Standards of Ethical Conduct for Practitioners of Management Accounting.‖ In particular, he would violate the (a) standards of competence, by not performing professional duties in accordance with relevant standards; (b) standards of integrity, by passively subverting the attainment of the organization’s objective to control costs; and (c) standards of credibility, by not communicating information fairly and not disclosing all relevant cost information.

4.

Jorgenson should discuss the situation with Fenton and point out that the standards are lax and that this practice is unethical. If Fenton does not agree to change, Jorgenson should escalate the issue up the hierarchy in order to effect change. If organizational change is not forthcoming, Jorgenson should be prepared to resign rather than compromise his professional ethics.

5.

Main pros of using Benchmarking Clearing House information to compute variances are: (a) Highlights to Stuckey in a direct way how it may or may not be cost-competitive. (b) Provides a ―reality check‖ to many internal positions about efficiency or effectiveness. Main cons are: (a) Stuckey may not be comparable to companies in the database. (b) Cost data about other companies may not be reliable. (c) Cost of Benchmarking Clearing House reports. Stuckey should be able to offset con #1 with a careful self-analysis of their firm to other firms. They can talk to the source to determine how reliable the information is.


7-42


1. Variance Analysis for Sol Electronics for the second quarter of 2011

Units Selling price Sales Variable costs Direct materials Direct manuf. labor Other variable costs Total variable costs Contribution margin Fixed costs Operating income a

4,800 units 4,800 units c 4,800 units b

SecondQuarter 2011 Actuals (1) 4,800 $ 71.50 $343,200 57,600 30,240 47,280 135,120 208,080 68,400 $139,680

b

4,800 units 4,800 units

$7,200 F 2,592 1,440 720 1,872 9,072 400 $8,672

Flexible Budget for Sales Second Volume Quarter Variance (3) (4) = (3) – (5) 4,800 800 F $ 70.00 $336,000 $56,000 F

F U F F F U F

60,192a 28,800b 48,000 c 136,992 199,008 68,000 $131,008

10,032 4,800 8,000 22,832 33,168 0 $33,168

Static Budget (5) 4,000 $ 70.00 $280,000

U U U U F F

50,160 24,000 40,000 114,160 165,840 68,000 $ 97,840

2.2 lbs. per unit $5.70 per lb. = $60,192 0.5 hrs. per unit $12 per hr. = $28,800 $10 per unit = $48,000

Direct materials Direct manuf. labor (DML) a

Flexible Budget Variance (2) = (1) – (3) 0

SecondQuarter 2011 Actuals $57,600 30,240

Price Variance $2,880 U 4,320 U

Actual Input Quantity Budgeted Price $54,720a 25,920b

Flexible Budget for Efficiency Second Variance Quarter $5,472 F $60,192 2,880 F 28,800

2 lbs. per unit $5.70 per lb. = $54,720 0.45 DML hours per unit $12 per DML hour = $25,920


2 The following details, revealed in the variance analysis, should be used to rebut the union if it focuses on the favorable operating income variance: Most of the static budget operating income variance of $41,840F ($139,680 – $97,840) comes from a favorable sales volume variance, which only arose because Sol sold more units than planned. Of the $8,672 F flexible-budget variance in operating income, most of it comes from the $7,200F flexible-budget variance in sales. The net flexible-budget variance in total variable costs of $1,872 F is small, and it arises from direct materials and other variable costs, not from labor. Direct manufacturing labor flexible-budget variance is $1,440 U. The direct manufacturing labor price variance, $4,320U, which is large and unfavorable, is indeed offset by direct manufacturing labor’s favorable efficiency variance—but the efficiency variance is driven by the fact that Sol is using new, more expensive materials. Shaw may have to ―prove‖ this to the union which will insist that it’s because workers are working smarter. Even if workers are working smarter, the favorable direct manufacturing labor efficiency variance of $2,880 does not offset the unfavorable direct manufacturing labor price variance of $4,320. 3. Changing the standards may make them more realistic, making it easier to negotiate with the union. But the union will resist any tightening of labor standards, and it may be too early (is one quarter’s experience enough to change on?); a change of standards at this point may be viewed as opportunistic by the union. Perhaps a continuous improvement program to change the standards will be more palatable to the union and will achieve the same result over a somewhat longer period of time.


CHAPTER 8 FLEXIBLE BUDGETS, OVERHEAD COST VARIANCES, AND MANAGEMENT CONTROL 8-1

Effective planning of variable overhead costs involves: 1. Planning to undertake only those variable overhead activities that add value for customers using the product or service, and 2. Planning to use the drivers of costs in those activities in the most efficient way.

8-2 At the start of an accounting period, a larger percentage of fixed overhead costs are locked-in than is the case with variable overhead costs. When planning fixed overhead costs, a company must choose the appropriate level of capacity or investment that will benefit the company over a long time. This is a strategic decision. 8-3 The key differences are how direct costs are traced to a cost object and how indirect costs are allocated to a cost object:

Direct costs Indirect costs

Actual Costing Actual prices × Actual inputs used Actual indirect rate × Actual inputs used

Standard Costing Standard prices × Standard inputs allowed for actual output Standard indirect cost-allocation rate × Standard quantity of cost-allocation base allowed for actual output

8-4

Steps in developing a budgeted variable-overhead cost rate are: 1. Choose the period to be used for the budget, 2. Select the cost-allocation bases to use in allocating variable overhead costs to the output produced, 3. Identify the variable overhead costs associated with each cost-allocation base, and 4. Compute the rate per unit of each cost-allocation base used to allocate variable overhead costs to output produced.

8-5

Two factors affecting the spending variance for variable manufacturing overhead are: a. Price changes of individual inputs (such as energy and indirect materials) included in variable overhead relative to budgeted prices. b. Percentage change in the actual quantity used of individual items included in variable overhead cost pool, relative to the percentage change in the quantity of the cost driver of the variable overhead cost pool.

8-6

Possible reasons for a favorable variable-overhead efficiency variance are: Workers more skillful in using machines than budgeted, Production scheduler was able to schedule jobs better than budgeted, resulting in lower-than-budgeted machine-hours, Machines operated with fewer slowdowns than budgeted, and Machine time standards were overly lenient.


8-7 A direct materials efficiency variance indicates whether more or less direct materials were used than was budgeted for the actual output achieved. A variable manufacturing overhead efficiency variance indicates whether more or less of the chosen allocation base was used than was budgeted for the actual output achieved. 8-8

Steps in developing a budgeted fixed-overhead rate are 1. Choose the period to use for the budget, 2. Select the cost-allocation base to use in allocating fixed overhead costs to output produced, 3. Identify the fixed-overhead costs associated with each cost-allocation base, and 4. Compute the rate per unit of each cost-allocation base used to allocate fixed overhead costs to output produced.

8-9

The relationship for fixed-manufacturing overhead variances is: Flexible-budget variance

Efficiency variance (never a variance)

Spending variance

There is never an efficiency variance for fixed overhead because managers cannot be more or less efficient in dealing with an amount that is fixed regardless of the output level. The result is that the flexible-budget variance amount is the same as the spending variance for fixedmanufacturing overhead. 8-10 For planning and control purposes, fixed overhead costs are a lump sum amount that is not controlled on a per-unit basis. In contrast, for inventory costing purposes, fixed overhead costs are allocated to products on a per-unit basis. 8-11 An important caveat is what change in selling price might have been necessary to attain the level of sales assumed in the denominator of the fixed manufacturing overhead rate. For example, the entry of a new low-price competitor may have reduced demand below the denominator level if the budgeted selling price was maintained. An unfavorable productionvolume variance may be small relative to the selling-price variance had prices been dropped to attain the denominator level of unit sales.


8-12 A strong case can be made for writing off an unfavorable production-volume variance to cost of goods sold. The alternative is prorating it among inventories and cost of goods sold, but this would ―penalize‖ the units produced (and in inventory) for the cost of unused capacity, i.e., for the units not produced. But, if we take the view that the denominator level is a ―soft‖ number—i.e., it is only an estimate, and it is never expected to be reached exactly, then it makes more sense to prorate the production volume variance—whether favorable or not—among the inventory stock and cost of goods sold. Prorating a favorable variance is also more conservative: it results in a lower operating income than if the favorable variance had all been written off to cost of goods sold. Finally, prorating also dampens the efficacy of any steps taken by company management to manage operating income through manipulation of the production volume variance. In sum, a production-volume variance need not always be written off to cost of goods sold. 8-13

The four variances are: Variable manufacturing overhead costs spending variance efficiency variance Fixed manufacturing overhead costs spending variance production-volume variance

8-14 Interdependencies among the variances could arise for the spending and efficiency variances. For example, if the chosen allocation base for the variable overhead efficiency variance is only one of several cost drivers, the variable overhead spending variance will include the effect of the other cost drivers. As a second example, interdependencies can be induced when there are misclassifications of costs as fixed when they are variable, and vice versa. 8-15 Flexible-budget variance analysis can be used in the control of costs in an activity area by isolating spending and efficiency variances at different levels in the cost hierarchy. For example, an analysis of batch costs can show the price and efficiency variances from being able to use longer production runs in each batch relative to the batch size assumed in the flexible budget.


8-16

(20 min.) Variable manufacturing overhead, variance analysis.

1.

Variable Manufacturing Overhead Variance Analysis for Esquire Clothing for June 2012 Actual Costs Incurred Actual Input Quantity × Actual Rate (1) (4,536 × $11.50) $52,164

Actual Input Quantity × Budgeted Rate (2) (4,536 × $12) $54,432

$2,268 F Spending variance

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (3) (4 × 1,080 × $12) $51,840


$324 U Flexible-budget variance

Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (4 × 1,080 × $12) $51,840

Never a variance

Never a variance

2. Esquire had a favorable spending variance of $2,268 because the actual variable overhead rate was $11.50 per direct manufacturing labor-hour versus $12 budgeted. It had an unfavorable efficiency variance of $2,592 U because each suit averaged 4.2 labor-hours (4,536 hours ÷ 1,080 suits) versus 4.0 budgeted labor-hours.


8-17

(20 min.) Fixed-manufacturing overhead, variance analysis (continuation of 8-16).

1 & 2.

Budgeted fixed overhead rate per unit of allocation base

$62,400 1,040 4 $62,400 = 4,160 = $15 per hour =

Fixed Manufacturing Overhead Variance Analysis for Esquire Clothing for June 2012

Actual Costs Incurred (1)

Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (2)

Flexible Budget: Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (3)

$63,916

$62,400

$62,400

$1,516 U Spending variance

Never a variance


Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (4 × 1,080 × $15) $64,800

$2,400 F Production-volume variance $2,400 F Production-volume variance

The fixed manufacturing overhead spending variance and the fixed manufacturing flexible budget variance are the same––$1,516 U. Esquire spent $1,516 above the $62,400 budgeted amount for June 2012. The production-volume variance is $2,400 F. This arises because Esquire utilized its capacity more intensively than budgeted (the actual production of 1,080 suits exceeds the budgeted 1,040 suits). This results in overallocated fixed manufacturing overhead of $2,400 (4 × 40 × $15). Esquire would want to understand the reasons for a favorable production-volume variance. Is the market growing? Is Esquire gaining market share? Will Esquire need to add capacity?


8-18 1.

(30 min.) Variable manufacturing overhead variance analysis.

Denominator level = (3,200,000 × 0.02 hours) = 64,000 hours

2. 1. 2. 3. 4. 5. 6. a

Actual Results 2,800,000 50,400 0.018 $680,400 $13.50 $0.243

Output units (baguettes) Direct manufacturing labor-hours Labor-hours per output unit (2 1) Variable manuf. overhead (MOH) costs Variable MOH per labor-hour (4 2) Variable MOH per output unit (4 1)

2,800,000

Flexible Budget Amounts 2,800,000 56,000a 0.020 $560,000 $10 $0.200

0.020= 56,000 hours

Variable Manufacturing Overhead Variance Analysis for French Bread Company for 2012 Actual Costs Incurred Actual Input Quantity × Actual Rate (1) (50,400 × $13.50) $680,400



Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (3) (56,000 × $10) $560,000



Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (56,000 × $10) $560,000

Never a variance

Never a variance

3. Spending variance of $176,400 U. It is unfavorable because variable manufacturing overhead was 35% higher than planned. A possible explanation could be an increase in energy rates relative to the rate per standard labor-hour assumed in the flexible budget. Efficiency variance of $56,000 F. It is favorable because the actual number of direct manufacturing labor-hours required was lower than the number of hours in the flexible budget. Labor was more efficient in producing the baguettes than management had anticipated in the budget. This could occur because of improved morale in the company, which could result from an increase in wages or an improvement in the compensation scheme. Flexible-budget variance of $120,400 U. It is unfavorable because the favorable efficiency variance was not large enough to compensate for the large unfavorable spending variance.


8-19

(30 min.) Fixed manufacturing overhead variance analysis (continuation of 8-18).

1.

Budgeted standard direct manufacturing labor used = 0.02 per baguette Budgeted output = 3,200,000 baguettes Budgeted standard direct manufacturing labor-hours = 3,200,000 × 0.02 = 64,000 hours Budgeted fixed manufacturing overhead costs = 64,000 × $4.00 per hour = $256,000 Actual output = 2,800,000 baguettes Allocated fixed manufacturing overhead = 2,800,000 × 0.02 × $4 = $224,000 Fixed Manufacturing Overhead Variance Analysis for French Bread Company for 2012




$272,000

$256,000

$256,000


Never a variance


Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (2,800,000 × 0.02 × $4) $224,000

$32,000 U Production-volume variance $32,000 U Production-volume variance

$48,000 U Underallocated fixed overhead (Total fixed overhead variance)

2.

The fixed manufacturing overhead is underallocated by $48,000.

3.

The production-volume variance of $32,000U captures the difference between the budgeted 3,200,0000 baguettes and the lower actual 2,800,000 baguettes produced—the fixed cost capacity not used. The spending variance of $16,000 unfavorable means that the actual aggregate of fixed costs ($272,000) exceeds the budget amount ($256,000). For example, monthly leasing rates for baguette-making machines may have increased above those in the budget for 2012.


8-20

(30–40 min.) Manufacturing overhead, variance analysis.

1.

The summary information is:

The Solutions Corporation (June 2012) Outputs units (number of assembled units) Hours of assembly time Assembly hours per unit Variable mfg. overhead cost per hour of assembly time Variable mfg. overhead costs Fixed mfg. overhead costs Fixed mfg. overhead costs per hour of assembly time a

200 units

b

411 hours

c

216 units

d

$12,741

e

432 assembly hours

$30 per assembly hour = $12,960

f

400 assembly hours

$30 per assembly hour = $12,000

g

$20,550

411 assembly hours = $50 per assembly hour

h

$19,200

400 assembly hours = $48 per assembly hour

Flexible Actual Budget 216 216 411 432c 1.90b 2.00 d $ 31.00 $ 30.00 $ $12,741 $12,960e $20,550 $19,200 g $ 50.00 $

Static Budget 200 400a 2.00 30.00 $12,000f $19,200 48.00h

2 assembly hours per unit = 400 hours 216 units = 1.90 assembly hours per unit 2 assembly hours per unit = 432 hours 411 assembly hours = $31.00 per assembly hour


Actual Costs Incurred Variable Manufacturing Overhead

$12,741

Flexible Budget: Budgeted Input Quantity Allowed Budgeted for Actual Output Rate 432 $30.00 assy. hrs. per assy. hr. $12,960

Actual Input Quantity Budgeted Rate 411 $30.00 assy. hrs. per assy. hr. $12,330 $411 U

$630 F

Spending variance

Efficiency variance

Allocated: Budgeted Input Quantity Allowed Budgeted for Actual Output Rate 432 $30.00 assy. hrs. per assy. hr. $12,960

Never a variance

$219 F Flexible-budget variance

Never a variance $219 F Overallocated variable overhead

Flexible Budget:

Fixed Manufacturing Overhead

Actual Costs Incurred

Static Budget Lump Sum Regardless of Output Level

Static Budget Lump Sum Regardless of Output Level

$20,550

$19,200

$19,200

$1,350 U

Allocated: Budgeted Input Allowed Budgeted for Actual Output Rate 432 $48.00 assy. hrs. per assy. hr. $20,736 $1,536 F

Spending Variance

Never a Variance $1,350 U

Production-volume variance $1,536 F

Flexible-budget variance

Production-volume variance $186 F

Overallocated fixed overhead


The summary analysis is:

Variable Manufacturing Overhead Fixed Manufacturing Overhead

2.

Spending Variance

Efficiency Variance

Production-Volume Variance

$ 411 U

$630 F

Never a variance

Never a variance

$1,536 F

$1,350 U

Variable Manufacturing Costs and Variances

a. Variable Manufacturing Overhead Control Accounts Payable Control and various other accounts To record actual variable manufacturing overhead costs incurred

12,741

b. Work-in-Process Control Variable Manufacturing Overhead Allocated To record variable manufacturing overhead allocated.

12,960

c. Variable Manufacturing Overhead Allocated Variable Manufacturing Overhead Spending Variance Variable Manufacturing Overhead Control Variable Manufacturing Overhead Efficiency Variance To isolate variances for the accounting period.

12,741

12,96

12,960 411 12,74 630

d. Variable Manufacturing Overhead Efficiency Variance 630 Variable Manufacturing Overhead Spending Variance Cost of Goods Sold To write off variable manufacturing overhead variances to cost of goods sold.

41 2


Fixed Manufacturing Costs and Variances a. Fixed Manufacturing Overhead Control Salaries Payable, Acc. Depreciation, various other accounts To record actual fixed manufacturing overhead costs incurred.

20,550

b. Work-in-Process Control Fixed Manufacturing Overhead Allocated To record fixed manufacturing overhead allocated.

20,736

c. Fixed Manufacturing Overhead Allocated Fixed Manufacturing Overhead Spending Variance Fixed Manufacturing Overhead Production-Volume Variance Fixed Manufacturing Overhead Control To isolate variances for the accounting period.

20,736 1,350

d. Fixed Manufacturing Overhead Production-Volume Variance Fixed Manufacturing Overhead Spending Variance Cost of Goods Sold To write off fixed manufacturing overhead variances to cost of goods sold.

20,550

20,736

1,536 20,550

1,536 1,350 186

3. Planning and control of variable manufacturing overhead costs has both a long-run and a short-run focus. It involves Solutions planning to undertake only value-added overhead activities (a long-run view) and then managing the cost drivers of those activities in the most efficient way (a short-run view). Planning and control of fixed manufacturing overhead costs at Solutions have primarily a long-run focus. It involves undertaking only value-added fixed-overhead activities for a budgeted level of output. Solutions makes most of the key decisions that determine the level of fixed-overhead costs at the start of the accounting period.


8-21

1. 2. 3. 4. 5.

(10 15 min.) 4-variance analysis, fill in the blanks. Variable $200 U 2,200 F NEVER 2,000 F 2,000 F

Spending variance Efficiency variance Production-volume variance Flexible-budget variance Underallocated (overallocated) MOH

Fixed $4,600 U NEVER 1,200 F 4,600 U 3,400 U

These relationships could be presented in the same way as in Exhibit 8-4.

Variable MOH


Actual Input Quantity × Budgeted Rate (2)

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (3)

$31,000

$30,800

$33,000

$200 U Spending variance


Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) $33,000

Never a variance

$2,000 F Flexible-budget variance

Never a variance

$2,000 F Overallocated variable overhead (Total variable overhead variance)

Fixed MOH




Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4)

$18,000

$13,400

$13,400

$14,600


Never a variance



$3,400 U Underallocated fixed overhead (Total fixed overhead variance)


An overview of the 4 overhead variances is:

4-Variance Analysis Variable Overhead Fixed Overhead

8-22

Spending Variance

Efficiency Variance

ProductionVolume Variance

$200 U

$2,200 F

Never a variance

$4,600 U

Never a variance

$1,200 F

(20–30 min.) Straightforward 4-variance overhead analysis.

1. The budget for fixed manufacturing overhead is 4,000 units × 6 machine-hours × $15 machine-hours/unit = $360,000. An overview of the 4-variance analysis is: 4-Variance Analysis Variable Manufacturing Overhead Fixed Manufacturing Overhead

Spending Variance

Efficiency Variance

$17,800 U

$13,000 U

$16,000 U


Never a Variance

Never a Variance

$36,000 F

Solution Exhibit 8-22 has details of these variances. A detailed comparison of actual and flexible budgeted amounts is: Output units (auto parts) Allocation base (machine-hours) Allocation base per output unit Variable MOH Variable MOH per hour Fixed MOH Fixed MOH per hour

Actual 4,400 28,400 6.45b $245,000 $8.63d $373,000 $13.13f

Flexible Budget 4,400 a 26,400 6.00 c $211,200 $8.00 e $360,000 –

a

4,400 units × 6.00 machine-hours/unit = 26,400 machine-hours 28,400 ÷ 4,400 = 6.45 machine-hours per unit c 4,400 units × 6.00 machine-hours per unit × $8.00 per machine-hour = $211,200 d $245,000 ÷ 28,400 = $8.63 e 4,000 units × 6.00 machine-hours per unit × $15 per machine-hour = $360,000 f $373,000 ÷ 28,400 = $13.13 b


2.

Variable Manufacturing Overhead Control Accounts Payable Control and other accounts

245,000

Work-in-Process Control Variable Manufacturing Overhead Allocated

211,200

Variable Manufacturing Overhead Allocated Variable Manufacturing Overhead Spending Variance Variable Manufacturing Overhead Efficiency Variance Variable Manufacturing Overhead Control

211,200 17,800 16,000

Fixed Manufacturing Overhead Control Wages Payable Control, Accumulated Depreciation Control, etc.

373,000

Work-in-Process Control Fixed Manufacturing Overhead Allocated

396,000

Fixed Manufacturing Overhead Allocated Fixed Manufacturing Overhead Spending Variance Fixed Manufacturing Overhead Production-Volume Variance Fixed Manufacturing Overhead Control

396,000 13,000

245,000

211,200

245,000

373,000

396,000

36,000 373,000

3. Individual fixed manufacturing overhead items are not usually affected very much by day-to-day control. Instead, they are controlled periodically through planning decisions and budgeting procedures that may sometimes have horizons covering six months or a year (for example, management salaries) and sometimes covering many years (for example, long-term leases and depreciation on plant and equipment). 4. The fixed overhead spending variance is caused by the actual realization of fixed costs differing from the budgeted amounts. Some fixed costs are known because they are contractually specified, such as rent or insurance, although if the rental or insurance contract expires during the year, the fixed amount can change. Other fixed costs are estimated, such as the cost of managerial salaries which may depend on bonuses and other payments not known at the beginning of the period. In this example, the spending variance is unfavorable, so actual FOH is greater than the budgeted amount of FOH. The fixed overhead production volume variance is caused by production being over or under expected capacity. You may be under capacity when demand drops from expected levels, or if there are problems with production. Over capacity is usually driven by favorable demand shocks or a desire to increase inventories. The fact that there is a favorable volume variance indicates that production exceeded the expected level of output (4,400 units actual relative to a denominator level of 4,000 output units).


SOLUTION EXHIBIT 8-22

Actual Costs Incurred (1) Variable MOH

$245,000



Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (3) (4,400 × 6 × $8) $211,200



Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (4,400 × 6 × $8) $211,200

Never a variance

Never a variance

$33,800 U Underallocated variable overhead (Total variable overhead variance)

Actual Costs Incurred (1) Fixed MOH

$373,000

Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (2) (4,000 × 6 × $15) $360,000


Flexible Budget: Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (3) (4,000 × 6 × $15) $360,000

Never a variance

Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (4,400 × 6 × $15) $396,000

$36,000 F Production-volume variance

$13,000 U $36,000 F Production-volume Flexible-budget variance variance $23,000 F Overallocated fixed overhead (Total fixed overhead variance)


8-23 (30 40 min.)

1.

Straightforward coverage of manufacturing overhead, standardcosting system.

Solution Exhibit 8-23 shows the computations. Summary details are: Actual 65,500 76,400 b 1.17 $618,840

Output units Allocation base (machine-hours) Allocation base per output unit Variable MOH Variable MOH per hour Fixed MOH Fixed MOH per hour a b c

65,500 × 1.2 = 78,600 76,400 ÷ 65,500 = 1.17 65,500 × 1.2 × $8 = $628,800

d e

d

$8.92 $145,790 e $1.91

Flexible Budget 65,500 a 78,600 1.2 c $628,800 $8.00 $144,000 –

$618,840 ÷ 76,400 = $8.10 $145,790 ÷ 76,400 = $1.91

An overview of the 4-variance analysis is: 4-Variance Analysis Variable Manufacturing Overhead Fixed Manufacturing Overhead

Spending Variance

Efficiency Variance

$7,640 U

Production Volume Variance

$17,600 F

Never a variance

$1,790 U Never a variance

$13,200 F


2.

Variable Manufacturing Overhead Control Accounts Payable Control and other accounts

618,840

Work-in-Process Control Variable Manufacturing Overhead Allocated

628,800

Variable Manufacturing Overhead Allocated Variable Manufacturing Overhead Spending Variance Variable Manufacturing Overhead Efficiency Variance Variable Manufacturing Overhead Control

628,800 7,640

Fixed Manufacturing Overhead Control Wages Payable Control, Accumulated Depreciation Control, etc.

145,790

Work-in-Process Control Fixed Manufacturing Overhead Allocated

157,200

618,840

628,800

17,600 618,840

145,790

Fixed Manufacturing Overhead Allocated 157,200 Fixed Manufacturing Overhead Spending Variance 1,790 Fixed Manufacturing Overhead Production-Volume Variance Fixed Manufacturing Overhead Control

157,200

13,200 145,790

3. The control of variable manufacturing overhead requires the identification of the cost drivers for such items as energy, supplies, and repairs. Control often entails monitoring nonfinancial measures that affect each cost item, one by one. Examples are kilowatt-hours used, quantities of lubricants used, and repair parts and hours used. The most convincing way to discover why overhead performance did not agree with a budget is to investigate possible causes, line item by line item. 4. The variable overhead spending variance is unfavorable. This means the actual rate applied to the manufacturing costs is higher than the budgeted rate. Since variable overhead consists of several different costs, this could be for a variety of reasons, such as the utility rates being higher than estimated or the indirect materials costs per unit of denominator activity being more than estimated. The variable overhead efficiency variance is favorable, which implies that the estimated denominator activity was too high. Since the denominator activity is machine hours, this could be the result of efficient use of machines, better scheduling of production runs, or machines that are well maintained and thus are working at more than the expected level of efficiency.



Actual Costs Incurred (1) Variable Manufacturing Overhead

$618,840


Flexible Budget: Allocated: Budgeted Input Budgeted Input Quantity Allowed Quantity Allowed for Actual Output for Actual Output × Budgeted Rate × Budgeted Rate (3) (4) (78,600 × $8) (78,600 × $8) $628,800 $628,800

$7,640 U $17,600 F Spending variance Efficiency variance

Never a variance

$9,960 F Flexible-budget variance Never a variance $9,960 F Overallocated variable overhead (Total variable overhead variance)





$145,790

$144,000

$144,000


Never a variance




$11,410 F Overallocated fixed overhead (Total fixed overhead variance) Fixed manufacturing overhead,budgeted rate machine-hour.

=$144,000 / 72,000 machine-hours

= $2 per


8-24

(20–25 min.) Overhead variances, service sector.

1. Meals on Wheels (May 2012) Output units (number of deliveries) Hours per delivery Hours of delivery time Variable overhead costs per delivery hour Variable overhead (VOH) costs Fixed overhead costs Fixed overhead cost per hour

Actual Results 8,800 0.65a 5,720 $1.80c $10,296 $38,600

Flexible Budget 8,800 0.70 6,160b $1.50 $9,240d $35,000

Static Budget 10,000 0.70 7,000b $1.50 $10,500d $35,000 $5.00e

a

5,720 hours 8,800 deliveries = 0.65 hours per delivery hrs. per delivery number of deliveries = 0.70 10,000 = 7,000 hours c $10,296 VOH costs 5,720 delivery hours = $1.80 per delivery hour d Delivery hours VOH cost per delivery hour = 7,000 $1.50 = $10,500 e Static budget delivery hours = 10,000 units 0.70 hours/unit = 7,000 hours; Fixed overhead rate = Fixed overhead costs Static budget delivery hours = $35,000 b

7,000 hours = $5 per hour

VARIABLE OVERHEAD


Actual Input Quantity Budgeted Rate 5,720 hrs $1.50 per hr. $8,580

$10,296


Flexible Budget: Budgeted Input Quantity Allowed for Actual Output Budgeted Rate 6,160 hrs $1.50 per hr. $9,240

$660 F Efficiency variance

2. FIXED OVERHEAD


$38,600

Flexible Budget: Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level

$35,000 $3,600 U Spending variance

Allocated: Budgeted Input Quantity Allowed for Actual Output Budgeted Rate 8,800 units 0.70 hrs./unit $5/hr. 6,160 hrs. $5/hr. $30,800

$4,200 U Production-volume variance


3. The spending variances for variable and fixed overhead are both unfavorable. This means that MOW had increases over budget in either or both the cost of individual items (such as telephone calls and gasoline) in the overhead cost pools, or the usage of these individual items per unit of the allocation base (delivery time). The favorable efficiency variance for variable overhead costs results from more efficient use of the cost allocation base––each delivery takes 0.65 hours versus a budgeted 0.70 hours. MOW can best manage its fixed overhead costs by long-term planning of capacity rather than day-to-day decisions. This involves planning to undertake only value-added fixed-overhead activities and then determining the appropriate level for those activities. Most fixed overhead costs are committed well before they are incurred. In contrast, for variable overhead, a mix of long-run planning and daily monitoring of the use of individual items is required to manage costs efficiently. MOW should plan to undertake only value-added variable-overhead activities (a long-run focus) and then manage the cost drivers of those activities in the most efficient way (a short-run focus). There is no production-volume variance for variable overhead costs. The unfavorable production-volume variance for fixed overhead costs arises because MOW has unused fixed overhead resources that it may seek to reduce in the long run.


8-25 (40 50 min.) Total overhead, 3-variance analysis. 1. This problem has two major purposes: (a) to give experience with data allocated on a total overhead basis instead of on separate variable and fixed bases and (b) to reinforce distinctions between actual hours of input, budgeted (standard) hours allowed for actual output, and denominator level. An analysis of direct manufacturing labor will provide the data for actual hours of input and standard hours allowed. One approach is to plug the known figures (designated by asterisks) into the analytical framework and solve for the unknowns. The direct manufacturing labor efficiency variance can be computed by subtracting $512 from $3,512. The complete picture is as follows:

Actual Costs Incurred (5,120 hrs. × $25.10) $128,512*

Actual Input Quantity × Budgeted Rate (5,120hrs. × $25.00*) $128,000

$512 U* Price variance

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (5,000 hrs. × $25.00*) $125,000


$3,512 U* Flexible-budget variance *

Given

Direct Labor calculations Actual input × Budgeted rate = Actual costs – Price variance = $128,512 – $512 = $128,000 Actual input = $128,000 ÷ Budgeted rate = $128,000 ÷ $25 = 5,120 hours Budgeted input × Budgeted rate = $128,000 – Efficiency variance = $128,000 – $3,000 = $125,000 Budgeted input = $125,000 ÷ Budgeted rate = $125,000 ÷ 25 = 5,000 hours Production Overhead Variable overhead rate = $43,200* ÷ 3,600* hrs. = $12.00 per standard labor-hour Budgeted fixed,overhead costs = $103,400* – (4,000* × $12.00) = $55,400 If total overhead is allocated at 120% of direct labor-cost, the single overhead rate must be 120% of $25.00, or $30.00 per hour. Therefore, the fixed overhead component of the rate must be $30.00 – $12.00, or $18.00 per direct labor-hour.


Let D = denominator level in input units Budgeted fixed overhead rate per input unit

= Error!

$18.00

= $55,400 ÷ D

D

= 3,077 direct labor-hours

A summary 3-variance analysis for October follows:


Actual Input Quantity × Budgeted Rate ($55,400 + (5,120 × $12.00) $116,840

$120,700*

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate $55,400 + ($12 × 5,000) $115,400

$3,860 U

$1,440 U

Spending variance

Efficiency variance $5,300 U

$34,600 F* Production-volume variance $34,600 F* Production-volume variance

Flexible-budget variance *

Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (5,000 hrs. × $30.00) $150,000

Known figure

An overview of the 3-variance analysis using the block format in the text is: 3-Variance Analysis Total Overhead

Spending Variance

Efficiency Variance

$3,860 U

$1,440U

Production Volume Variance $34,600 F

2. The control of variable manufacturing overhead requires the identification of the cost drivers for such items as energy, supplies, equipment, and maintenance. Control often entails monitoring nonfinancial measures that affect each cost item, one by one. Examples are kilowatts used, quantities of lubricants used, and equipment parts and hours used. The most convincing way to discover why overhead performance did not agree with a budget is to investigate possible causes, line item by line item. Individual fixed manufacturing overhead items are not usually affected very much by dayto-day control. Instead, they are controlled periodically through planning decisions and budgeting that may sometimes have horizons covering six months or a year (for example, management salaries) and sometimes covering many years (for example, long-term leases and depreciation on plant and equipment).


8-26

(30 min.) Overhead variances, missing information.

1. In the columnar presentation of variable overhead variance analysis, all numbers shown in bold are calculated from the given information, in the order (a) – (e).

Actual Costs Incurred (b)

$89,625

VARIABLE MANUFACTURING OVERHEAD Flexible Budget: Budgeted Input Actual Input Quantity Quantity Allowed Budgeted Budgeted Rate for Actual Output Rate (a) (c) 15,000 $6.00 14,850 $6.00 mach. hrs. per mach. hr. mach. hrs. per mach. hr. $90,000 $89,100

$375 F Spending variance

$900 U (d) Efficiency variance $525 U (e) Flexible-budget variance

a.


$6 per machine-hour = $90,000

b.

Actual VMOH = $90,000 – $375F (VOH spending variance) = $89,625

c.


d.

VOH efficiency variance = $90,000 – $89,100 = $900 U

e.

VOH flexible budget variance = $900U – $375F = $525 U

$6 per machine-hour = $89,100

Allocated variable overhead will be the same as the flexible budget variable overhead of $89,100. The actual variable overhead cost is $89,625. Therefore, variable overhead is underallocated by $525.


2. In the columnar presentation of fixed overhead variance analysis, all numbers shown in bold are calculated from the given information, in the order (a) – (e).

Actual Costs Incurred (a)

$30,375

FIXED MANUFACTURING OVERHEAD Flexible Budget: Allocated: Static Budget Lump Sum Budgeted Input Regardless of Output Quantity Allowed Budgeted Level for Actual Output Rate (b) 14,850 $1.60* (c) mach. hrs. per mach. hr. $28,800 $23,760


$5,040 U (d) Production-volume variance

$1,575 U (e) Flexible-budget variance

a.

Actual FOH costs = $120,000 total overhead costs – $89,625 VOH costs = $30,375

b.

Static budget FOH lump sum = $30,375 – $1,575 spending variance = $28,800

c.

*FOH allocation rate = $28,800 FOH static-budget lump sum 18,000 static-budget machine-hours = $1.60 per machine-hour Allocated FOH = 14,850 machine-hours $1.60 per machine-hour = $23,760

d.

PVV = $28,800 – $23,760 = $5,040 U

e.

FOH flexible budget variance = FOH spending variance = $1,575 U

Allocated fixed overhead is $23,760. The actual fixed overhead cost is $30,375. Therefore, fixed overhead is underallocated by $6,615.


8-27

(15 min.) Identifying favorable and unfavorable variances. VOH Spending Variance Cannot be determined: no information on actual versus budgeted VOH rates

VOH Efficiency Variance Cannot be determined: no information on actual versus flexible-budget machine-hours

FOH Spending Variance Unfavorable: actual fixed costs are more than budgeted fixed costs

FOH ProductionVolume Variance Unfavorable: output is less than budgeted causing FOH costs to be underallocated

Production output is 12% less than budgeted; actual machine-hours are 7% more than budgeted

Cannot be determined: no information on actual versus budgeted VOH rates

Unfavorable: actual machine-hours more than flexiblebudget machinehours

Cannot be determined: no information on actual versus budgeted FOH costs

Unfavorable: output is less than budgeted causing FOH costs to be underallocated

Production output is 9% more than budgeted



Favorable: output more than budgeted will cause FOH costs to be overallocated

Actual machine-hours are 20% less than flexible-budget machine-hours


Cannot be determined: no information on actual machinehours versus flexible-budget machine-hours Favorable: less machine-hours used relative to flexible budget


Relative to the flexible budget, actual machine-hours are 12% less, and actual variable manufacturing overhead costs are 20% greater

Unfavorable: actual VOH rate greater than budgeted VOH rate

Favorable: actual machine-hours less than flexiblebudget machinehours


Cannot be determined: no information on flexible-budget machine-hours relative to staticbudget machinehours Cannot be determined: no information on actual output relative to budgeted output

Scenario Production output is 4% less than budgeted, and actual fixed manufacturing overhead costs are 5% more than budgeted


8-28

(35 min.) Flexible-budget variances, review of Chapters 7 and 8.

1. Solution Exhibit 8-28 contains a columnar presentation of the variances for Doorknob Design Company (DDC) for April 2012.


Direct Materials

Actual Costs Incurred: Actual Input Quantity × Actual Rate (12,000 $11) $132,000

Actual Input Quantity Budgeted Price Purchases Usage (12,000 $10) (10,450 $10) $120,000 $104,500

$12,000 U

$500 F

a. Price variance Direct Manufacturing Labor

Variable Manufacturing Overhead

b. Efficiency variance

(38,500 $20) $770,000

$808,500

(42,000 $20) $840,000

$38,500 U

$70,000 F

c. Price variance

d. Efficiency variance


Actual Input Quantity Budgeted Rate

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output Budgeted Rate

Allocated: (Budgeted Input Quantity Allowed for Actual Output Budgeted Rate)

$64,150

(10,450 $6) $62,700

(10,500 $6) $63,000

(10,500 $6) $63,000

$1,450U

$300 F

e. Spending variance


Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Price (10,500 $10) $105,000

$152,000

f. Efficiency variance

$150,000*

Never a variance

$2,000 U h. Spending variance

(10,500 $15) $157,500

$150,000

$7,500 F Never a variance

g. Production volume variance

*

Denominator level (Annual) in pounds of material: 400,000 .3 = 120,000 pounds Annual Budgeted Fixed Overhead: 120,000 $15/lb = $1,800,000 Monthly budgeted FOH: $1,800,000 / 12 = $150,000


2. The direct materials price variance indicates that DDC paid more for brass than they had planned. If this is because they purchased a higher quality of brass, it may explain why they used less brass than expected (leading to a favorable material efficiency variance). In turn, since variable manufacturing overhead is assigned based on pounds of materials used, this directly led to the favorable variable overhead efficiency variance. The purchase of a better quality of brass may also explain why it took less labor time to produce the doorknobs than expected (the favorable direct labor efficiency variance). Finally, the unfavorable direct labor price variance could imply that the workers who were hired were more experienced than expected, which could also be related to the positive direct material and direct labor efficiency variances.


8-29


1.

Budgeted number of machine-hours planned can be calculated by multiplying the number of units planned (budgeted) by the number of machine-hours allocated per unit: 888 units

2.

2 machine-hours per unit = 1,776 machine-hours.

Budgeted fixed MOH costs per machine-hour can be computed by dividing the flexible budget amount for fixed MOH (which is the same as the static budget) by the number of machine-hours planned (calculated in (a.)): $348,096 ÷ 1,776 machine-hours = $196.00 per machine-hour

3.

Budgeted variable MOH costs per machine-hour are calculated as budgeted variable MOH costs divided by the budgeted number of machine-hours planned: $71,040 ÷ 1,776 machine-hours = $40.00 per machine-hour.

4.

Budgeted number of machine-hours allowed for actual output achieved can be calculated by dividing the flexible-budget amount for variable MOH by budgeted variable MOH costs per machine-hour: $76,800 ÷ $40.00 per machine-hour= 1,920 machine-hours allowed

5.

The actual number of output units is the budgeted number of machine-hours allowed for actual output achieved divided by the planned allocation rate of machine hours per unit: 1,920 machine-hours ÷ 2 machine-hours per unit = 960 units.

6.

The actual number of machine-hours used per output unit is the actual number of machine hours used (given) divided by the actual number of units manufactured: 1,824 machine-hours ÷ 960 units = 1.9 machine-hours used per output unit.


8-30

(60 min.) Journal entries (continuation of 8-29).

1. Key information underlying the computation of variances is: Actual Flexible-Budget Results Amount 1. Output units (food processors) 960 960 2. Machine-hours 1,824 1,920 3. Machine-hours per output unit 1.90 2.00

Static-Budget Amount 888 1,776 2.00

4. Variable MOH costs 5. Variable MOH costs per machinehour (Row 4 ÷ Row 2) 6. Variable MOH costs per unit (Row 4 ÷ Row 1)

$ 76,608

$ 76,800

$ 71,040

$

42.00

$

40.00

$

40.00

$

79.80

$

80.00

$

80.00

7. Fixed MOH costs 8. Fixed MOH costs per machinehour (Row 7 ÷ Row 2) 9. Fixed MOH costs per unit (7 ÷ 1)

$350,208

$348,096

$348,096

$ 192.00 $ 364.80

$ 181.30 $ 362.60

$ 196.00 $ 392.00

Solution Exhibit 8-30 shows the computation of the variances. Journal entries for variable MOH, year ended December 31, 2012: Variable MOH Control Accounts Payable Control and Other Accounts

76,608

Work-in-Process Control Variable MOH Allocated

76,800

Variable MOH Allocated Variable MOH Spending Variance Variable MOH Control Variable MOH Efficiency Variance

76,800 3,648

76,608

76,800

76,608 3,840

Journal entries for fixed MOH, year ended December 31, 2012: Fixed MOH Control Wages Payable, Accumulated Depreciation, etc.

350,208

Work-in-Process Control Fixed MOH Allocated

376,320

Fixed MOH Allocated Fixed MOH Spending Variance Fixed MOH Control Fixed MOH Production-Volume Variance

376,320 2,112

350,208

376,320

350,208 28,224


2. Adjustment of COGS Variable MOH Efficiency Variance Fixed MOH Production-Volume Variance Variable MOH Spending Variance Fixed MOH Spending Variance Cost of Goods Sold

3,840 28,224 3,648 2,112 26,304

SOLUTION EXHIBIT 8-30 Variable Manufacturing Overhead

Actual Costs Incurred (1) (1,824 $42) $76,608

Actual Input Quantity × Budgeted Rate (2) (1,824 $40) $72,960


Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (3) (1,920 $40) $76,800


Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (1,920 $40) $76,800

Never a variance



Same Budgeted Lump Sum (as in Static Budget) Regardless Of Output Level (2)


$350,208

$348,096

$348,096


Never a variance




8-31 1.

(30 40 min.) Graphs and overhead variances. Variable Manufacturing Overhead Costs Total Variable Manuf. Overhead Costs $17,000,000

Graph for planning and control and inventory costing purposes at $10 per machine-hour

$8,500,000

1,000,000 Machine-Hours

Fixed Manufacturing Overhead Costs Total Fixed Manuf. Overhead Costs

Graph for planning and control purpose Graph for inventory costing purpose ($17 per machine-hour)

$17,000,000

$8,500,000

1,000,000 Machine-Hours

* Budgeted fixed manufacturing,overhead rate per hour = Error! = $17,000,000/ 1,000,000 machine hours = $17 per machine-hour


2.

(a) Variable Manufacturing Overhead Variance Analysis for Best Around, Inc. for 2012

Actual Costs Incurred (1) $12,075,000

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (3) (1,125,000 $10) $11,250,000

Actual Input Quantity × Budgeted Rate (2) (1,150,000 $10) $11,500,000



Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (1,125,000 $10) $11,250,000

Never a variance

$,825,000 U Flexible-budget variance

Never a variance

$825 000 U Underallocated variable overhead (Total variable overhead variance)

(b) Fixed Manufacturing Overhead Variance Analysis for Best Around, Inc. for 2012




$17,100,000

$17,000,000

$17,000,000


Never a variance


Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (1,125,000 × $17) $19,125,000

$2,125,000 F* Production-volume variance $2,125,000 F* Production-volume variance

$2,025,000 F Overallocated fixed overhead (Total fixed overhead variance) Alternative computation: 1,125,000 budgeted hrs. allowed – 1,000,000 denominator hrs. = 125,000 hrs. 125,000 $17 = $2,125,000 F

*


3. The underallocated variable manufacturing overhead was $825,000 and overallocated fixed overhead was $2,025,000. The flexible-budget variance and underallocated overhead are always the same amount for variable manufacturing overhead, because the flexible-budget amount of variable manufacturing overhead and the allocated amount of variable manufacturing overhead coincide. In contrast, the budgeted and allocated amounts for fixed manufacturing overhead only coincide when the budgeted input of the allocation base for the actual output level achieved exactly equals the denominator level. 4. The choice of the denominator level will affect inventory costs. The new fixed manufacturing overhead rate would be $17,000,000 ÷ 1,360,000 = $12.50 per machine-hour. In turn, the allocated amount of fixed manufacturing overhead and the production-volume variance would change as seen below: Actual

Budget

$17,100,000

$17,000,000

Allocated 1,125,000 × $12.50 = $14,062,500

$100,000 U $2,937,500 U* Flexible-budget variance Prodn. volume variance $3,037,500 U Total fixed overhead variance *

Alternate computation: (1,360,000 – 1,125,000) × $12.50 = $2,937,500 U

The major point of this requirement is that inventory costs (and, hence, income determination) can be heavily affected by the choice of the denominator level used for setting the fixed manufacturing overhead rate.


8-32

(30 min.) 4-variance analysis, find the unknowns.

Known figures denoted by an * Case A:



Actual Input Quantity × Budgeted Rate

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate

Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate

$120,000*

(6,230 × $20) $124,600

(6,200* × $20) $124,000*

(6,200* × $20) $124,000*

$4,600* F Spending variance


$84,920*

$600 U Efficiency variance

(Lump sum) $88,200*


Never a variance

(Lump sum) $88,200*

Never a variance

a

(6,200* × $14 ) $86,800*


Total budgeted manufacturing overhead = $124,000 + $88,200 = $212,200

Case B:

Actual Costs Incurred Variable Manufacturing Overhead

$45,640

Actual Input Quantity × Budgeted Rate

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate

Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate

(1,141

(1,200

(1,200

$42.00*) $47,922

$2,282 F* $2,478 F* Spending variance Efficiency variance

$42.00*) b $50,400

$42.00*) $50,400

Never a variance



(Lump sum) $23,180* $20,000* $3,180 U Spending variance

(Lump sum) $20,000*

Never a variance

c

$24,000

$4,000 F* Production-volume variance

Total budgeted manufacturing overhead = $50,400 + $20,000 = $70,400 a

Budgeted FMOH rate = Standard fixed manufacturing overhead allocated ÷ Standard machine-hours allowed for actual output achieved = $86,800 ÷ 6,200 = $14 b Budgeted hours allowed for actual output achieved must be derived from the output level variance before this figure can be derived, or, since the fixed manufacturing overhead rate is $20,000 ÷ 1,000 = $20, and the allocated amount is $24,000, the budgeted hours allowed for the actual output achieved must be 1,200 ($24,000 $20). c 1,200 ($20,000* ÷ 1,000*) = $24,000


8-33 1.

(15 25 min.) Flexible budgets, 4-variance analysis. Budgeted hours allowed,per unit of output = Error! 3,600,000 = = 5 hours per unit 720,000 Budgeted DLH allowed for May output = 66,000 units 5 hrs./unit = 330,000 hrs. Allocated total MOH = 330,000 Total MOH rate per hour = 330,000 $1.20 = $396,000

2, 3, 4, 5. See Solution Exhibit 8-33 Variable manuf. overhead rate per DLH = $0.25 + $0.34 = $0.59 Fixed manuf. overhead rate per DLH = $0.18 + $0.15 + $0.28 = $0.61 Fixed manuf. overhead budget for May = ($648,000 + $540,000 + $1,008,000) ÷ 12 = $2,196,000 ÷ 12 = $183,000 or, Fixed manuf. overhead budget for May = $54,000 + $45,000 + $84,000 = $183,000 Using the format of Exhibit 8-5 for variable manufacturing overhead and then fixed manufacturing overhead: Actual variable manuf. overhead: $75,000 + $111,000 = $186,000 Actual fixed manuf. overhead: $51,000 + $54,000 + $84,000 = $189,000

An overview of the 4-variance analysis using the block format of the text is:

4-Variance Analysis

Spending Variance

Efficiency Variance


$8,850 F

Never a variance


$150 U


$6,000 U Never a variance

$18,300 F


SOLUTION EXHIBIT 8-33 Variable Manufacturing Overhead

Actual Costs Incurred (1) $186,000

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (3) (330,000 $0.59) $194,700

Actual Input Quantity × Budgeted Rate (2) (315,000 $0.59) $185,850

$150 U Spending variance


Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (330,000 $0.59) $194,700

Never a variance





$189,000

$183,000

$183,000


Never a variance

Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) (330,000 $0.61) $201,300


Alternate computation of the production volume variance: =

Budgeted hours allowed for actual output achieved

=

330,000

3, 600, 000 12

Denominator hours

Budgeted fixed overhead rate

× $ 0.61

= (330,000 – 300,000) × $0.61 = $18,300 F


8-34 (20 min.) Overhead Variances 1.

Direct Manufacturing Labor and Variable Manufacturing

Direct Manufacturing Labor variance analysis for Sarah Beth’s Art Supply Company

Actual Costs Incurred 29,000 × 2.3 × 10.4 $693,680

Actual Input Quantity Budgeted Rate 29,000 × 2.3 × 10 $667,000 $26,680 U Price variance

2.

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output Budgeted Price 29,000 × 2 × 10.0 $580,000


Variable Manufacturing Overhead variance analysis for Sarah Beth’s Art Supply Company

Actual Costs Incurred 29,000 × 2.3 × 18.95 $1,263,965

Actual Input Quantity Budgeted Rate 29,000 × 2.3 × 20.0 $1,334,000


Flexible Budget: Budgeted Input Quantity Allowed for Actual Output Budgeted Rate 29,000 × 2 × 20.0 $1,160,000


3. The favorable spending variance for variable manufacturing overhead suggests that less costly items were used, which could have a negative impact on labor efficiency. But note that the workers were paid a higher rate than budgeted, which, if it indicates the hiring of more qualified employees, should lead to favorable labor efficiency variances. Moreover, the price variance and the spending variance are both much smaller than the efficiency variances. It is clear therefore that the efficiency variances are related to factors other than the cost of the labor or overhead.

4. If the variable overhead consisted only of costs that were related to direct manufacturing labor, then Sarah is correct—both the labor efficiency variance and the variable overhead efficiency variance would reflect real cost overruns due to the inefficient use of labor. However, a portion of variable overhead may be a function of factors other than direct labor (e.g., the costs of energy or the usage of indirect materials). In this case, allocating variable overhead using direct labor as the only base will inflate the effect of inefficient labor usage on the variable overhead efficiency variance. The real effect on firm profitability will be lower, and will likely be captured in a favorable spending variance for variable overhead.


8-35

(20 min.)

Activity-based costing, batch-level variance analysis

1.

Static budget number of crates = Budgeted pairs shipped / Budgeted pairs per crate = 250,000/10 = 25,000 crates

2.

Flexible budget number of crates = Actual pairs shipped / Budgeted pairs per crate = 175,000/10 = 17,500 crates

3.

Actual number of crates shipped = Actual pairs shipped / Actual pairs per box = 175,000/8 = 21,875 crates

4.

Static budget number of hours = Static budget number of crates × budgeted hours per box = 25,000 × 1.1 = 27,500 hours Fixed overhead rate = Static budget fixed overhead / static budget number of hours = $55,000/27,500 = $2.00 per hour

5.

Variable Direct Variance Analysis for Pointe’s Fleet Feet, Inc. for 2011 Actual Variable Cost (21,875 × 0.9 × $24) $472,500

Actual Hours Budgeted Rate (21,875 × 0.9 × $22) $433,125


6.

Budgeted Hours Allowed for Actual Output Budgeted Rate (17,500 × 1.1 × $22) $423,500


Fixed Overhead Variance Analysis for Pointe’s Fleet Feet, Inc. for 2011 Actual Fixed Overhead

Static Budget Fixed Overhead

$52,500

$55,000 $2,500 F Spending variance

Budgeted Hours Allowed for Actual Output × Budgeted Rate (17,500 × 1.1 × $2.0) $38,500

$16,500 U Production volume variance


8-36 (30 min.) Activity-based costing, batch-level variance analysis 1. Static budget number of setups = Budgeted books produced/ Budgeted books per setup = 300,000 ÷ 500 = 600 setups 2. Flexible budget number of setups = Actual books produced / Budgeted books per setup = 324,000 ÷ 500 = 648 setups 3. Actual number of setups = Actual books produced / Actual books per setup = 324,000/480 = 675 setups 4. Static budget number of hours = Static budget # of setups × Budgeted hours per setup = 600 × 8 = 4,800 hours Fixed overhead rate = Static budget fixed overhead / Static budget number of hours = 105,600/4,800 = $22 per hour 5. Budgeted direct variable cost of a setup = Budgeted variable cost per setup-hour × Budgeted number of setup-hours = $40 × 8 = $320. Budgeted total cost of a setup = Budgeted direct variable cost + Fixed overhead rate × Budgeted number of setup-hours = $320 + $22 × 8 = $496. So, the charge of $400 covers the budgeted incremental (i.e., variable) cost of a setup, but not the budgeted full cost. 6. Direct Variable Variance Analysis for Jo Nathan Publishing Company for 2012 Actual Variable Cost (675 × 8.2 × $39) $215,865

Actual Hours Budgeted Rate (675 × 8.2 × $40) $221,400


Standard Hours Standard Rate (648 × 8.0 × $40) $207,360



7. Fixed Setup Overhead Variance Analysis for Jo Nathan Publishing Company for 2012 Actual Fixed Overhead $119,000

Static Budget Fixed Overhead $105,600


Standard Hours Budgeted Rate (648 × 8.0 × $22) $114,048


8. Rejecting an order may have implications for future orders (i.e., professors would be reluctant to order books from this publisher again). Jo Nathan should consider factors such as prior history with the customer and potential future sales. If a book is relatively new, Jo Nathan might consider running a full batch and holding the extra books in case of a second special order or just hold the extra books until next semester. If the special order comes at heavy volume times, Jo Nathan should look at the opportunity cost of filling it, i.e., accepting the order may interfere with or delay the printing of other books.


8-37

(35 min.) Production-Volume Variance Analysis and Sales Volume Variance.

1. and 2.

Fixed Overhead Variance Analysis for Dawn Floral Creations, Inc. for February Actual Fixed Overhead


$9,200

$9,000 $200 U Spending variance

Standard Hours × Budgeted Rate (600 × 1.5 × $6*) $5,400


* fixed overhead rate = (budgeted fixed overhead)/(budgeted DL hours at capacity) = $9,000/(1000 1.5 hours) = $9,000/1,500 hours = $6/hour 3. An unfavorable production-volume variance measures the cost of unused capacity. Production at capacity would result in a production-volume variance of 0 since the fixed overhead rate is based upon expected hours at capacity production. However, the existence of an unfavorable volume variance does not necessarily imply that management is doing a poor job or incurring unnecessary costs. Using the suggestions in the problem, two reasons can be identified. a. For most products, demand varies from month to month while commitment to the factors that determine capacity, e.g. size of workshop or supervisory staff, tends to remain relatively constant. If Dawn wants to meet demand in high demand months, it will have excess capacity in low demand months. In addition, forecasts of future demand contain uncertainty due to unknown future factors. Having some excess capacity would allow Dawn to produce enough to cover peak demand as well as slack to deal with unexpected demand surges in non-peak months. b. Basic economics provides a demand curve that shows a tradeoff between price charged and quantity demanded. Potentially, Dawn could have a lower net revenue if they produce at capacity and sell at a lower price than if they sell at a higher price at some level below capacity. In addition, the unfavorable production-volume variance may not represent a feasible cost savings associated with lower capacity. Even if Dawn could shift to lower fixed costs by lowering capacity, the fixed cost may behave as a step function. If so, fixed costs would decrease in fixed amounts associated with a range of production capacity, not a specific production volume. The production-volume variance would only accurately identify potential cost savings if the fixed cost function is continuous, not discrete.


4. The static-budget operating income for February is: Revenues $55 × 1,000 Variable costs $25 × 1,000 Fixed overhead costs Static-budget operating income

$55,000 25,000 9,000 $21,000

The flexible-budget operating income for February is: Revenues $55 × 600 Variable costs $25 × 600 Fixed overhead costs Flexible-budget operating income

$33,000 15,000 9,000 $ 9,000

The sales-volume variance represents the difference between the static-budget operating income and the flexible-budget operating income: Static-budget operating income Flexible-budget operating income Sales-volume variance

$21,000 9,000 $12,000 U

Equivalently, the sales-volume variance captures the fact that when Dawn sells 600 units instead of the budgeted 1,000, only the revenue and the variable costs are affected. Fixed costs remain unchanged. Therefore, the shortfall in profit is equal to the budgeted contribution margin per unit times the shortfall in output relative to budget. Sales-volume,variance = Budgeted,selling price – Budgeted,variable cost,per unit Difference in quantity of,units sold relative to the, static budget

×

= ($55 – $25) × 400 = $30 × 400 = $12,000 U In contrast, we computed in requirement 2 that the production-volume variance was $3,600U. This captures only the portion of the budgeted fixed overhead expected to be unabsorbed because of the 400-unit shortfall. To compare it to the sales-volume variance, consider the following: Budgeted selling price Budgeted variable cost per unit Budgeted fixed cost per unit ($9,000 ÷ 1,000) Budgeted cost per unit Budgeted profit per unit Operating income based on budgeted profit per unit $21 per unit × 600 units

$

55

$

34 21

$25 9

$12,600


The $3,600 U production-volume variance explains the difference between operating income based on the budgeted profit per unit and the flexible-budget operating income: Operating income based on budgeted profit per unit Production-volume variance Flexible-budget operating income

$12,600 3,600 U $ 9,000

Since the sales-volume variance represents the difference between the static- and flexible-budget operating incomes, the difference between the sales-volume and production-volume variances, which is referred to as the operating-income volume variance is: Operating-income volume variance = Sales-volume variance – Production-volume variance = Static-budget operating income – Operating income based on budgeted profit per unit = $21,000 U – $12,600 U = $8,400 U. The operating-income volume variance explains the difference between the static-budget operating income and the budgeted operating income for the units actually sold. The staticbudget operating income is $21,000 and the budgeted operating income for 600 units would have been $12,600 ($21 operating income per unit 600 units). The difference, $8,400 U, is the operating-income volume variance, i.e., the 400 unit drop in actual volume relative to budgeted volume would have caused an expected drop of $8,400 in operating income, at the budgeted operating income of $21 per unit. The operating-income volume variance assumes that $50,000 in fixed cost ($9 per unit 400 units) would be saved if production and sales volumes decreased by 400 units.


8-38 (30 40 min.) Comprehensive review of Chapters 7 and 8, working backward from given variances. 1.

Solution Exhibit 8-38 outlines the Chapter 7 and 8 framework underlying this solution. a.

Pounds of direct materials purchased = $176,000 ÷ $1.10 = 160,000 pounds

b.

Pounds of excess direct materials used = $69,000 ÷ $11.50 = 6,000 pounds

c.

Variable manufacturing overhead spending variance = $10,350 – $18,000 = $7,650 F

d.

Standard direct manufacturing labor rate = $800,000 ÷ 40,000 hours = $20 per hour Actual direct manufacturing labor rate = $20 + $0.50 = $20.50 Actual direct manufacturing labor-hours = $522,750 ÷ $20.50 = 25,500 hours

e.

Standard variable manufacturing overhead rate = $480,000 ÷ 40,000 = $12 per direct manuf. labor-hour Variable manuf. overhead efficiency variance of $18,000 ÷ $12 = 1,500 excess hours Actual hours – Excess hours = Standard hours allowed for units produced 25,500 – 1,500 = 24,000 hours

f.

Budgeted fixed manufacturing overhead rate

= $640,000 ÷ 40,000 hours = $16 per direct manuf. labor-hour Fixed manufacturing overhead allocated = $16 24,000 hours = $384,000 Production-volume variance = $640,000 – $384,000 = $256,000 U

2. The control of variable manufacturing overhead requires the identification of the cost drivers for such items as energy, supplies, and repairs. Control often entails monitoring nonfinancial measures that affect each cost item, one by one. Examples are kilowatts used, quantities of lubricants used, and repair parts and hours used. The most convincing way to discover why overhead performance did not agree with a budget is to investigate possible causes, line item by line item. Individual fixed overhead items are not usually affected very much by day-to-day control. Instead, they are controlled periodically through planning decisions and budgeting procedures that may sometimes have planning horizons covering six months or a year (for example, management salaries) and sometimes covering many years (for example, long-term leases and depreciation on plant and equipment).



Direct Materials

Direct Manuf. Labor

Actual Costs Incurred (Actual Input Quantity Actual Rate) 160,000 $10.40 $1,664,000

Flexible Budget: Budgeted Input Actual Input Quantity Quantity Allowed for Actual Output Budgeted Rate Purchases Usage Budgeted Rate 160,000 $11.50 96,000 $11.50 3 30,000 $11.50 $1,840,000 $1,104,000 $1,035,000 $69,000 U $176,000 F Efficiency variance Price variance

0.85

30,000 $20.50 $522,750

0.85

30,000 $20 $510,000


0.80

30,000 $20 $480,000



Variable MOH

Actual Costs Incurred Actual Input Quantity Actual Rate 0.85 30,000 $11.70 $298,350

Actual Input Quantity Budgeted Rate 0.85 30,000 $12 $306,000

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output Budgeted Rate 0.80 30,000 $12 $288,000


$18,000 U Efficiency $10,350 U variance Flexible-budget variance

Actual Costs Incurred (1) Fixed MOH

$597,460

Never a variance Never a variance

Flexible Budget: Same Budgeted Same Budgeted Lump Sum Lump Sum (as in Static Budget) (as in Static Budget) Regardless of Regardless of Output Level Output Level (2) (3) 0.80 × 50,000 × $16 $640,000 $640,000

$42,540 F Spending variance Never a variance volume variance $42,540 F Flexible-budget variance

Allocated: Budgeted Input Quantity Allowed for Actual Output Budgeted Rate 0.80 30,000 $12 $288,000

Allocated: Budgeted Input Quantity Allowed for Actual Output × Budgeted Rate (4) 0.80

30,000 × $16 $384,000

$256,000 U $256,000 U Production volume variance


8-39 1.

(30 50 min.) Review of Chapters 7 and 8, 3-variance analysis. Total standard production costs are based on 7,800 units of output. Direct materials, 7,800 $15.00 7,800 3 lbs. $5.00 (or 23,400 lbs. $5.00) Direct manufacturing labor, 7,800 $75.00 7,800 5 hrs. $15.00 (or 39,000 hrs. $15.00) Manufacturing overhead: Variable, 7,800 $30.00 (or 39,000 hrs. $6.00) Fixed, 7,800 $40.00 (or 39,000 hrs. $8.00) Total

$ 117,000 585,000 234,000 312,000 $1,248,000

The following is for later use: Fixed manufacturing overhead, a lump-sum budget

$ 320,000*

*

Fixed manufacturing overhead rate = Error! $8.00 =

Budget 40,000 hours

Budget = 40,000 hours

$8.00 = $320 000

2. Solution Exhibit 8-39 presents a columnar presentation of the variances. An overview of the 3-variance analysis using the block format of the text is: 3-Variance Analysis Total Manufacturing Overhead

Spending Variance

Efficiency Variance

Production Volume Variance

$39,400 U

$6,600 U

$8,000 U


SOLUTION EXHIBIT 8-39 Actual Costs Incurred: Actual Input Quantity × Actual Rate Direct (25,000 $5.20) Materials $130,000

Actual Input Quantity Budgeted Price Purchases Usage (25,000 $5.00) (23,100 $5.00) $125,000 $115,500

$5,000 U

$1,500 F

a. Price variance

Direct Manuf. Labor

(40,100 $14.60) $585,460

b. Efficiency variance

(40,100 $15.00) $601,500

$16,040 F c. Price variance

Variable Manuf. Overhead

(39,000 $15.00) $585,000

$16,500 U d. Efficiency variance


Actual Input Quantity Budgeted Rate

(not given)

(40,100 $6.00) $240,600

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output Budgeted Rate

Allocated: (Budgeted Input Quantity Allowed for Actual Output Budgeted Rate)

(39,000 $6.00) $234,000

(39,000 $6.00) $234,000


Fixed Manuf. Overhead

(not given)

$320,000

(given) $600,000

($240,600 + $320,000) $560,600

(39,000 $8.00) $312,000

$8,000 U* Prodn. volume variance

($234,000 + $320,000) $554,000

$39,400 U e. Spending variance

$6,600 U f. Efficiency variance

Denominator level in hours Production volume in standard hours allowed Production-volume variance

40,000 39,000 1,000 hours

*

Never a variance

$320,000

Never a variance Total Manuf. Overhead

Flexible Budget: Budgeted Input Quantity Allowed for Actual Output × Budgeted Price (23,400 $5.00) $117,000

($234,000 + $312,000) $546,000

$8,000 U g. Prodn. volume variance

$8.00 = $8,000 U


8-40 (20 minutes) Non-financial variances 1.

Variance Analysis of Inspection Hours for Supreme Canine Products for May

Actual Hours For Inspections 215 hours

Actual Pounds Standard Pounds Inspected Inspected/Budgeted for Actual Output /Budgeted Pounds per hour Pounds per hour 277,500lbs/1,500 lbs/hr (3,000,000 0.1)lbs/(1,500 lbs/hr) 185 hours 200 hours

30 hours U Efficiency Variance 2.

15 hours F Quantity Variance

Variance Analysis of Pounds Failing Inspection for Supreme Canine Products for May

Actual Pounds Failing Inspections 15,650 lbs

Actual pounds Standard Pounds Inspected Inspected Budgeted for Actual Output Budgeted Inspection Failure Rate Inspection Failure Rate (277,500 lbs .06) (3,000,000 .1 .06) 16,650 lbs 18,000 lbs

1,000 lbs F Quality Variance

1,350 lbs F Quantity Variance


8-41

1.

(30 – 40 minutes) Overhead variances and sales volume variance

Variable overhead variances Actual Variable Overhead $699,600

Actual Hours Budgeted Rate (440,000 × $1.60) $704,000


Standard Hours Standard Rate (900,000 × .5 × $1.60) $720,000


Fixed overhead variances Actual Fixed Overhead


$501,900

Standard Hours Budgeted Rate (900,000 .5 × $1.175*) $528,750

$470,000



*FOH rate is $470,000 / 400,000 std hours = $1.175 per hour

2.

Units sold Unit price Revenues Variable costs Direct materials Direct labor Variable overhead Total variable costs Contribution margin Fixed manufacturing costs Operating income

$

Actual results (1) 900,000 6 $5,400,000

FlexibleBudget Variances (2) = (1) – (3)

$900,000 F

Flexible Budget (3) 900,000 5 $4,500,000

1,080,000 1,620,000 699,600 3,399,600 2,000,400

0 0 20,400 F 20,400 F 920,400 F

1,080,000 1,620,000 720,000 3,420,000 1,080,000

501,900 $1,498,500

31,900 U $888,500 F

$

470,000 $ 610,000

SalesVolume Variances (4) = (3)-(5)

St Bu ( 8 $

$500,000 F 120,000 U 180,000 U 80,000 U 380,000 U 120,000 F

9

0 $120,000 F

4 $ 4


6

9

3. Budgeted cost per shopping bag: Direct materials per bag (given) Direct labor per bag (given) Variable overhead ($1.6 per hour .5 MH) Fixed overhead ($1.175 per hour .5 MH) Total Budgeted sales revenue 900,000 units $5 Budgeted cost of goods sold 900,000 $4.3875 Budgeted operating income

$1.20 1.80 .80 .5875 $4.3875

$4,500,000 3,948,750 $ 551,250

4. Budgeted operating income (from #3) $ 551,250 Add: favorable volume variance (from #1) 58,750 Flexible budget operating income 610,000 Add: Favorable flexible budget variance 888,500 Actual operating income $1,498,500 5. Operating income volume variance: Budgeted operating income for actual output – static budget operating income = $551,250 – $490,000 = $61,250 F Sales volume variance = $120,000 F = production volume variance + operating income volume variance = $58,750 + $ 61,250 = $120,000 F


Collaborative Learning Problem 8-42 (40–50 minutes) Overhead variances, ethics 1.

a. Nevada plant: Expected output in units Direct labor hours per unit Total budgeted labor hours

4,000,000 .25 1,000,000

Budgeted fixed OH rate = $2,500,000 / 1,000,000 DLH = $2.50 per DLH Ohio plant: Expected output in units Direct labor hours per unit Total budgeted labor hours

4,200,000 .25 1,050,000

Budgeted fixed OH rate = $2,310,000 / 1,050,000 DLH = $2.20 per DLH b.

Allocation of common fixed costs: To Nevada: $3,150,000 2/3 = $2,100,000 To Ohio: $3,150,000 1/3 = $1,050,000

Nevada plant: Budgeted fixed OH rate = ($2,500,000 + $2,100,000) / 1,000,000 DLH = $4.60 per DLH Ohio plant: Budgeted fixed OH rate = ($2,310,000 + $1,050,000)/ 1,050,000 DLH = $3.20 per DLH

2.

Variable overhead variances:

Nevada plant: Actual Variable Overhead (1,014,000 × $3.20) $3,244,800

Actual Hours Budgeted Rate (1,014,000 × $3.25) $3,295,500


Budgeted Input Allowed for Actual Output Budgeted Rate (3,900,000 × .25 × $3.25) $3,168,750



Ohio plant: Actual Variable Overhead (1,218,000 × $3.10) $3,775,800

Actual Hours Budgeted rate (1,218,000 × $3) $3,654,000


Budgeted Input Allowed for Actual Output Budgeted Rate (4,350,000 × .25 × $3) $3,262,500


3. Fixed overhead variances a.

Excluding the allocated common costs

Nevada plant: Actual Fixed Overhead $2,520,000

Static Budget Fixed Overhead $2,500,000




Ohio plant: Actual Fixed Overhead $2,400,000

Static Budget Fixed Overhead $2,310,000





b.

Including allocated common costs

Nevada plant: Actual Static Budget Fixed Overhead Fixed Overhead $2,520,000 + (2/3 ×$3,126,000) ($2,500,000+$2,100,000) $4,604,000 $4,600,000 $4,000 U Spending variance



Ohio plant: Actual Static Budget Fixed Overhead Fixed Overhead $2,400,000 + (1/3 ×$3,126,000) ($2,310,000+$1,050,000) $3,442,000 $3,360,000 $82,000 U Spending variance



4.

Jack Jones’s attempt did not fully work. Even though he tried to allocate a significantly larger amount of common cost to the Nevada plant than to the Ohio plant, the cost becomes part of the fixed overhead rate and thus will only cause a large unfavorable spending variance for the Nevada plant if the cost itself is much larger than expected. Since the actual common costs were lower, the result was actually to lower Nevada’s unfavorable spending variance. Also, the spending variance for the Ohio plant is already larger than that of the Nevada plant, and that carries over even adding the common fixed costs to both plants. That said, the inclusion of the common fixed cost does exacerbate the impact of the underproduction by Ohio relative to budget (via the higher unfavorable production volume variance), while increasing the favorable volume variance for Ohio.

5.

Common fixed costs should not be allocated to units that are being evaluated for performance because common fixed costs are not controllable by those units. Thus, the units should not be responsible for such costs.

6.

Jack Jones’s behavior is not ethical. He attempted to make his friend better off by manipulating costs and overhead rates, rather than focusing on which cost system would provide the best measure of relative performance among the divisions.


CHAPTER 9 INVENTORY COSTING AND CAPACITY ANALYSIS 9-1 No. Differences in operating income between variable costing and absorption costing are due to accounting for fixed manufacturing costs. Under variable costing only variable manufacturing costs are included as inventoriable costs. Under absorption costing both variable and fixed manufacturing costs are included as inventoriable costs. Fixed marketing and distribution costs are not accounted for differently under variable costing and absorption costing. 9-2

The term direct costing is a misnomer for variable costing for two reasons: a. Variable costing does not include all direct costs as inventoriable costs. Only variable direct manufacturing costs are included. Any fixed direct manufacturing costs, and any direct nonmanufacturing costs (either variable or fixed), are excluded from inventoriable costs. b. Variable costing includes as inventoriable costs not only direct manufacturing costs but also some indirect costs (variable indirect manufacturing costs).

9-3 No. The difference between absorption costing and variable costs is due to accounting for fixed manufacturing costs. As service or merchandising companies have no fixed manufacturing costs, these companies do not make choices between absorption costing and variable costing. 9-4 The main issue between variable costing and absorption costing is the proper timing of the release of fixed manufacturing costs as costs of the period: a. at the time of incurrence, or b. at the time the finished units to which the fixed overhead relates are sold. Variable costing uses (a) and absorption costing uses (b). 9-5 No. A company that makes a variable-cost/fixed-cost distinction is not forced to use any specific costing method. The Stassen Company example in the text of Chapter 9 makes a variable-cost/fixed-cost distinction. As illustrated, it can use variable costing, absorption costing, or throughput costing. A company that does not make a variable-cost/fixed-cost distinction cannot use variable costing or throughput costing. However, it is not forced to adopt absorption costing. For internal reporting, it could, for example, classify all costs as costs of the period in which they are incurred. 9-6 Variable costing does not view fixed costs as unimportant or irrelevant, but it maintains that the distinction between behaviors of different costs is crucial for certain decisions. The planning and management of fixed costs is critical, irrespective of what inventory costing method is used. 9-7 Under absorption costing, heavy reductions of inventory during the accounting period might combine with low production and a large production volume variance. This combination could result in lower operating income even if the unit sales level rises. 9-8

(a) The factors that affect the breakeven point under variable costing are: 1. Fixed (manufacturing and operating) costs. 2. Contribution margin per unit.


(b) The factors that affect the breakeven point under absorption costing are: 1. Fixed (manufacturing and operating) costs. 2. Contribution margin per unit. 3. Production level in units in excess of breakeven sales in units. 4. Denominator level chosen to set the fixed manufacturing cost rate. 9-9 Examples of dysfunctional decisions managers may make to increase reported operating income are: a. Plant managers may switch production to those orders that absorb the highest amount of fixed manufacturing overhead, irrespective of the demand by customers. b. Plant managers may accept a particular order to increase production even though another plant in the same company is better suited to handle that order. c. Plant managers may defer maintenance beyond the current period to free up more time for production. 9-10 Approaches used to reduce the negative aspects associated with using absorption costing include: a. Change the accounting system: Adopt either variable or throughput costing, both of which reduce the incentives of managers to produce for inventory. Adopt an inventory holding charge for managers who tie up funds in inventory. b. Extend the time period used to evaluate performance. By evaluating performance over a longer time period (say, 3 to 5 years), the incentive to take short-run actions that reduce long-term income is lessened. c. Include nonfinancial as well as financial variables in the measures used to evaluate performance. 9-11 The theoretical capacity and practical capacity denominator-level concepts emphasize what a plant can supply. The normal capacity utilization and master-budget capacity utilization concepts emphasize what customers demand for products produced by a plant. 9-12 The downward demand spiral is the continuing reduction in demand for a company‘s product that occurs when the prices of competitors‘ products are not met and (as demand drops further), higher and higher unit costs result in more and more reluctance to meet competitors‘ prices. Pricing decisions need to consider competitors and customers as well as costs. 9-13 No. It depends on how a company handles the production-volume variance in the end-ofperiod financial statements. For example, if the adjusted allocation-rate approach is used, each denominator-level capacity concept will give the same financial statement numbers at year-end. 9-14 For tax reporting in the U.S., the IRS requires only that indirect production costs are ―fairly‖ apportioned among all items produced. Overhead rates based on normal or masterbudget capacity utilization, as well as the practical capacity concept are permitted. At year-end, proration of any variances between inventories and cost of goods sold is required (unless the variance is immaterial in amount). 9-15 No. The costs of having too much capacity/too little capacity involve revenue opportunities potentially forgone as well as costs of money tied up in plant assets. 9-2 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

9-16 (30 min.) Variable and absorption costing, explaining operating-income differences. 1.

Key inputs for income statement computations are April 0 500 500 350 150

Beginning inventory Production Goods available for sale Units sold Ending inventory

May 150 400 550 520 30

The budgeted fixed cost per unit and budgeted total manufacturing cost per unit under absorption costing are

(a) (b) (c)=(a)÷(b) (d) (e)=(c)+(d) (a)

Budgeted fixed manufacturing costs Budgeted production Budgeted fixed manufacturing cost per unit Budgeted variable manufacturing cost per unit Budgeted total manufacturing cost per unit

April $2,000,000 500 $4,000 $10,000 $14,000

May $2,000,000 500 $4,000 $10,000 $14,000

Variable costing April 2011 $8,400,000

a

Revenues Variable costs Beginning inventory Variable manufacturing costsb Cost of goods available for sale Deduct ending inventoryc Variable cost of goods sold d Variable operating costs Total variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed operating costs Total fixed costs Operating income a $24,000 × 350; $24,000 × 520 b $10,000 × 500; $10,000 × 400

$

0 5,000,000 5,000,000 (1,500,000) 3,500,000 1,050,000

May 2011 $12,480,000 $1,500,000 4,000,000 5,500,000 (300,000) 5,200,000 1,560,000

4,550,000 3,850,000 2,000,000 600,000

6,760,000 5,720,000 2,000,000 600,000

2,600,000 $1,250,000

2,600,000 $3,120,000

c $10,000 × 150; $10,000 × 30 d $3,000 × 350; $3,000 × 520


(b)

Absorption costing

Revenuesa Cost of goods sold Beginning inventory Variable manufacturing costsb Allocated fixed manufacturing costsc Cost of goods available for sale Deduct ending inventoryd Adjustment for prod.-vol. variancee Cost of goods sold Gross margin Operating costs Variable operating costsf Fixed operating costs Total operating costs Operating income a

d

b

e

$24,000 × 350; $24,000 × 520 $10,000 × 500; $10,000 × 400 c $4,000 × 500; $4,000 × 400

2.

April 2011 $8,400,000 $

0 5,000,000 2,000,000 7,000,000 (2,100,000) 0

May 2011 $12,480,000 $2,100,000 4,000,000 1,600,000 7,700,000 (420,000) 400,000 U

4,900,000 3,500,000 1,050,000 600,000

7,680,000 4,800,000 1,560,000 600,000

1,650,000 $1,850,000

2,160,000 $ 2,640,000

$14,000 × 150; $14,000 × 30 $2,000,000 – $2,000,000; $2,000,000 – $1,600,000 f $3,000 × 350; $3,000 × 520

Absorption-costing Variable-costing Fixed manufacturing costs Fixed manufacturing costs – = – operating income operating income in ending inventory in beginning inventory

April: $1,850,000 – $1,250,000 $600,000

= ($4,000 × 150) – ($0) = $600,000

May: $2,640,000 – $3,120,000 = ($4,000 × 30) – ($4,000 × 150) – $480,000 = $120,000 – $600,000 – $480,000 = – $480,000 The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into inventories as inventories increase (as in April) and out of inventories as they decrease (as in May).


9-17

(20 min.) Throughput costing (continuation of Exercise 9-16).

1. April 2011 a Revenues $8,400,000 Direct material cost of goods sold Beginning inventory Direct materials in goods $ 0 b manufactured 3,350,000 Cost of goods available for sale 3,350,000 c Deduct ending inventory (1,005,000) Total direct material cost of goods sold 2,345,000 Throughput margin 6,055,000 Other costs Manufacturing costs 3,650,000d Other operating costs 1,650,000f Total other costs 5,300,000 Operating income $ 755,000 a

e

b

f

$24,000 × 350; $24,000 × 520 $6,700 × 500; $6,700 × 400 c $6,700 × 150; $6,700 × 30 d ($3,300 × 500) + $2,000,000

2.

May 2011 $12,480,000

$1,005,000 2,680,000 3,685,000 (201,000) 3,484,000 8,996,000 3,320,000e 2,160,000g 5,480,000 $ 3,516,000

($3,300 × 400) + $2,000,000 ($3,000 × 350) + $600,000 g ($3,000 × 520) + $600,000

Operating income under: April $1,250,000 1,850,000 755,000

Variable costing Absorption costing Throughput costing

May $3,120,000 2,640,000 3,516,000

In April, throughput costing has the lowest operating income, whereas in May throughput costing has the highest operating income. Throughput costing puts greater emphasis on sales as the source of operating income than does either absorption or variable costing. 3. Throughput costing puts a penalty on production without a corresponding sale in the same period. Costs other than direct materials that are variable with respect to production are expensed in the period of incurrence, whereas under variable costing they would be capitalized. As a result, throughput costing provides less incentive to produce for inventory than either variable costing or absorption costing.


9-18 (40 min.) Variable and absorption costing, explaining operating-income differences. 1.

Key inputs for income statement computations are:

Beginning inventory Production Goods available for sale Units sold Ending inventory

January 0 1,000 1,000 700 300

February 300 800 1,100 800 300

March 300 1,250 1,550 1,500 50

The budgeted fixed manufacturing cost per unit and budgeted total manufacturing cost per unit under absorption costing are:

(a) (b) (c)=(a)÷(b) (d) (e)=(c)+(d)

Budgeted fixed manufacturing costs Budgeted production Budgeted fixed manufacturing cost per unit Budgeted variable manufacturing cost per unit Budgeted total manufacturing cost per unit

January $400,000 1,000 $ 400 $ 900 $ 1,300

February $400,000 1,000 $ 400 $ 900 $ 1,300

March $400,000 1,000 $ 400 $ 900 $ 1,300


(a)

Variable Costing

Revenuesa Variable costs Beginning inventoryb Variable manufacturing costsc Cost of goods available for sale Deduct ending inventoryd Variable cost of goods sold Variable operating costse Total variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed operating costs Total fixed costs Operating income

January 2012 $1,750,000 $

0 900,000 900,000 (270,000) 630,000 420,000

February 2012 $2,000,000 $270,000 720,000 990,000 (270,000) 720,000 480,000

1,050,000 700,000

March 2012 $3,750,000 $ 270,000 1,125,000 1,395,000 (45,000) 1,350,000 900,000

1,200,000 800,000

400,000 140,000

400,000 140,000 540,000 $ 160,000

2,250,000 1,500,000 400,000 140,000

540,000 $ 260,000

540,000 $ 960,000

a $2,500 × 700; $2,500 × 800; $2,500 × 1,500 b $? × 0; $900 × 300; $900 × 300 c $900 × 1,000; $900 × 800; $900 × 1,250 d $900 × 300; $900 × 300; $900 × 50 e $600 × 700; $600 × 800; $600 × 1,500


(b)

Absorption Costing

Revenuesa Cost of goods sold Beginning inventoryb Variable manufacturing costsc Allocated fixed manufacturing costsd Cost of goods available for sale Deduct ending inventorye Adjustment for prod. vol. var.f Cost of goods sold Gross margin Operating costs Variable operating costsg Fixed operating costs Total operating costs Operating income

January 2012 $1,750,000 $

February 2012 $2,000,000

March 2012 $3,750,000

0 900,000

$ 390,000 720,000

$ 390,000 1,125,000

400,000 1,300,000

320,000 1,430,000

500,000 2,015,000

(390,000) 0

(390,000) 80,000 U

(65,000) (100,000) F

910,000 840,000

1,120,000 880,000

420,000 140,000

480,000 140,000 560,000 $ 280,000

1,850,000 1,900,000 900,000 140,000

620,000 $ 260,000

a

$2,500 × 700; $2,500 × 800; $2,500 × 1,500 $?× 0; $1,300 × 300; $1,300 × 300 c $900 × 1,000; $900 × 800; $900 × 1,250 d $400 × 1,000; $400 × 800; $400 × 1,250 e $1,300 × 300; $1,300 × 300; $1,300 × 50 f $400,000 – $400,000; $400,000 – $320,000; $400,000 – $500,000 g $600 × 700; $600 × 800; $600 × 1,500 b


1,040,000 $ 860,000

2.

Absorption-costing operating income

Variable costing operating income

Fixed manufacturing costs in ending inventory

Fixed manufacturing costs in beginning inventory

January:

$280,000 – $160,000 = ($400 × 300) – $0 $120,000 = $120,000

February:

$260,000 – $260,000 = ($400 × 300) – ($400 × 300) $0 = $0

March:

$860,000 – $960,000 = ($400 × 50) – ($400 × 300) – $100,000 = – $100,000

The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into inventories as inventories increase (as in January) and out of inventories as they decrease (as in March).


9-19

(20–30 min.) Throughput costing (continuation of Exercise 9-18).

1. January Revenuesa Direct material cost of goods sold Beginning inventoryb Direct materials in goods manufacturedc Cost of goods available for sale Deduct ending inventoryd Total direct material cost of goods sold Throughput margin Other costs Manufacturinge Operatingf Total other costs Operating income

February

$1,750,000

$

0

March

$2,000,000

$3,750,000

$150,000

$ 150,000

500,000

400,000

625,000

500,000 (150,000)

550,000 (150,000)

775,000 (25,000)

350,000 1,400,000 800,000 560,000

400,000 1,600,000 720,000 620,000

$

1,360,000 40,000

750,000 3,000,000 900,000 1,040,000

1,340,000 $ 260,000

1,940,000 $1,060,000

a

$2,500 × 700; $2,500 × 800; $2,500 × 1,500 $? × 0; $500 × 300; $500 × 300 c $500 × 1,000; $500 × 800; $500 × 1,250 d $500 × 300; $500 × 300; $500 ×50 e ($400 × 1,000) + $400,000; ($400 × 800) + $400,000; ($400 × 1,250) + $400,000 f ($600 × 700) + $140,000; ($600 × 800) + $140,000; ($600 × 1,500) + $140,000 b

2. Operating income under:

Variable costing Absorption costing Throughput costing

January $160,000 280,000 40,000

February $260,000 260,000 260,000

March $ 960,000 860,000 1,060,000

Throughput costing puts greater emphasis on sales as the source of operating income than does absorption or variable costing. Accordingly, income under throughput costing is highest in periods where the number of units sold is relatively large (as in March) and lower in periods of weaker sales (as in January). 3. Throughput costing puts a penalty on producing without a corresponding sale in the same period. Costs other than direct materials that are variable with respect to production are expensed when incurred, whereas under variable costing they would be capitalized as an inventoriable cost.


9-20

(40 min)

Variable versus absorption costing.

1. Beginning Inventory + 2012 Production = 2012 Sales + Ending Inventory 85,000 units + 2012 Production = 345,400 units + 34,500 units 2012 Production = 294,900 units Income Statement for the Zwatch Company, Variable Costing for the Year Ended December 31, 2012 Revenues: $22 × 345,400 Variable costs Beginning inventory: $5.10 × 85,000 Variable manufacturing costs: $5.10 × 294,900 Cost of goods available for sale Deduct ending inventory: $5.10 × 34,500 Variable cost of goods sold Variable operating costs: $1.10 × 345,400 Adjustment for variances Total variable costs Contribution margin Fixed costs Fixed manufacturing overhead costs Fixed operating costs Total fixed costs Operating income

$7,598,800 $

433,500 1,503,990 1,937,490 (175,950) 1,761,540 379,940 0 2,141,480 5,457,320 1,440,000 1,080,000 2,520,000 $2,937,320


Absorption Costing Data Fixed manufacturing overhead allocation rate = Fixed manufacturing overhead/Denominator level machine-hours = $1,440,000 6,000 = $240 per machine-hour Fixed manufacturing overhead allocation rate per unit = Fixed manufacturing overhead allocation rate/standard production rate = $240 50 = $4.80 per unit Income Statement for the Zwatch Company, Absorption Costing for the Year Ended December 31, 2012 Revenues: $22 × 345,400 Cost of goods sold Beginning inventory ($5.10 + $4.80) × 85,000 Variable manuf. costs: $5.10 × 294,900 Allocated fixed manuf. costs: $4.80 × 294,900 Cost of goods available for sale Deduct ending inventory: ($5.10 + $4.80) × 34,500 Adjust for manuf. variances ($4.80 × 5,100)a Cost of goods sold Gross margin Operating costs Variable operating costs: $1.10 × 345,400 Fixed operating costs Total operating costs Operating income a

$7,598,800 $ 841,500 1,503,990 1,415,520 $3,761,010 (341,550) 24,480 U 3,443,940 4,154,860 $ 379,940 1,080,000 1,459,940 $2,694,920

Production volume variance = [(6,000 hours × 50) – 294,900] × $4.80 = (300,000 – 294,900) × $4.80 = $24,480

2. Zwatch‘s operating margins as a percentage of revenues are Under variable costing: Revenues Operating income Operating income as percentage of revenues

$7,598,800 2,937,320 38.7%

Under absorption costing: Revenues Operating income Operating income as percentage of revenues

$7,598,800 2,694,920 35.5%


3. Operating income using variable costing is about 9% higher than operating income calculated using absorption costing. Variable costing operating income – Absorption costing operating income = $2,937,320 – $2,694,920 = $242,400 Fixed manufacturing costs in beginning inventory under absorption costing – Fixed manufacturing costs in ending inventory under absorption costing = ($4.80 × 85,000) – ($4.80 × 34,500) = $242,400

4.

The factors the CFO should consider include (a) Effect on managerial behavior. (b) Effect on external users of financial statements.

I would recommend absorption costing because it considers all the manufacturing resources (whether variable or fixed) used to produce units of output. Absorption costing has many critics. However, the dysfunctional aspects associated with absorption costing can be reduced by Careful budgeting and inventory planning. Adding a capital charge to reduce the incentives to build up inventory. Monitoring nonfinancial performance measures.


9-21 (10 min.) Absorption and variable costing. The answers are 1(a) and 2(c). Computations: 1. Absorption Costing: Revenuesa Cost of goods sold: Variable manufacturing costsb Allocated fixed manufacturing costsc Gross margin Operating costs: Variable operatingd Fixed operating Operating income

$4,800,000 $2,400,000 360,000

1,200,000 400,000

2,760,000 2,040,000

1,600,000 $ 440,000

a

$40 × 120,000 $20 × 120,000 c Fixed manufacturing rate = $600,000 ÷ 200,000 = $3 per output unit Fixed manufacturing costs = $3 × 120,000 d $10 × 120,000 b

2. Variable Costing: Revenuesa Variable costs: Variable manufacturing cost of goods soldb Variable operating costsc Contribution margin Fixed costs: Fixed manufacturing costs Fixed operating costs Operating income

$4,800,000 $2,400,000 1,200,000

600,000 400,000

3,600,000 1,200,000

1,000,000 $ 200,000

a

$40 × 120,000 $20 × 120,000 c $10 × 120,000 b


9-22

(40 min)

Absorption versus variable costing.

1. The variable manufacturing cost per unit is $30 + $25 + $60 = $115. 2011 Variable-Costing Based Income Statement Revenues (17,500 $425 per unit) Variable costs Beginning inventory Variable manufacturing costs (18,000 units $115 per unit) Cost of goods available for sale Deduct: Ending inventory (500 units $115 per unit) Variable cost of goods sold Variable marketing costs (17,500 units $45 per unit) Total variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed administrative costs Fixed marketing Total fixed costs Operating income

$7,437,500 $

0 2,070,000 2,070,000 (57,500) 2,012,500 787,500 2,800,000 4,637,500 1,100,000 965,450 1,366,400 3,431,850 $1,205,650

2. Fixed manufacturing overhead rate = $1,100,000 / 20,000 units = $55 per unit

2011 Absorption-Costing Based Income Statement Revenues (17,500 units $425 per unit) Cost of goods sold Beginning inventory Variable manufacturing costs (18,000 units $115 per unit) Allocated fixed manufacturing costs (18,000 units $55 per unit) Cost of goods available for sale Deduct ending inventory (500 units ($115 + $55) per unit) Add unfavorable production volume variance Cost of goods sold Gross margin Operating costs Variable marketing costs (17,500 units $45 per unit) Fixed administrative costs Fixed marketing Total operating costs Operating income a

$7,437,500 $

0 2,070,000 990,000 3,060,000 (85,000) 110,000a U 3,085,000 4,352,500 787,500 965,450 1,366,400 3,119,350 $1,233,150

PVV = $1,100,000 budgeted fixed mfg. costs – $990,000 allocated fixed mfg. costs = $110,000 U


3. 2011 operating income under absorption costing is greater than the operating income under variable costing because in 2011 inventories increased by 500 units. As a result, under absorption costing, a portion of the fixed overhead remained in the ending inventory, and led to a lower cost of goods sold (relative to variable costing). As shown below, the difference in the two operating incomes is exactly the same as the difference in the fixed manufacturing costs included in ending vs. beginning inventory (under absorption costing). Operating income under absorption costing Operating income under variable costing Difference in operating income under absorption vs. variable costing Under absorption costing: Fixed mfg. costs in ending inventory (500 units $55 per unit) Fixed mfg. costs in beginning inventory (0 units $55 per unit) Change in fixed mfg. costs between ending and beginning inventory

$1,233,150 1,205,650 $ 27,500

$ $

27,500 0 27,500

4. Relative to the alternative of using contribution margin (from variable costing), the absorption-costing based gross margin has some pros and cons as a performance measure for Grunewald‘s supervisors. It takes into account both variable costs and fixed costs—costs that the supervisors should be able to control in the long-run—and therefore is a more complete measure than contribution margin which ignores fixed costs (and may cause the supervisors to pay less attention to fixed costs). The downside of using absorption-costing-based gross margin is the supervisor‘s temptation to use inventory levels to control the gross margin—in particular, to shore up a sagging gross margin by building up inventories. This can be offset by specifying, or limiting, the inventory build-up that can occur, charging the supervisor a carrying cost for holding inventory, and using nonfinancial performance measures such as the ratio of ending to beginning inventory.


9-23

(20–30 min.) Comparison of actual-costing methods.

The numbers are simplified to ease computations. This problem avoids standard costing and its complications. 1.

Variable-costing income statements: 2011 Sales 1,000 units Production 1,400 units $3,000

Revenues ($3 per unit) Variable costs: Beginning inventory Variable cost of goods manufactured Cost of goods available for sale Deduct ending inventorya Variable cost of goods sold Variable operating costs Variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed operating costs Total fixed costs Operating income a

$

0 700 700 (200) 500 1,000

2012 Sales 1,200 units Production 1,000 units $3,600 $

200 500 700 (100) 600 1,200

1,500 1,500

1,800 1,800

700 400

700 400 $

1,100 400

1,100 $ 700

Unit inventoriable costs: Year 1: $700 ÷ 1,400 = $0.50 per unit; $0.50 × (1,400 – 1,000) Year 2: $500 ÷ 1,000 = $0.50 per unit; $0.50 × (400 + 1,000 – 1,200)

2. Absorption-costing income statements:

Revenues ($3 per unit) Cost of goods sold: Beginning inventory Variable manufacturing costs Fixed manufacturing costsa Cost of goods available for sale Deduct ending inventoryb Cost of goods sold Gross margin Operating costs: Variable operating costs Fixed operating costs Total operating costs Operating income

2011 Sales 1,000 units Production 1,400 units $3,000 $

0 700 700 1,400 (400)

2012 Sales 1,200 units Production 1,000 units $3,600 $ 400 500 700 1,600 (240)

1,000 2,000 1,000 400

1,360 2,240 1,200 400

1,400 $ 600

1,600 $ 640

a

Fixed manufacturing cost rate: Year 1: $700 ÷ 1,400 = $0.50 per unit Year 2: $700 ÷ 1,000 = $0.70 per unit b Unit inventoriable costs: Year 1: $1,400 ÷ 1,400 = $1.00 per unit; $1.00 × (1400 – 1000) Year 2: $1,200 ÷ 1,000 = $1.20 per unit; $1.20 × (400 + 1,000 – 1,200)


3. Variable Costing: Operating income Ending inventory Absorption Costing: Operating income Ending inventory Fixed manuf. overhead • in beginning inventory • in ending inventory

Absorption costing operating income


Year 1: $600 – $400 $200 Year 2: $640 – $700 –$60

2011

2012

$400 200

$700 100

$600 400

$640 240

0 200

200 140

Fixed manuf. costs in ending inventory = = = =

Fixed manuf. costs in beginning inventory

$0.50 × 400 – $0 $200 ($0.70 × 200) – ($0.50 × 400) –$60

The difference in reported operating income is due to the amount of fixed manufacturing overhead in the beginning and ending inventories. In Year 1, absorption costing has a higher operating income of $200 due to ending inventory having $200 in fixed manufacturing overhead, while beginning inventory does not exist. In Year 2, variable costing has a higher operating income of $60 due to ending inventory under absorption costing having $60 less in fixed manufacturing overhead than does beginning inventory. 4.

a. Absorption costing is more likely to lead to inventory build-ups than variable costing. Under absorption costing, operating income in a given accounting period is increased by inventory buildup, because some fixed manufacturing costs are accounted for as an asset (inventory) instead of as a cost of the period of production. b. Although variable costing will counteract undesirable inventory build-ups, other measures can be used without abandoning absorption costing. Examples include: (1) careful budgeting and inventory planning; (2) incorporating a carrying charge for inventory; (3) changing the period used to evaluate performance to be long-term; (4) including nonfinancial variables that measure inventory levels in performance evaluations.


9-24

(40 min.) Variable and absorption costing, sales, and operating-income changes.

1. Helmetsmart‘s annual fixed manufacturing costs are $1,078,000. It allocates $22 of fixed manufacturing costs to each unit produced. Therefore, it must be using $1,078,000 $22 = 49,000 units (annually) as the denominator level to allocate fixed manufacturing costs to the units produced. We can see from Helmetsmart‘s income statements that it disposes of any production volume variance against cost of goods sold. In 2012, 58,800 units were produced instead of the budgeted 49,000 units. This resulted in a favorable production volume variance of $215,600 F ((58,800 – 49,000) units $22 per unit), which, when written off against cost of goods sold, increased gross margin by that amount. 2.

The breakeven calculation, same for each year, is shown below: Calculation of breakeven volume Selling price ($1,960,000 49,000; $1,960,000 49,000; $2,352,000 58,800) Variable cost per unit (all manufacturing) Contribution margin per unit Total fixed costs (fixed mfg. costs + fixed selling & admin. costs) Breakeven quantity = Total fixed costs contribution margin per unit

2011 $ $

2012 40 $ 14 26 $

2013 40 $ 14 26 $

40 14 26

$1,274,000 $1,274,000 $1,274,000 49,000

49,000

49,000

3. Variable Costing Sales (units) Revenues Variable cost of goods sold Beginning inventory $14 0; 0; 9,800 Variable manuf. costs $14 49,000; 58,800; 49,000 Deduct ending inventory $14 0; 9,800; 0 Variable cost of goods sold Contribution margin Fixed manufacturing costs Fixed selling and administrative expenses Operating income Explaining variable costing operating income Contribution margin ($26 contribution margin per unit sales units) Total fixed costs Operating income

2011 2012 2013 49,000 49,000 58,800 $1,960,000 $1,960,000 $2,352,000 0 0 137,200 686,000 823,200 686,000 0 (137,200) 0 686,000 686,000 823,200 $1,274,000 $1,274,000 $1,528,800 $1,078,000 $1,078,000 $1,078,000 196,000 196,000 196,000 $ 0 $ 0 $ 254,800

$1,274,000 $1,274,000 $1,528,800 1,274,000 1,274,000 1,274,000 $ 0 $ 0 $ 254,800


4. Reconciliation of absorption/variable costing operating incomes (1) Absorption costing operating income (2) Variable costing operating income (3) Difference in operating incomes = (1) – (2)

2011 $0 0 $0

2012 $215,600 0 $215,600

(4) Fixed mfg. costs in ending inventory under absorption costing (ending inventory in units $22 per unit)

$0

$215,600

(5) Fixed mfg. costs in beginning inventory under absorption costing (beginning inventory in units $22 per unit) (6) Difference = (4) – (5)

0 $0

0 $215,600

2013 $ 39,200 254,800 $(215,600) $

0 215,600 $(215,600)

In the table above, row (3) shows the difference between the operating income under absorption costing and the operating income under variable costing, for each of the three years. In 2011, the difference is $0; in 2012, absorption costing income is greater by $215,600; and in 2013, it is less by $215,600. Row (6) above shows the difference between the fixed costs in ending inventory and the fixed costs in beginning inventory under absorption costing; this figure is $0 in 2011, $215,600 in 2012 and –$215,600 in 2013. Row (3) and row (6) explain and reconcile the operating income differences between absorption costing and variable costing. Stuart Weil is surprised at the non-zero, positive net income (reported under absorption costing) in 2012, when sales were at the ‗breakeven volume‘ of 49,000; further, he is concerned about the drop in operating income in 2013, when, in fact, sales increased to 58,800 units. In 2012, starting with zero inventories, 58,800 units were produced and 49,000 were sold, i.e., at the end of the year, 9,800 units remained in inventory. These 9,800 units had each absorbed $22 of fixed costs (total of $215,600), which would remain as assets on Helmetsmart‘s balance sheet until they were sold. Cost of goods sold, representing only the costs of the 49,000 units sold in 2012, was accordingly reduced by $215,600, the production volume variance, resulting in a positive operating income even though sales were at breakeven levels. The following year, in 2013, production was 49,000 units, sales were 58,800 units i.e., all of the fixed costs that were included in 2012 ending inventory, flowed through COGS in 2013. Contribution margin in 2013 was $1,528,800 (58,800 units $26), but, in absorption costing, COGS also contains the allocated fixed manufacturing costs of the units sold, which were $1,293,600 (58,800 units $22), resulting in an operating income of $39,200 = 1,528,800 – $1,293,600 – $196,000 (fixed sales and admin.) Hence the drop in operating income under absorption costing, even though sales were greater than the computed breakeven volume: inventory levels decreased sufficiently in 2013 to cause 2013‘s operating income to be lower than 2012 operating income. Note that beginning and ending with zero inventories during the 2011-2013 period, under both costing methods, Helmetsmart‘s total operating income was $254,800.


9-25

(10 min.) Capacity management, denominator-level capacity concepts. 1. a, b 2. a 3. d 4. c, d 5. c 6. d 7. a 8. b (or a) 9. b 10. c, d 11. a, b

9-26

(20 min.) Denominator-level problem.

1.

Budgeted fixed manufacturing overhead costs rates:

Denominator Level Capacity Concept Theoretical Practical Normal Master-budget

Budgeted Fixed Manufacturing Overhead per Period $ 6,480,000 6,480,000 6,480,000 6,480,000

Budgeted Capacity Level 5,400 3,840 3,240 3,600

Budgeted Fixed Manufacturing Overhead Cost Rate $ 1,200.00 1687.50 2,000.00 1,800.00

The rates are different because of varying denominator-level concepts. Theoretical and practical capacity levels are driven by supply-side concepts, i.e., ―how much can I produce?‖ Normal and master-budget capacity levels are driven by demand-side concepts, i.e., ―how much can I sell?‖ (or ―how much should I produce?‖) The variances that arise from use of the theoretical or practical level concepts will signal that there is a divergence between the supply of capacity and the demand for capacity. This is useful input to managers. As a general rule, however, it is important not to place undue reliance on the production volume variance as a measure of the economic costs of unused capacity. 2.

3. Under a cost-based pricing system, the choice of a master-budget level denominator will lead to high prices when demand is low (more fixed costs allocated to the individual product level), further eroding demand; conversely, it will lead to low prices when demand is high, forgoing profits. This has been referred to as the downward demand spiral—the continuing reduction in demand that occurs when the prices of competitors are not met and demand drops, resulting in even higher unit costs and even more reluctance to meet the prices of competitors. The positive aspects of the master-budget denominator level are that it is based on demand for the product and indicates the price at which all costs per unit would be recovered to enable the company to make a profit. Master-budget denominator level is also a good benchmark against which to evaluate performance.


9-27

(60 min.) Variable and absorption costing and breakeven points

1. 2011 Variable-Costing Based Operating Income Statement Revenues (995 boards $750 per board) Variable costs Beginning inventory (240 boards $335 per board) Variable manufacturing costs (900 boards $335 per board) Cost of goods available for sale Deduct: Ending inventory (145 boards $335 per board) Variable cost of goods sold Variable shipping costs (995 boards $15 per board) Total variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed selling and administrative

$746,250 $ 80,400 301,500 381,900 (48,575) 333,325 14,925 348,250 398,000 280,000 112,000

Total fixed costs Operating income

$

392,000 6,000

2. 2011 Absorption-Costing Based Operating Income Statement Revenues (995 boards $750 per board) Cost of goods sold Beginning inventory (240 boards $615a per board) Variable manufacturing costs (900 boards $335 per board) Allocated fixed manufacturing costs (900 boards $280 per board) Cost of goods available for sale Deduct ending inventory (145 boards $615 per board) Cost of goods sold at standard cost Production-volume variance [$280 Gross margin Operating costs Variable shipping costs (995 boards Fixed selling and administrative

(1,000 – 900)]

$15 per board)

$746,250 $147,600 301,500 252,000 701,100 (89,175) 611,925 28,000 U

639,925 106,325

14,925 112,000

Total operating costs Operating income

126,925 $ (20,600)

a

Fixed manufacturing cost per unit = Fixed manufacturing cost/denominator level of production = $280,000/1,000 snowboards = $280 per snowboard $280 fixed manufacturing cost + $335 variable manufacturing cost = $615 per board


3.

Breakeven point in units: a. Variable Costing: Q

=

Total Fixed Costs Target Operating Income Contribution Margin Per Unit

Q

=

($280 ,000 $112 ,000 ) $0 $750 ($335 $15)

Q

=

$392,000 $400

Q

= 980 snowboards

b. Absorption costing: Fixed manufacturing cost rate = $280,000 ÷ 1,000 = $280 per snowboard

Q

Total Target fixed operating costs income

Q

Fixed manufacturing cost rate

Breakeven Units sales produced in units

Contribution margin per unit

=

($280,000

$112,000 ) $0 $400

$280 (Q 900 )

$400Q = $392,000 + $280Q – $252,000 $400Q

$280Q = $392,000 – $252,000

$120Q = $140,000 Q = 1,167 snowboards


4.

Proof of breakeven point:

a. Variable Costing: Revenues, $750 980 units Variable costs, $350 980 Contribution margin, $400 980 Fixed costs Operating income

$

$735,000 343,000 392,000 392,000 0

b. Absorption costing: Revenues, $750 1,167 units Cost of goods sold: Cost of goods at standard cost, $615 1,167 units Production-volume variance, $280 (1,000 – 900) Gross margin Variable shipping costs, $15 1,167 units Fixed selling and administrative costs Operating income

$875,250 $717,705 28,000 U

745,705 129,545

17,505 112,000 $

129,505 40*

*This is not zero due to rounding to 1,167 whole units sold.

5. If $20,000 of fixed administrative costs were reclassified as production costs, there would be no change in breakeven sales using variable costing. This is because all fixed costs, regardless of whether they are for production or administrative activities, are treated the same way in a variable costing system. However, this is not true for absorption costing. The change in classification would impact the fixed manufacturing overhead rate that is applied to units of production. If sales and production are unequal, the additional fixed overhead would either increase or decrease breakeven sales.

6. The additional $25 per unit variable production cost will cause unit contribution margin to decrease from $400 to $375. This decrease will cause the breakeven point to increase. In the case of variable costing: Q = $392,000 ÷ $375 Q = 1,045 units (rounded) In the case of absorption costing: $375Q = $392,000 + $280Q – $252,000 $375Q – $280Q = $392,000 – $252,000 $95Q = $140,000 Q = 1,474 units (rounded)


9-28 1.

(40 min.) Variable costing versus absorption costing. Absorption Costing: Mavis Company Income Statement For the Year Ended December 31, 2012 Revenues (540,000 × $5.00) Cost of goods sold: Beginning inventory (30,000 × $3.70a) Variable manufacturing costs (550,000 × $3.00) Allocated fixed manufacturing costs (550,000 × $0.70) Cost of goods available for sale Deduct ending inventory (40,000 × $3.70) Add adjustment for prod.-vol. variance (50,000b × $0.70) Cost of goods sold Gross margin Operating costs: Variable operating costs (540,000 × $1) Fixed operating costs Total operating costs Operating income

$2,700,000 $ 111,000 1,650,000 385,000 2,146,000 (148,000) 35,000 U 2,033,000 667,000 540,000 120,000 660,000 $ 7,000

a $3.00 + ($7.00 ÷ 10) = $3.00 + $0.70 = $3.70 b [(10 units per mach. hr. × 60,000 mach. hrs.) – 550,000 units)] = 50,000 units unfavorable

2.

Variable Costing: Mavis Company Income Statement For the Year Ended December 31, 2012 Revenues Variable cost of goods sold: Beginning inventory (30,000 × $3.00) Variable manufacturing costs (550,000 × $3.00) Cost of goods available for sale Deduct ending inventory (40,000 × $3.00) Variable cost of goods sold Variable operating costs Contribution margin Fixed costs: Fixed manufacturing overhead costs Fixed operating costs Total fixed costs Operating income

$2,700,000 $

90,000 1,650,000 1,740,000 (120,000) 1,620,000 540,000 540,000 420,000 120,000 $

540,000 0


3.

The difference in operating income between the two costing methods is:



$7,000 – $0 $7,000 $7,000

Fixed manuf. costs in ending inventory


= [(40,000 × $0.70) – (30,000 × $0.70)] = $28,000 – $21,000 = $7,000

The absorption-costing operating income exceeds the variable costing figure by $7,000 because of the increase of $7,000 during 2012 of the amount of fixed manufacturing costs in ending inventory vis-à-vis beginning inventory. 4. Total fixed manufacturing costs

Actual and budget line $420,000 $385,000

Unfavorable production-volume variance

productionvolume variance } Favorable

{

55,000

Allocated line @ $7.00

60,000

Machine-hours

5. Absorption costing is more likely to lead to buildups of inventory than does variable costing. Absorption costing enables managers to increase reported operating income by building up inventory which reduces the amount of fixed manufacturing overhead included in the current period‘s cost of goods sold. Ways to reduce this incentive include (a) Careful budgeting and inventory planning. (b) Change the accounting system to variable costing or throughput costing. (c) Incorporate a carrying charge for carrying inventory. (d) Use a longer time period to evaluate performance than a quarter or a year. (e) Include nonfinancial as well as financial measures when evaluating management performance.


9-29

(40 min.) Variable costing and absorption costing, the All-Fixed Company.

This problem always generates active classroom discussion. 1. The treatment of fixed manufacturing overhead in absorption costing is affected primarily by what denominator level is selected as a base for allocating fixed manufacturing costs to units produced. In this case, is 20,000 tons per year, 40,000 tons, or some other denominator level the most appropriate base? We usually place the following possibilities on the board or overhead projector and then ask the students to indicate by vote how many used one denominator level versus another. Incidentally, discussion tends to move more clearly if variable-costing income statements are discussed first, because there is little disagreement as to computations under variable costing. a.

Variable-Costing Income Statement: Revenues (and contribution margin) Fixed costs: Manufacturing costs Operating costs Operating income

b.

$320,000 60,000

2010 $400,000

2011 $400,000

Together $800,000

380,000 $ 20,000

380,000 $ 20,000

760,000 $ 40,000

Absorption-Costing Income Statement:

The ambiguity about the 20,000- or 40,000-unit denominator level is intentional. IF YOU WISH, THE AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS A SPECIFIC DENOMINATOR LEVEL IN ADVANCE. Alternative 1. Use 40,000 units as a denominator; fixed manufacturing overhead per unit is $320,000 40,000 = $8. 2010 2011 Together Revenues $400,000 $ 400,000 $800,000 Cost of goods sold Beginning inventory 0 160,000* 0 Allocated fixed manufacturing costs at $8 320,000 — 320,000 Deduct ending inventory (160,000) — — Adjustment for production-volume variance 0 320,000 U 320,000 U Cost of goods sold 160,000 480,000 640,000 Gross margin 240,000 (80,000) 160,000 Operating costs 60,000 60,000 120,000 Operating income $180,000 $(140,000) $ 40,000 *

Inventory carried forward from 2010 and sold in 2011.


Alternative 2. Use 20,000 units as a denominator; fixed manufacturing overhead per unit is $320,000 20,000 = $16.

Revenues Cost of goods sold Beginning inventory Allocated fixed manufacturing costs at $16 Deduct ending inventory Adjustment for production-volume variance Cost of goods sold Gross margin Operating costs Operating income

2010 $400,000

2011 $400,000

Together $800,000

0 640,000 (320,000) (320,000) F 0 400,000 60,000 $340,000

320,000* — — 320,000 U 640,000 (240,000) 60,000 $(300,000)

0 640,000 — 0 640,000 160,000 120,000 $ 40,000

*

Inventory carried forward from 2010 and sold in 2011.

Note that operating income under variable costing follows sales and is not affected by inventory changes. Note also that students will understand the variable-costing presentation much more easily than the alternatives presented under absorption costing.

2.

Breakeven point Fixed costs under variable = Contribution margin per ton costing

$380,000 $20

= 19,000 tons per year or 38,000 for two years. Most students will say that the breakeven point is 19,000 tons per year under both absorption costing and variable costing. The logical question to ask a student who answers 19,000 tons for variable costing is: ―What operating income do you show for 2011 under absorption costing?‖ If a student answers $(140,000) (alternative 1 above), or $(300,000) (alternative 2 above), ask: ―But you say your breakeven point is 19,000 tons. How can you show an operating loss on 20,000 tons sold during 2011?‖ The answer to the above dilemma lies in the fact that operating income is affected by both sales and production under absorption costing. Given that sales would be 20,000 tons in 2010, solve for the production level that will provide a breakeven level of zero operating income. Using the formula in the chapter, sales of 20,000 units, and a fixed manufacturing overhead rate of $8 (based on $320,000 ÷ 40,000 units denominator level = $8):


Let P = Production level Total Target fixed + operating + costs income

Breakeven = sales in units

Breakeven sales in units

Units produced

Unit contributin margin

$0 $8(20‚000 P) $20 = $380,000 + $160,000 – $8P = $140,000 = 17,500 units

20,000 tons = $400,000 $8P P

Fixed manuf. overhead rate

$380‚000

Proof: Gross margin, 20,000 × ($20 – $8) Production-volume variance, (40,000 – 17,500) × $8 Marketing and administrative costs Operating income

$240,000 $180,000 60,000

240,000 0

$

Given that production would be 40,000 tons in 2010, solve for the breakeven unit sales level. Using the formula in the chapter and a fixed manufacturing overhead rate of $8 (based on a denominator level of 40,000 units): Let N = Breakeven sales in units

N =

Total Target fixed + operating + costs income

Fixed manuf. overhead rate

N

Unit contributin margin

$380‚000

$0 $8( N 40,000 ) $20 $20N = $380,000 + $8N – $320,000 $12N = $60,000 N = 5,000 Proof: Gross margin, 5,000 × ($20 – $8) Production-volume variance Marketing and administrative costs Operating income N

Units produced

=

$60,000 $

0 60,000

60,000 0

$

We find it helpful to put the following comparisons on the board: Variable costing breakeven

= f(sales) = 19,000 tons 9-29


Absorption costing breakeven

= f(sales and production) = f(20,000 and 17,500) = f(5,000 and 40,000)

3. Absorption costing inventory cost: Either $160,000 (using 40,000 denominator level) or $320,000 (using 20,000 denominator level) at the end of 2010 and zero at the end of 2011. Variable costing: Zero at all times. This is a major criticism of variable costing and focuses on the issue of the definition of an asset. 4. Operating income is affected by both production and sales under absorption costing. Hence, most managers would prefer absorption costing because their performance in any given reporting period, at least in the short run, is influenced by how much production is scheduled near the end of a period.


9-30 (30–35 min.)

Comparison of variable costing and absorption costing.

1. Since production volume variance is unfavorable, the budgeted fixed manufacturing overhead must be larger than the fixed manufacturing overhead allocated. Budgeted fixed Production-volume = Fixed manufacturing manufacturing overhead – overhead allocated variance

$400,000

= $1,200,000 – Allocated

Allocated = $800,000, which is 67% of $1,200,000 If 67% of the budgeted fixed costs were allocated, the plant must have been operating at 67% of denominator level in 2012. 2. The problem provides the beginning and ending inventory balances under both, variable and absorption costing. Under variable costing, all fixed costs are written off as period costs, i.e., they are not inventoried. Under absorption costing, inventories include variable and fixed costs. Therefore the difference between inventory under absorption costing and inventory under variable costing is the amount of fixed costs included in the inventory.

Absorption Costing Inventories: December 31, 2011 December 31, 2012

Variable Costing

$1,720,000 206,000

Fixed Manuf. Overhead in Inventory

$1,200,000 66,000

$520,000 140,000

3. Note that the answer to (3) is independent of (1). The difference in operating income of $380,000 ($1,520,000 – $1,140,000) is explained by the release of $380,000 of fixed manufacturing costs when the inventories were decreased during 2012:

Absorption Costing Inventories: December 31, 2011 December 31, 2012 Release of fixed manuf. costs

$1,720,000 206,000

Variable Costing $1,200,000 66,000

Fixed Manuf. Overhead in Inventory $520,000 140,000 $380,000

The above schedule in this requirement is a formal presentation of the equation:



Fixed manuf. costs in ending inventory


($1,140,000 – $1,520,000) = ($140,000 – $520,000) – $380,000 = – $380,000 Alternatively, the presence of fixed manufacturing overhead costs in each income statement can be analyzed: 9-31 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Absorption costing, Fixed manuf. costs in cost of goods sold ($5,860,000 − $4,680,000) Production-volume variance Variable costing, fixed manuf. costs charged to expense Difference in operating income explained

$1,180,000 400,000 1,580,000 (1,200,000) $ 380,000

4. Under absorption costing, operating income is a function of both sales and production (i.e., change in inventory levels). During 2012, Hinkle experienced a severe decline in inventory levels: sales were probably higher than anticipated, production was probably lower than planned (at 67% of denominator level), resulting in much of the 2012 beginning inventory passing through cost of goods sold in 2012. This means that under absorption costing, large amounts of inventoried fixed costs have flowed through 2012 cost of goods sold, resulting in a smaller operating income than in 2011, despite an increase in sales volume. 9-31 (30 min.) Effects of differing production levels on absorption costing income: Metrics to minimize inventory buildups. 1.

Revenues Cost of goods sold Production volume --*variance Net cost of goods sold Gross Margin

20,000 books $1,600,000 1,400,000a 0b

24,000 books $1,600,000 1,400,000 (80,000)c

1,400,000 $ 200,000

30,000 Books $1,600,000 1,400,000 (200,000)d

1,320,000 $ 280,000

1,200,000 $ 400,000

a

cost per unit = ($50 + $400,000/20,000 books sold) = $70 per book CGS = $70 20,000 = $1,400,000 b volume variance = Budgeted fixed cost – fixed overhead rate production $400,000 – ($20 20,000 books) = $0 c volume variance = Budgeted fixed cost – fixed overhead rate production $400,000 – ($20 24,000 books) = $80,000 d volume variance = Budgeted fixed cost – fixed overhead rate production $400,000 – ($20 30,000 books) = $200,000


2.

Beginning inventory + Production - Books sold Ending inventory Cost per book Cost of Ending Inventory

20,000 Books 0 20,000 books 20,000 20,000 0 books × $70 $0

24,000 books 0 24,000 books 24,000 20,000 4,000 books × $70 $280,000

30,000 books 0 30,000 books 30,000 20,000 10,000 books × $70 $700,000

3a.

Gross margin Less 10% Ending inventory Adjusted gross margin

20,000 books $200,000 0 $200,000

24,000 books $280,000 (28,000) $252,000

30,000 books $400,000 (70,000) $330,000

While adjusting for ending inventory does to some degree mitigate the increase in inventory associated with excess production, it may be difficult to mechanically compensate for all of the increased income. In addition, it does nothing to hold the manager responsible for the poor decisions from the organization‘s standpoint. 3b. 20,000 books 1) Inventory change: End inventory ─ begin inventory 2) Excess production (%) Production ÷ sales

0

24,000 Books 4,000 books

20,000 ÷ 20,000 1.0

24,000 ÷ 20,000 1.2

30,000 books 10,000 books

30,000 ÷20,000 1.5

A ratio of ending inventory to beginning inventory, as suggested in the book, is not possible since beginning inventory was 0, so we substituted change in inventory level. For these non-financial measures to be useful they must be incorporated into the reward function of the manager.


9-32 (25–30 min.) Alternative denominator-level capacity concepts, effect on operating income.

1. Denominator-Level Capacity Concept Theoretical capacity Practical capacity Normal capacity utilization Master-budget utilization (a) January-June 2012 (b) July-December 2012

Budgeted Fixed Manuf. Overhead per Period (1) $28,000,000 28,000,000 28,000,000 14,000,000 14,000,000

Days of Hours of Production Production per Period per Day (2) (3) 360 24 350 20 350 20 175 175

Barrels per Hour (4) 540 500 400

Budgeted Denominator Level (Barrels) (5) = (2) (3) (4) 4,665,600 3,500,000 2,800,000

Budgeted Fixed Manufacturing Overhead Rate per Barrel (6) = (1) (5) $ 6.00 8.00 10.00

320 480

1,120,000 1,680,000

12.50 8.33

20 20

The differences arise for several reasons: a. The theoretical and practical capacity concepts emphasize supply factors and are consequently higher, while normal capacity utilization and master-budget utilization emphasize demand factors. b. The two separate six-month rates for the master-budget utilization concept differ because of seasonal differences in budgeted production. 2.

Using column (6) from above,

Denominator-Level Capacity Concept Theoretical capacity Practical capacity Normal capacity utilization a

Per Barrel Budgeted Budgeted Fixed Mfg. Variable Overhead Mfg. Rate per Barrel Cost Rate (6) (7) $6.00 $30.20a 8.00 30.20 10.00 30.20

Budgeted Total Mfg Cost Rate (8) = (6) + (7) $36.20 38.20 40.20

Fixed Mfg. Overhead Costs Allocated (9) = 2,600,000 (6) $15,600,000 20,800,000 26,000,000

Fixed Mfg. Overhead Variance (10) = $27,088,000 – (9) $11,488,000 U 6,288,000 U 1,088,000 U

$78,520,000 2,600,000 barrels


Absorption-Costing Income Statement

Revenues (2,400,000 bbls. $45 per bbl.) Cost of goods sold Beginning inventory Variable mfg. costs Fixed mfg. overhead costs allocated (2,600,000 units $6.00; $8.00; $10.00 per unit) Cost of goods available for sale Deduct ending inventory (200,000 units $36.20; $38.20; $40.20 per unit) Adjustment for variances (add: all unfavorable) Cost of goods sold Gross margin Other costs Operating income

Theoretical Capacity $108,000,000

Practical Capacity $108,000,000

Normal Capacity Utilization $108,000,000

0 78,520,000

0 78,520,000

0 78,520,000

15,600,000

20,800,000

26,000,000

94,120,000

99,320,000

104,520,000

(7,240,000) (7,640,000) 11,488,000U 6,288,000U 98,368,000 97,968,000 9,632,000 10,032,000 0 0 $ 9,632,000 $ 10,032,000

(8,040,000) 1,088,000U 97,568,000 10,432,000 0 $ 10,432,000


9-33

(20 min.)

Motivational considerations in denominator-level capacity selection (continuation of 9-32).

1. If the plant manager gets a bonus based on operating income, he/she will prefer the denominator-level capacity to be based on normal capacity utilization (or master-budget utilization). In times of rising inventories, as in 2012, this denominator level will maximize the fixed overhead trapped in ending inventories and will minimize COGS and maximize operating income. Of course, the plant manager cannot always hope to increase inventories every period, but on the whole, he/she would still prefer to use normal capacity utilization because the smaller the denominator, the higher the amount of overhead costs capitalized for inventory units. Thus, if the plant manager wishes to be able to ―adjust‖ plant operating income by building inventory, normal capacity utilization (or master-budget capacity utilization) would be preferred. 2. Given the data in this question, the theoretical capacity concept reports the lowest operating income and thus (other things being equal) the lowest tax bill for 2012. Lucky Lager benefits by having deductions as early as possible. The theoretical capacity denominator-level concept maximizes the deductions for manufacturing costs. 3.

The IRS may restrict the flexibility of a company in several ways: a. Restrict the denominator-level concept choice (to say, practical capacity). b. Restrict the cost line items that can be expensed rather than inventoried. c. Restrict the ability of a company to use shorter write-off periods or more accelerated write-off periods for inventoriable costs. d. Require proration or allocation of variances to represent actual costs and actual capacity used.


9-34

(25 min.) Denominator-level choices, changes in inventory levels, effect on operating income.

1.

Denominator level in units Budgeted fixed manuf. costs Budgeted fixed manuf. cost allocated per unit Production in units Allocated fixed manuf. costs (production in units budgeted fixed manuf. cost allocated per unit) Production volume variance (Budgeted fixed manuf. costs – allocated fixed manuf. costs)a a

Theoretical Capacity 280,000 $2,800,000 $ 10.00 220,000

Practical Capacity 224,000 $2,800,000 $ 12.50 220,000

Normal Capacity Utilization 200,000 $2,800,000 $ 14.00 220,000

$2,200,000

$2,750,000

$3,080,000

$ 600,000 U

$

$ 280,000 F

50,000 U

PVV is unfavorable if budgeted fixed manuf. costs are greater than allocated fixed costs

2.

Units sold Budgeted fixed mfg. cost allocated per unit Budgeted var. mfg. cost per unit Budgeted cost per unit of inventory or production ABSORPTION-COSTING BASED INCOME STATEMENTS Revenues ($40 selling price per unit units sold) Cost of goods sold Beginning inventory (20,000 units budgeted cost per unit of inventory) Variable manufacturing costs (220,000 units $5 per unit) Allocated fixed manufacturing overhead (220,000 units budgeted fixed mfg. cost allocated per unit) Cost of goods available for sale Deduct ending inventory (10,000b units budgeted cost per unit of inventory) Adjustment for production-volume variance Total cost of goods sold Gross margin Operating costs Operating income b

Theoretical Capacity 230,000 $10.00 $ 5.00 $15.00

Practical Capacity 230,000 $12.50 $ 5.00 $17.50

Normal Capacity Utilization 230,000 $14.00 $ 5.00 $19.00

$9,200,000

$9,200,000

$9,200,000

300,000

350,000

380,000

1,100,000

1,100,000

1,100,000

2,200,000 3,600,000

2,750,000 4,200,000

3,080,000 4,560,000

(150,000)

(175,000)

600,000 U 4,050,000 5,150,000 900,000 $4,250,000

50,000 U 4,075,000 5,125,000 900,000 $4,225,000

(190,000) (280,000) F 4,090,000 5,110,000 900,000 $4,210,000

Ending inventory = Beginning inventory + production – sales = 20,000 + 220,000 – 230,000 = 10,000 units 10,000 $15.00; 10,000 $17.50; 10,000 $19.00


3. Koshu‘s 2011 beginning inventory was 20,000 units; its ending inventory was 10,000 units. So, during 2011, there was a drop of 10,000 units in inventory levels (matching the 10,000 more units sold than produced). The smaller the denominator level, the larger is the budgeted fixed cost allocated to each unit of production, and, when those units are sold (all the current production is sold, and then some), the larger is the cost of each unit sold, and the smaller is the operating income. Normal capacity utilization is the smallest capacity of the three, hence in this year, when production was less than sales, the absorption-costing based operating income is the smallest when normal capacity utilization is used as the denominator level. 4. Reconciliation Theoretical Capacity Operating Income – Practical Capacity Operating Income Decrease in inventory level during 2011 10,000 Fixed mfg cost allocated per unit under practical capacity – fixed mfg. cost allocated per unit under theoretical capacity ($12.50 – $10) $2.50 Additional allocated fixed cost included in COGS under practical capacity = 10,000 units $2.50 per unit =

$25,000

$25,000

More fixed manufacturing costs are included in inventory under practical capacity, so, when inventory level decreases (as it did in 2011), more fixed manufacturing costs are included in COGS under practical capacity than under theoretical capacity, resulting in a lower operating income.


9-35

(30-35 min.) Effects of denominator-level choice.

1.

Normal capacity utilization. Givens denoted*



Allocated: Budgeted Input Allowed for Actual Costs Actual Output Incurred × Budgeted Rate (1) (4) 37,680 hrs.* × $2.50a $90,600 $96,600* $96,600* = $94,200 $6,000 F* $2,400 U* Spending variance Never a variance Prodn. volume variance Production volume = variance

Budgeted Fixed overhead allocated fixed – using budgeted input allowed for actual output achieved overhead $2,400 X

= ($96,600 – X) = $94,200

a Budgeted fixed manufacturing,overhead rate per unit

= $94,200 ÷

37,680 machine-hours = $2.50 per machine-hour Denominator level

= $96,600 ÷ $2.50 per machine-hour = 38,640 machine-hours


2.

Practical capacity. Givens denoted*

Same Lump Sum (as in Static Budget) Regardless of Budgeted Output Level (2)

Flexible Budget: Same Lump Sum (as in Static Budget) Regardless of Budgeted Output Level (3)

Allocated: Budgeted Input Allowed for Actual Costs Actual Output Incurred × Budgeted Rate (1) (4) 37,680* × $2.24a $90,600 $96,600* $96,600* = $84,400 $6,000 F* $12,200 U* Spending variance Never a variance Prodn. volume variance Production volume = variance

Budgeted Fixed overhead allocated fixed – using budgeted input allowed for actual output achieved overhead

$12,200

= ($96,600 – X) X = $84,400

a Budgeted manufacturing,overhead rate per unit = $84,400 ÷ 37,680 machine-hours = $2.24 per machine-hour Denominator level = $96,600 ÷ $2.24 per machine-hour = 43,125 machine-hours 3. To maximize operating income, the executive vice president would favor using normal capacity utilization rather than practical capacity. Why? Because normal capacity utilization is a smaller base than practical capacity, resulting in any year-end inventory having a higher unit cost. Thus, less fixed manufacturing overhead would become a 2011 expense as part of the production-volume variance if normal capacity utilization were used as the denominator level.


9-36

(20 min.)

Downward demand spiral.

1. Fixed manufacturing overhead rate = $700,000/25,000 units = $28 per unit Manufacturing cost per unit: $24 direct materials + $36 direct mfg. labor + $12 var. mfg. OH + $28 fixed mfg. OH = $100 Selling price: $100 × 120% = $120.00 2. Fixed manufacturing overhead rate = $700,000/20,000 units = $35 per unit Manufacturing cost per unit: $24 direct materials + $36 direct mfg. labor + $12 var. mfg. OH + $35 fixed mfg. OH = $107 Selling price: $107 × 120% = $128.40 By using budgeted units produced, and not practical capacity, as the denominator level, Spirelli is burdening its products with the cost of unused capacity. Apparently, the competitor has not done this, and because of its higher selling price, Spirelli‘s sales decline. Consequently, 2012 budgeted quantities are even lower, which increases the unit cost and selling price. This phenomenon is known as the downward demand spiral, and it causes Spirelli to continually inflate its selling price, which in turn leads to progressively lower sales. 3. Fixed manufacturing overhead rate = $700,000/50,000 units = $14 per unit Manufacturing cost per unit: $24 direct materials + $36 direct mfg. labor + $12 var. mfg. OH + $14 fixed mfg. OH = $86 Selling price: $86 × 120% = $103.20 If Spirelli had used practical capacity as its denominator level of activity, its initial selling price of $103.20 would have been lower than the $105.00 selling price of Spirelli‘s competitor, and it would likely have resulted in higher sales. Using practical capacity will result in a higher unfavorable production-volume variance, which will most likely be written off to cost of goods sold and reduce operating income. However, as sales and production increase in future years and the company ―grows into‖ its capacity, the amount of unused capacity will be lower, resulting in future cost savings.


9-37 (35 min.) Absorption costing and production volume variance -- alternative capacity bases 1. Inventoriable cost per unit = Variable production cost + Fixed manufacturing overhead/Capacity

Capacity Type Theoretical Practical Normal Master Budget

Capacity Level 725,000 406,000 290,000 175,000

Fixed Mfg. Overhead Rate $1.40 $2.50 $3.50 $5.80

Fixed Mfg. Overhead $1,015,000 $1,015,000 $1,015,000 $1,015,000

Variable Production Cost $2.70 $2.70 $2.70 $2.70

Inventoriable Cost Per Unit $4.10 $5.20 $6.20 $8.50

2. EBL‘s actual production level is 250,000 bulbs. We can compute the production-volume variance as: Production Volume Variance = Budgeted Fixed Mfg. Overhead – (Fixed Mfg. Overhead Rate × Actual Production Level)

Capacity Type Theoretical Practical Normal Master Budget

Capacity Level 725,000 406,000 290,000 175,000

Fixed Mfg. Overhead $1,015,000 $1,015,000 $1,015,000 $1,015,000

Fixed Mfg. Overhead Rate $1.40 $2.50 $3.50 $5.80

Fixed Mfg. Overhead Rate × Actual Production $ 350,000 $ 625,000 $ 875,000 $1,450,000

Production Volume Variance $665,000 U $390,000 U $140,000 U $435,000 F

3. Operating Income for EBL given production of 250,000 bulbs and sales of 175,000 bulbs @ $9.60 apiece: Revenue a Less: Cost of goods sold b Productionvolume variance Gross margin Variable selling c Fixed selling Operating income

Theoretical $1,680,000

$

Practical $1,680,000

Normal Master Budget $1,680,000 $1,680,000

717,500

910,000

1,085,000

1,487,500

665,000 U 297,500

390,000 U 380,000

140,000 U 455,000

70,000 200,000

70,000 200,000

70,000 200,000

70,000 200,000

27,500

$ 110,000

$ 185,000

$ 357,500

(435,000)F 627,500

a

175,000 × 9.60 175,000 × 4.10, × 5.20, × 6.20, × 8.50 c 175,000 × 0.40 b


9-38

(35 min.) Operating income effects of denominator-level choice and disposal of production-volume variance (continuation of 9-37)

1. Since no beginning inventories exist, if EBL sells all 250,000 bulbs manufactured, its operating income will be the same under all four capacity options. Calculations are provided below: Revenue a Less: Cost of goods sold b Production volume variance Gross margin Variable selling c Fixed selling Operating income



Normal $2,400,000

Master Budget $2,400,000

1,025,000

1,300,000

1,550,000

2,125,000

665,000 U

390,000 U

140,000 U

(435,000) F

710,000

710,000

710,000

710,000

100,000

100,000

100,000

100,000

200,000

200,000

200,000

200,000

$ 410,000

$ 410,000

$ 410,000

$ 410,000

a

250,000 × 9.60 250,000 × 4.10, × 5.20, × 6.20, × 8.50 c 250,000 × 0.40 b

2. If the manager of EBL produces and sells 250,000 bulbs, then all capacity levels will result in the same operating income of $410,000 (see requirement 1 above). If the manager of EBL is able to sell only 175,000 of the bulbs produced and if the production-volume variance is closed to cost of goods sold, then the operating income is given as in requirement 3 of 9-37. Both sets of numbers are reproduced below. Income with sales of 250,000 bulbs Income with sales of 175,000 bulbs Decrease in income when there is over-production

Theoretical $410,000 27,500

Practical $410,000 110,000

Normal $410,000 185,000

Master Budget $410,000 357,500

$382,500

$ 300,000

$225,000

$ 52,500

Comparing these results, it is clear that for a given level of overproduction relative to sales, the manager‘s performance will appear better if he/she uses as the denominator a level that is lower. In this example, setting the denominator to equal the master budget (the lowest of the four capacity levels here), minimizes the loss to the manager from being unable to sell the entire production quantity of 250,000 bulbs.


3. In this scenario, the manager of EBL produces 250,000 bulbs and sells 175,000 of them, and the production volume variance is prorated. Given the absence of ending work in process inventory or beginning inventory of any kind, the fraction of the production volume variance that is absorbed into the cost of goods sold is given by 175,000/250,000 or 7/10. The operating income under various denominator levels is then given by the following modification of the solution to requirement 3 of 9-37: Revenue Less: Cost of goods sold Prorated productionvolume variance a Gross margin Variable selling b Fixed selling Operating income

a b



Normal $1,680,000

Master Budget $1,680,000

717,500

910,000

1,085,000

1,487,500

465,500 U

273,000 U

497,000

497,000

497,000

497,000

70,000

70,000

70,000

70,000

200,000

200,000

200,000

200,000

$ 227,000

$ 227,000

$ 227,000

$ 227,000

98,000 U

(304,500) F

(7/10) × 665,000, × 390,000, × 140,000, × (435,000) 175,000 × 0.40

Under the proration approach, operating income is $227,000 regardless of the denominator initially used. Thus, in contrast to the case where the production volume variance is written off to cost of goods sold, there is no temptation under the proration approach for the manager to play games with the choice of denominator level.


9-39

(25 min.) Cost allocation, downward demand spiral.


Budgeted fixed costs Denominator level Budgeted fixed cost per meal Budgeted fixed costs Denominator level ($1,521,000 975,000; $1,521,000 1,300,000; $1,521,000 780,000) Budgeted variable cost per meal Total budgeted cost per meal

2012 Master Budget (1) $1,521,000 975,000

$ $

1.56 4.90 6.46

2013 Master Budget (3) $1,521,000 780,000

Practical Capacity (2) $1,521,000 1,300,000

$ $

1.17 4.90 6.07

$ $

1.95 4.90 6.85

1. The 2012 budgeted fixed costs are $1,521,000. Mealman budgets for 975,000 meals in 2012, and this is used as the denominator level to calculate the fixed cost per meal. $1,521,000 975,000 = $1.56 fixed cost per meal. (see column (1) in Solution Exhibit 9-39). 2. In 2013, 3 hospitals have dropped out of the purchasing group and the master budget is 780,000 meals. If this is used as the denominator level, fixed cost per meal = $1,521,000 780,000 = $1.95 per meal, and the total budgeted cost per meal would be $6.85 (see column (3) in Solution Exhibit 9-39). If the hospitals have already been complaining about quality and cost and are allowed to purchase from outside, they will not accept this higher price. More hospitals may begin to purchase meals from outside the system, leading to a downward demand spiral, possibly putting Mealman out of business. 3. The basic problem is that Mealman has excess capacity and the associated excess fixed costs. If Smith uses the practical capacity of 1,300,000 meals as the denominator level, the fixed cost per meal will be $1.17 (see column (2) in Solution Exhibit 9-39), and the total budgeted cost per meal would be $6.07, probably a more acceptable price to the customers (it may even draw back the three hospitals that have chosen to buy outside). This denominator level will also isolate the cost of unused capacity and not allocate it to the meals produced. To make the $6.07 price per meal profitable in the long run, Smith will have to find ways to either use the extra capacity or reduce Mealman‘s practical capacity and the related fixed costs.


9-40

(20 min.) Cost allocation, responsibility accounting, ethics (continuation of 9-39).

1. (See Solution Exhibit 9-39). If Mealman uses the rate based on its master budget capacity utilization to allocate fixed costs in 2013, it would allocate 760,500 $1.95 = $1,482,975. Budgeted fixed costs are $1,521,000. Therefore, the production volume variance = $1,521,000 – $1,482,795 = $38,025 U. An unfavorable production volume variance will reduce operating income by this amount. (Note: in this business, there are no inventories. All variances are written off to cost of goods sold). 2. Hospitals are charged a budgeted variable cost rate and allocated budgeted fixed costs. By overestimating budgeted meal counts, the denominator-level is larger, hence the amount charged to individual hospitals is lower. Consider 2013 where the budgeted fixed cost rate is computed as follows: $1,521,000/780,000 meals = $1.95 per meal If in fact, the hospital administrators had better estimated and revealed their true demand (say, 760,500 meals), the allocated fixed cost per meal would have been $1,521,000/760,500 meals = $2.00 per meal, 2.6% higher than the $1.95 per meal. Hence, by deliberately overstating budgeted meal count, hospitals are able to reduce the price charged by Mealman for each meal. In this scheme, Mealman bears the downside risk of demand overestimates. 3.

Evidence that could be collected include: (a) Budgeted meal-count estimates and actual meal-count figures each year for each hospital controller. Over an extended time period, there should be a sizable number of both underestimates and overestimates. Controllers could be ranked on both their percentage of overestimation and the frequency of their overestimation. (b) Look at the underlying demand estimates by patients at individual hospitals. Each hospital controller has other factors (such as hiring of nurses) that give insight into their expectations of future meal-count demands. If these factors are inconsistent with the meal-count demand figures provided to the central food-catering facility, explanations should be sought. 4. (a) Highlight the importance of a corporate culture of honesty and openness. Cayzer could institute a Code of Ethics that highlights the upside of individual hospitals providing honest estimates of demand (and the penalties for those who do not). (b) Have individual hospitals contract in advance for their budgeted meal count. Unused amounts would be charged to each hospital at the end of the accounting period. This approach puts a penalty on hospital administrators who overestimate demand. (c) Use an incentive scheme that has an explicit component for meal-count forecasting accuracy. Each meal-count ―forecasting error‖ would reduce the bonus by $0.05. Thus, if a hospital bids for 292,000 meals and actually uses 200,000 meals, its bonus would be reduced by $0.05 × (292,000 – 200,000) = $4,600.


Collaborative Learning Problem 9-41

(60 min.) Absorption, variable, and throughput costing; performance evaluation

NOTE: This problem can be broken up, with parts 1, 2, and 3 assigned to 3 or 6 different group members. The group members may reconvene to discuss parts 4 and 5. (1)

a. Absorption Costing with leased truck and salaried driver April 2011 Revenuesa Cost of goods sold Beginning inventoryb Variable manufacturing costsc Allocated fixed manufacturing costsd Cost of goods available for sale Deduct ending inventorye Adjustment for prod. vol. var.f Cost of goods sold Gross margin Fixed administrative costs Operating income

May 2011 $72,000

$

0 20,740 12,200 32,940 (540)

$

7,800 U

June 2011 $75,000

540 30,600 18,000 49,140 (15,390)

$78,000 $15,390 15,300 9,000 39,690 (4,590)

2,000 U

11,000 U

40,200

35,750

46,100

31,800

39,250

31,900

28,000 $ 3,800

28,000 $11,250

28,000 $ 3,900

a

$6.00 × 12,000, 12,500, 13,000 Fixed overhead rate: $20,000 ÷ 20,000 practical capacity = $1.00/box; Cost per box: $1.20 + 0.35 + 0.15 + 1.00 = $2.70; Beginning inventory: $2.70 × 0; $2.70(0+12,200-12,000); $2.70(200+18,000-12,500) c $1.70 × 12,200, 18,000, 9,000 d $1.00 × 12,200, 18,000, 9,000 e $2.70 × (12,200 – 12,000); $2.70 × (200 + 18,000 – 12,500); $2.70 × (5,700 + 9,000 – 13,000) f $20,000 – 12,200; $20,000 – 18,000; $20,000 – 9,000 b


b. Absorption Costing with variable delivery service April 2011 Revenuesa Cost of goods sold Beginning inventoryb Variable manufacturing costsc Allocated fixed manufacturing costsd Cost of goods available for sale Deduct ending inventorye Adjustment for prod. vol. var.f Cost of goods sold Gross margin Fixed administrative costs Operating income

May 2011 $72,000

$

0 25,620 9,150 34,770 (570)

$

5,850 U

June 2011 $75,000

570 37,800 13,500 51,870 (16,245)

$78,000 $ 16,245 18,900 6,750 41,895 (4,845)

1,500 U

8,250 U

40,050 31,950

37,125 37,875

45,300 32,700

28,000 $ 3,950

28,000 $ 9,875

28,000 $ 4,700

a

$6.00 × 12,000, 12,500, 13,000 Fixed overhead rate: $15,000 ÷ 20,000 practical capacity = $0.75/box; Cost per box: $1.20 + 0.35 + 0.15 + 0.40 + 0.75 = $2.85; Beginning inventory: $2.85 × 0; $2.85 × (0 + 12,200 – 12,000); $2.85 × (200 + 18,000 – 12,500) c $2.10 × 12,200, 18,000, 9,000 d $0.75 × 12,200, 18,000, 9,000 e $2.85 × (12,200 – 12,000); $2.85 × (200 + 18,000 – 12,500); $2.85 × (5,700 + 9,000 – 13,000) f $15,000 – 9,150; $15,000 – 13,500; $15,000 – 6,750 b


(2)

a. Variable Costing with leased truck and salaried driver April 2011 Revenuesa Variable costs Beginning inventoryb Variable manufacturing costsc Cost of goods available for sale Deduct ending inventory

May 2011 $72,000

$

Variable cost of goods sold Contribution margin Fixed costs Fixed manufacturing costsd Fixed administrative costs Total fixed costs Operating income

0 20,740 20,740 (340)

June 2011 $75,000

$

340 30,600 30,940 (9,690)

20,400 51,600

$78,000 $ 9,690 15,300 24,990 (2,890)

21,250 53,750

20,000 28,000

20,000 28,000 48,000 $ 3,600

22,100 55,900 20,000 28,000

48,000 $ 5,750

48,000 $ 7,900

a $6 × 12,000, 12,500, 13,000 b $0; $1.70 × (0 + 12,200 – 12,000): $1.70 × (200 + 18,000 – 12,500) c $1.70 × 12,200, 18,000, 9,000 d $15,000 + $5,000

b. Variable Costing with variable delivery servicea April 2011 Revenues Variable costs Beginning inventory Variable manufacturing costs Cost of goods available for sale Deduct ending inventory Variable cost of goods sold Contribution margin Fixed costs Fixed manufacturing costsd Fixed administrative costs Total fixed costs Operating income

May 2011 $72,000

$

0 25,620 25,620 (420)

$

420 37,800 38,220 (11,970)

25,200 46,800 15,000 28,000

June 2011 $75,000 $ 11,970 18,900 30,870 (3,570) 26,250 48,750

15,000 28,000 43,000 $ 3,800

$78,000

27,300 50,700 15,000 28,000

43,000 $ 5,750

a Variable cost per unit: $1.70 + $0.40 = $2.10


43,000 $ 7,700

(3)

a. Throughput costing with leased truck and salaried driver Revenues Direct material cost of goods sold Beginning inventorya Direct materials in goods manufacturedb Cost of goods available for sale Deduct ending inventoryc Total direct material cost of goods sold Throughput margin Other costs Manufacturingd Administrative Total other costs Operating income

April 2011 $72,000

$

0

May 2011 $75,000

$

June 2011 $78,000

240

$ 6,840

14,640

21,600

10,800

14,640 (240)

21,840 (6,840)

17,640 (2,040)

14,400

15,000

15,600

57,600

60,000

62,400

26,100 28,000

29,000 28,000 54,100 $ 3,500

24,500 28,000 57,000 $ 3,000

a

$0; $1.20 × (0 + 12,200 – 12,000): $1.20 × (200 + 18,000 – 12,500) $1.20 × 12,200, 18,000, 9,000 c $1.20 200; $1.20 (200 + 18,000 – 12,500); $1.20 (5,700 + 9,000 + 13,000) d ($0.50 × 12,200) + $20,000; ($0.50 × 18,000) + $20,000; ($0.50 × 9,000) + $20,000 b


52,500 $ 9,900

b. Throughput costing with variable delivery service Revenues Direct material cost of goods sold Beginning inventorya Direct materials in goods manufacturedb Cost of goods available for sale Deduct ending inventoryc Total direct material cost of goods sold Throughput margin Other costs Manufacturingd Administrative Total other costs Operating income

April 2011 $72,000

$

0

May 2011 $75,000

$

June 2011 $78,000

240

$ 6,840

14,640

21,600

10,800

14,640 (240)

21,840 (6,840)

17,640 (2,040)

14,400

15,000

15,600

57,600

60,000

62,400

25,980 28,000

31,200 28,000 53,980 $ 3,620

23,100 28,000 $

59,200 800

a

$0; $1.20 × (0 + 12,200 – 12,000): $1.20 × (200 + 18,000 – 12,500) $1.20 × 12,200, 18,000, 9,000 c $1.20 200; $1.20 (200 + 18,000 – 12,500); $1.20 (5,700 + 9,000 + 13,000) d ($0.90 × 12,200) + $15,000; ($0.90 × 18,000) + $15,000; ($0.90 × 9,000) + $15,000 b


51,100 $11,300

4. Variable costing seems to be the best method to use in this situation, given that the fluctuations in production are due to planning for actual needs and not due to irresponsible buildup of inventories. Actual costs of the inventory produced are not fluctuating, and sales are steadily increasing. Therefore, the method that reflects that steady increase in sales as a steady increase in operating income is the most realistic portrayal of the managers‘ performance. In the case of absorption costing, operating income is unrealistically high in May and low in June, and the reverse is true with throughput costing. The benefit of using throughput costing is that net income is reduced if managers produce more units than they can sell. By treating all costs, except direct material costs, as period costs, the income statement expenses not only the cost of goods sold but also the direct labor and variable overhead costs associated with units in ending inventory. So reported income is reduced by the cost of unnecessary production. Throughput costing may be considered superior to variable costing because not only is management not rewarded for producing more than can be sold, they are penalized for excess production. In this example, income is highest when management produced less than demand and therefore reduced inventory that already existed. However, the company does not wish to penalize managers for a necessary temporary buildup of inventory, such as in this case. 5. Because the company is forecasting future growth, the leased truck and salaried driver seem to be the best solution. By June, the total variable cost of the delivery service (based on sales volume in that month) has already exceeded $5,000, the fixed cost of the truck and driver. Had the company not been confident about the potential for the future, however, the delivery service may have been a good choice, at least at the beginning.


CHAPTER 10 DETERMINING HOW COSTS BEHAVE 10-1 1. 2.

10-2 1. 2. 3.

The two assumptions are Variations in the level of a single activity (the cost driver) explain the variations in the related total costs. Cost behavior is approximated by a linear cost function within the relevant range. A linear cost function is a cost function where, within the relevant range, the graph of total costs versus the level of a single activity forms a straight line. Three alternative linear cost functions are Variable cost function––a cost function in which total costs change in proportion to the changes in the level of activity in the relevant range. Fixed cost function––a cost function in which total costs do not change with changes in the level of activity in the relevant range. Mixed cost function––a cost function that has both variable and fixed elements. Total costs change but not in proportion to the changes in the level of activity in the relevant range.

10-3 A linear cost function is a cost function where, within the relevant range, the graph of total costs versus the level of a single activity related to that cost is a straight line. An example of a linear cost function is a cost function for use of a videoconferencing line where the terms are a fixed charge of $10,000 per year plus a $2 per minute charge for line use. A nonlinear cost function is a cost function where, within the relevant range, the graph of total costs versus the level of a single activity related to that cost is not a straight line. Examples include economies of scale in advertising where an agency can double the number of advertisements for less than twice the costs, step-cost functions, and learning-curve-based costs. 10-4 No. High correlation merely indicates that the two variables move together in the data examined. It is essential also to consider economic plausibility before making inferences about cause and effect. Without any economic plausibility for a relationship, it is less likely that a high level of correlation observed in one set of data will be similarly found in other sets of data. 10-5 1. 2. 3. 4.

Four approaches to estimating a cost function are Industrial engineering method. Conference method. Account analysis method. Quantitative analysis of current or past cost relationships.

10-6 The conference method estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company (purchasing, process engineering, manufacturing, employee relations, etc.). Advantages of the conference method include 1. The speed with which cost estimates can be developed. 2. The pooling of knowledge from experts across functional areas. 3. The improved credibility of the cost function to all personnel.


10-7 The account analysis method estimates cost functions by classifying cost accounts in the subsidiary ledger as variable, fixed, or mixed with respect to the identified level of activity. Typically, managers use qualitative, rather than quantitative, analysis when making these costclassification decisions. 10-8 The six steps are 1. Choose the dependent variable (the variable to be predicted, which is some type of cost). 2. Identify the independent variable or cost driver. 3. Collect data on the dependent variable and the cost driver. 4. Plot the data. 5. Estimate the cost function. 6. Evaluate the cost driver of the estimated cost function. Step 3 typically is the most difficult for a cost analyst. 10-9 Causality in a cost function runs from the cost driver to the dependent variable. Thus, choosing the highest observation and the lowest observation of the cost driver is appropriate in the high-low method. 10-10 1. 2. 3.

Three criteria important when choosing among alternative cost functions are Economic plausibility. Goodness of fit. Slope of the regression line.

10-11 A learning curve is a function that measures how labor-hours per unit decline as units of production increase because workers are learning and becoming better at their jobs. Two models used to capture different forms of learning are 1. Cumulative average-time learning model. The cumulative average time per unit declines by a constant percentage each time the cumulative quantity of units produced doubles. 2. Incremental unit-time learning model. The incremental time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of units produced doubles. 10-12 Frequently encountered problems when collecting cost data on variables included in a cost function are 1. The time period used to measure the dependent variable is not properly matched with the time period used to measure the cost driver(s). 2. Fixed costs are allocated as if they are variable. 3. Data are either not available for all observations or are not uniformly reliable. 4. Extreme values of observations occur. 5. A homogeneous relationship between the individual cost items in the dependent variable cost pool and the cost driver(s) does not exist. 6. The relationship between the cost and the cost driver is not stationary. 7. Inflation has occurred in a dependent variable, a cost driver, or both.


10-13 Four key assumptions examined in specification analysis are 1. Linearity of relationship between the dependent variable and the independent variable within the relevant range. 2. Constant variance of residuals for all values of the independent variable. 3. Independence of residuals. 4. Normal distribution of residuals. 10-14 No. A cost driver is any factor whose change causes a change in the total cost of a related cost object. A cause-and-effect relationship underlies selection of a cost driver. Some users of regression analysis include numerous independent variables in a regression model in an attempt to maximize goodness of fit, irrespective of the economic plausibility of the independent variables included. Some of the independent variables included may not be cost drivers. 10-15 No. Multicollinearity exists when two or more independent variables are highly correlated with each other. 10-16 (10 min.) Estimating a cost function. 1.

Slope coefficient = Error! =

$5, 400 $4,000 10,000 6,000

=

$1, 400 = $0.35 per machine-hour 4, 000

Constant = Total cost – (Slope coefficient

Quantity of cost driver)

= $5,400 – ($0.35

10,000) = $1,900

= $4,000 – ($0.35

6,000) = $1,900

The cost function based on the two observations is Maintenance costs = $1,900 + $0.35

Machine-hours

2. The cost function in requirement 1 is an estimate of how costs behave within the relevant range, not at cost levels outside the relevant range. If there are no months with zero machinehours represented in the maintenance account, data in that account cannot be used to estimate the fixed costs at the zero machine-hours level. Rather, the constant component of the cost function provides the best available starting point for a straight line that approximates how a cost behaves within the relevant range.


10-17 (15 min.) Identifying variable-, fixed-, and mixed-cost functions. 1.

See Solution Exhibit 10-17.

2.

Contract 1: y = $50 Contract 2: y = $30 + $0.20X Contract 3: y = $1X where X is the number of miles traveled in the day.

3.

Contract 1 2 3

Cost Function Fixed Mixed Variable

SOLUTION EXHIBIT 10-17 Plots of Car Rental Contracts Offered by Pacific Corp.


10-18 1. 2. 3. 4.

5. 6. 7. 8. 9.

(20 min.) Various cost-behavior patterns. K B G J Note that A is incorrect because, although the cost per pound eventually equals a constant at $9.20, the total dollars of cost increases linearly from that point onward. I The total costs will be the same regardless of the volume level. L F This is a classic step-cost function. K C

10-19 (30 min.) Matching graphs with descriptions of cost and revenue behavior. a. b. c. d. e. f.

(1) (6) (9) (2) (8) (10)

g. h.

(3) (8)

A step-cost function.

It is data plotted on a scatter diagram, showing a linear variable cost function with constant variance of residuals. The constant variance of residuals implies that there is a uniform dispersion of the data points about the regression line.

10-20 (15 min.) Account analysis method. 1.

Variable costs: Car wash labor $260,000 Soap, cloth, and supplies 42,000 Water 38,000 Electric power to move conveyor belt 72,000 Total variable costs $412,000 Fixed costs: Depreciation $ 64,000 Salaries 46,000 Total fixed costs $110,000 Some costs are classified as variable because the total costs in these categories change in proportion to the number of cars washed in Lorenzo’s operation. Some costs are classified as fixed because the total costs in these categories do not vary with the number of cars washed. If the conveyor belt moves regardless of the number of cars on it, the electricity costs to power the conveyor belt would be a fixed cost. 2.

$412,000 = $5.15 per car 80,000 Total costs estimated for 90,000 cars = $110,000 + ($5.15 × 90,000) = $573,500

Variable costs per car =


10-21 (20 min.) Account analysis 1. The electricity cost is variable because, in each month, the cost divided by the number of kilowatt hours equals a constant $0.30. The definition of a variable cost is one that remains constant per unit. The telephone cost is a mixed cost because the cost neither remains constant in total nor remains constant per unit. The water cost is fixed because, although water usage varies from month to month, the cost remains constant at $60. 2. The month with the highest number of telephone minutes is June, with 1,440 minutes and $98.80 of cost. The month with the lowest is April, with 980 minutes and $89.60. The difference in cost ($98.80 – $89.60), divided by the difference in minutes (1,440 – 980) equals $0.02 per minute of variable telephone cost. Inserted into the cost formula for June: $98.80 = a fixed cost + ($0.02 × number of minutes used) $98.80 = a + ($0.02 × 1,440) $98.80 = a + $28.80 a = $70 monthly fixed telephone cost Therefore, Java Joe’s cost formula for monthly telephone cost is: Y = $70 + ($0.02 × number of minutes used) 3. The electricity rate is $0.30 per kw hour The telephone cost is $70 + ($0.02 per minute) The fixed water cost is $60 Adding them together we get: Fixed cost of utilities = $70 (telephone) + $60 (water) = $130 Monthly Utilities Cost = $130 + (0.30 per kw hour) + ($0.02 per telephone min.) 4. Estimated utilities cost = $130 + ($0.30 × 2,200 kw hours) + ($0.02 × 1,500 minutes) = $130 + $660 + $30 = $820


10-22 (30 min.) Account analysis method. 1.

Manufacturing cost classification for 2012:

Account Direct materials Direct manufacturing labor Power Supervision labor Materials-handling labor Maintenance labor Depreciation Rent, property taxes, admin Total

Total Costs (1) $300,000 225,000 37,500 56,250 60,000 75,000 95,000 100,000 $948,750

% of Total Costs That is Variable Fixed Variable Variable Costs Costs Cost per Unit (2) (3) = (1) (2) (4) = (1) – (3) (5) = (3) ÷ 75,000 100% 100 100 20 50 40 0 0

$300,000 225,000 37,500 11,250 30,000 30,000 0 0 $633,750

$

0 0 0 45,000 30,000 45,000 95,000 100,000 $315,000

$4.00 3.00 0.50 0.15 0.40 0.40 0 0 $8.45

Total manufacturing cost for 2012 = $948,750 Variable costs in 2013:

Account Direct materials Direct manufacturing labor Power Supervision labor Materials-handling labor Maintenance labor Depreciation Rent, property taxes, admin. Total

Unit Variable Increase in Cost per Variable Variable Cost Unit for Percentage Cost per Unit 2012 Increase per Unit for 2013 (6) (7) (8) = (6) (7) (9) = (6) + (8) $4.00 3.00 0.50 0.15 0.40 0.40 0 0 $8.45

5% 10 0 0 0 0 0 0

$0.20 0.30 0 0 0 0 0 0 $0.50

Total Variable Costs for 2013 (10) = (9) 80,000

$4.20 3.30 0.50 0.15 0.40 0.40 0 0 $8.95


$336,000 264,000 40,000 12,000 32,000 32,000 0 0 $716,000

Fixed and total costs in 2013:

Account

Fixed Costs for 2012 (11)

Direct materials $ 0 Direct manufacturing labor 0 Power 0 Supervision labor 45,000 Materials-handling labor 30,000 Maintenance labor 45,000 Depreciation 95,000 Rent, property taxes, admin. 100,000 Total $315,000

Percentage Increase (12)

0% 0 0 0 0 0 5 7

Dollar Increase in Fixed Costs (13) = (11) (12)

$

Fixed Costs for 2013 (14) = (11) + (13)

Variable Costs for 2013 (15)

Total Costs (16) = (14) + (15)

0 $ 0 $336,000 $ 336,000 0 0 264,000 264,000 0 0 40,000 40,000 0 45,000 12,000 57,000 0 30,000 32,000 62,000 0 45,000 32,000 77,000 4,750 99,750 0 99,750 7,000 107,000 0 107,000 $11,750 $326,750 $716,000 $1,042,750

Total manufacturing costs for 2013 = $1,042,750 2.

Total cost per unit, 2012 Total cost per unit, 2013

$948,750 = $12.65 75,000 $1,042,750 = = $13.03 80,000

=

3. Cost classification into variable and fixed costs is based on qualitative, rather than quantitative, analysis. How good the classifications are depends on the knowledge of individual managers who classify the costs. Gower may want to undertake quantitative analysis of costs, using regression analysis on time-series or cross-sectional data to better estimate the fixed and variable components of costs. Better knowledge of fixed and variable costs will help Gower to better price his products, to know when he is getting a positive contribution margin, and to better manage costs.


10-23 (15–20 min.) Estimating a cost function, high-low method. 1. The key point to note is that the problem provides high-low values of X (annual round trips made by a helicopter) and Y X (the operating cost per round trip). We first need to calculate the annual operating cost Y (as in column (3) below), and then use those values to estimate the function using the high-low method.

Highest observation of cost driver Lowest observation of cost driver Difference

Cost Driver: Annual RoundTrips (X) (1) 2,000 1,000 1,000

Operating Cost per Round-Trip (2) $300 $350

Annual Operating Cost (Y) (3) = (1) (2) $600,000 $350,000 $250,000

Slope coefficient = $250,000 1,000 = $250 per round-trip Constant = $600,000 – ($250 2,000) = $100,000 The estimated relationship is Y = $100,000 + $250 X; where Y is the annual operating cost of a helicopter and X represents the number of round trips it makes annually. 2. The constant a (estimated as $100,000) represents the fixed costs of operating a helicopter, irrespective of the number of round trips it makes. This would include items such as insurance, registration, depreciation on the aircraft, and any fixed component of pilot and crew salaries. The coefficient b (estimated as $250 per round-trip) represents the variable cost of each round trip—costs that are incurred only when a helicopter actually flies a round trip. The coefficient b may include costs such as landing fees, fuel, refreshments, baggage handling, and any regulatory fees paid on a per-flight basis. 3. If each helicopter is, on average, expected to make 1,200 round trips a year, we can use the estimated relationship to calculate the expected annual operating cost per helicopter: Y = $100,000 + $250 X X = 1,200 Y = $100,000 + $250 1,200 = $100,000 + $300,000 = $400,000 With 10 helicopters in its fleet, Reisen’s estimated operating budget is 10 $400,000 = $4,000,000.


10-24 (20 min.) Estimating a cost function, high-low method. 1. See Solution Exhibit 10-24. There is a positive relationship between the number of service reports (a cost driver) and the customer-service department costs. This relationship is economically plausible. 2.

Number of Customer-Service Service Reports Department Costs Highest observation of cost driver 455 $21,500 Lowest observation of cost driver 115 13,000 Difference 340 $ 8,500 Customer-service department costs = a + b (number of service reports) Slope coefficient (b) Constant (a)

$8,500 = $25 per service report 340 = $21,500 – ($25 455) = $10,125 = $13,000 – ($25 115) = $10,125

=

Customer-service department costs = $10,125 + $25 (number of service reports)

3.

Other possible cost drivers of customer-service department costs are: a. Number of products replaced with a new product (and the dollar value of the new products charged to the customer-service department). b. Number of products repaired and the time and cost of repairs.

SOLUTION EXHIBIT 10-24 Plot of Number of Service Reports versus Customer-Service Dept. Costs for Capitol Products


10-25 (30–40 min.) Linear cost approximation. 1.

Slope coefficient (b) Constant (a)

Cost function

= Error!=

$533,000 6,500

$400,000 = $38.00 3,000

= $533,000 – ($38.00 × 6,500) = $286,000 = $286,000 + ($38.00

professional labor-hours)

The linear cost function is plotted in Solution Exhibit 10-25. No, the constant component of the cost function does not represent the fixed overhead cost of the Chicago Reviewers Group. The relevant range of professional labor-hours is from 2,000 to 7,500. The constant component provides the best available starting point for a straight line that approximates how a cost behaves within the 2,000 to 7,500 relevant range. 2. A comparison at various levels of professional labor-hours follows. The linear cost function is based on the formula of $286,000 per month plus $38.00 per professional labor-hour. Total overhead cost behavior: Month 1 Month 2 Month 3 Month 4 Month 5 Professional labor-hours 2,000 3,000 4,000 5,000 6,500 Actual total overhead costs $335,000 $400,000 $430,000 $472,000 $533,000 Linear approximation 362,000 400,000 438,000 476,000 533,000 Actual minus linear Approximation $(27,000) $ 0 $ (8,000) $ (4,000) $ 0

Month 6 7,500 $582,000 571,000 $ 11,000

The data are shown in Solution Exhibit 10-25. The linear cost function overstates costs by $8,000 at the 4,000-hour level and understates costs by $11,000 at the 7,500-hour level. 3. Contribution before deducting incremental overhead Incremental overhead Contribution after incremental overhead

Based on Based on Linear Actual Cost Function $35,000 $35,000 30,000 38,000 $ 5,000 $ (3,000)

The total contribution margin actually forgone is $5,000.


SOLUTION EXHIBIT 10-25 Linear Cost Function Plot of Professional Labor-Hours on Total Overhead Costs for Chicago Reviewers Group


10-26 (20 min.) Cost-volume-profit and regression analysis. 1a.

Total manufacturing costs Number of bicycle frames $1,056,000 = = $33 per frame 32,000 This cost is higher than the $32.50 per frame that Ryan has quoted.

Average cost of manufacturing

=

1b. Goldstein cannot take the average manufacturing cost in 2012 of $33 per frame and multiply it by 35,000 bicycle frames to determine the total cost of manufacturing 35,000 bicycle frames. The reason is that some of the $1,056,000 (or equivalently the $33 cost per frame) are fixed costs and some are variable costs. Without distinguishing fixed from variable costs, Goldstein cannot determine the cost of manufacturing 35,000 frames. For example, if all costs are fixed, the manufacturing costs of 35,000 frames will continue to be $1,056,000. If, however, all costs are variable, the cost of manufacturing 35,000 frames would be $33 35,000 = $1,155,000. If some costs are fixed and some are variable, the cost of manufacturing 35,000 frames will be somewhere between $1,056,000 and $1,155,000. Some students could argue that another reason for not being able to determine the cost of manufacturing 35,000 bicycle frames is that not all costs are output unit-level costs. If some costs are, for example, batch-level costs, more information would be needed on the number of batches in which the 35,000 bicycle frames would be produced, in order to determine the cost of manufacturing 35,000 bicycle frames. 2.

Expected cost to make 35,000 bicycle frames

= $435,000 + $19

35,000

= $435,000 + $665,000 = $1,100,000 Purchasing bicycle frames from Ryan will cost $32.50 35,000 = $1,137,500. Hence, it will cost Goldstein $1,137,500 $1,100,000 = $37,500 more to purchase the frames from Ryan rather than manufacture them in-house. 3. Goldstein would need to consider several factors before being confident that the equation in requirement 2 accurately predicts the cost of manufacturing bicycle frames. a. Is the relationship between total manufacturing costs and quantity of bicycle frames economically plausible? For example, is the quantity of bicycles made the only cost driver or are there other cost-drivers (for example batch-level costs of setups, production-orders or material handling) that affect manufacturing costs? b. How good is the goodness of fit? That is, how well does the estimated line fit the data? c. Is the relationship between the number of bicycle frames produced and total manufacturing costs linear? d. Does the slope of the regression line indicate that a strong relationship exists between manufacturing costs and the number of bicycle frames produced? e. Are there any data problems such as, for example, errors in measuring costs, trends in prices of materials, labor or overheads that might affect variable or fixed costs over time, extreme values of observations, or a nonstationary relationship over time between total manufacturing costs and the quantity of bicycles produced? f. How is inflation expected to affect costs? g. Will Ryan supply high-quality bicycle frames on time? 10-13 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

10-27

(25 min.)

Regression analysis, service company.

1. Solution Exhibit 10-27 plots the relationship between labor-hours and overhead costs and shows the regression line. y = $48,271 + $3.93 X Economic plausibility. Labor-hours appears to be an economically plausible driver of overhead costs for a catering company. Overhead costs such as scheduling, hiring and training of workers, and managing the workforce are largely incurred to support labor. Goodness of fit The vertical differences between actual and predicted costs are extremely small, indicating a very good fit. The good fit indicates a strong relationship between the laborhour cost driver and overhead costs. Slope of regression line. The regression line has a reasonably steep slope from left to right. Given the small scatter of the observations around the line, the positive slope indicates that, on average, overhead costs increase as labor-hours increase. 2. The regression analysis indicates that, within the relevant range of 2,500 to 7,500 laborhours, the variable cost per person for a cocktail party equals: Food and beverages Labor (0.5 hrs. $10 per hour) Variable overhead (0.5 hrs $3.93 per labor-hour) Total variable cost per person

$15.00 5.00 1.97 $21.97

3. To earn a positive contribution margin, the minimum bid for a 200-person cocktail party would be any amount greater than $4,394. This amount is calculated by multiplying the variable cost per person of $21.97 by the 200 people. At a price above the variable costs of $4,394, Bob Jones will be earning a contribution margin toward coverage of his fixed costs. Of course, Bob Jones will consider other factors in developing his bid including (a) an analysis of the competition––vigorous competition will limit Jones’s ability to obtain a higher price (b) a determination of whether or not his bid will set a precedent for lower prices––overall, the prices Bob Jones charges should generate enough contribution to cover fixed costs and earn a reasonable profit, and (c) a judgment of how representative past historical data (used in the regression analysis) is about future costs.


SOLUTION EXHIBIT 10-27 Regression Line of Labor-Hours on Overhead Costs for Bob Jones’s Catering Company


10-28 High-low, regression 1. Melissa will pick the highest point of activity, 3,390 parts (March) at $14,400 of cost, and the lowest point of activity, 1,930 parts (August) at $8,560.

Highest observation of cost driver Lowest observation of cost driver Difference

Cost driver: Quantity Purchased 3,390 1,930 1,460

Cost $14,400 8,560 $ 5,840

Purchase costs = a + b Quantity purchased Slope Coefficient =

$5,840 = $4 per part 1, 460

Constant (a) = $14,400 ─ ($4 3,390) = $840 The equation Melissa gets is: Purchase costs = $840 + ($4 Quantity purchased) 2. Using the equation above, the expected purchase costs for each month will be:

Month October November December

Purchase Quantity Expected 2,800 parts 3,100 2,500

Formula y = $840 + ($4 2,800) y = $840 + ($4 3,100) y = $840 + ($4 2,500)

Expected cost $12,040 13,240 10,840

3. Economic Plausibility: Clearly, the cost of purchasing a part is associated with the quantity purchased. Goodness of Fit: As seen in Solution Exhibit 10-28, the regression line fits the data well. The vertical distance between the regression line and observations is small. An r-squared value of greater than 0.98 indicates that more than 98% of the change in cost can be explained by the change in quantity. Significance of the Independent Variable: The relatively steep slope of the regression line suggests that the quantity purchased is correlated with purchasing cost for part #4599.



According to the regression, Melissa’s original estimate of fixed cost is too low given all the data points. The original slope is too steep, but only by 33 cents. So, the variable rate is lower but the fixed cost is higher for the regression line than for the high-low cost equation. The regression is the more accurate estimate because it uses all available data (all nine data points) while the high-low method only relies on two data points and may therefore miss some important information contained in the other data. 4. Using the regression equation, the purchase costs for each month will be:

Month October November December

Purchase Quantity Expected 2,800 parts 3,100 2,500

Formula y = $1,779.60 + ($3.67 2,800) y = $1,779.60 + ($3.67 3,100) y = $1,779.60 + ($3.67 2,500)

Expected cost $12,056 13,157 10,955

Although the two equations are different in both fixed element and variable rate, within the relevant range they give similar expected costs. This implies that the high and low points of the data are a reasonable representation of the total set of points within the relevant range.


10-29

(20 min.) Learning curve, cumulative average-time learning model.

The direct manufacturing labor-hours (DMLH) required to produce the first 2, 4, and 8 units given the assumption of a cumulative average-time learning curve of 85%, is as follows: 85% Learning Curve Cumulative Number of Units (X) (1) 1 2 4 8

Cumulative Average Time per Unit (y): Labor Hours (2) 6,000 5,100 = (6,000 0.85) 4,335 = (5,100 0.85) 3,685 = (4,335 0.85)

Cumulative Total Time: Labor-Hours (3) = (1) (2) 6,000 10,200 17,340 29,480

Alternatively, to compute the values in column (2) we could use the formula y = aXb where a = 6,000, X = 2, 4, or 8, and b = – 0.234465, which gives when X = 2, y = 6,000 2– 0.234465 = 5,100 when X = 4, y = 6,000 4– 0.234465 = 4,335 when X = 8, y = 6,000 8– 0.234465 = 3,685

Direct materials $160,000 2; 4; 8 Direct manufacturing labor $30 10,200; 17,340; 29,480 Variable manufacturing overhead $20 10,200; 17,340; 29,480 Total variable costs

Variable Costs of Producing 2 Units 4 Units 8 Units $320,000 $ 640,000 $1,280,000 306,000

520,200

884,400

204,000 $830,000

346,800 $1,507,000

589,600 $2,754,000


10-30

(20 min.) Learning curve, incremental unit-time learning model.

1. The direct manufacturing labor-hours (DMLH) required to produce the first 2, 3, and 4 units, given the assumption of an incremental unit-time learning curve of 85%, is as follows:

Cumulative Number of Units (X) (1) 1 2 3 4

85% Learning Curve Individual Unit Time for Xth Unit (y): Labor Hours (2) 6,000 5,100 = (6,000 0.85) 4,637 4,335 = (5,100 0.85)

Cumulative Total Time: Labor-Hours (3) 6,000 11,100 15,737 20,072

Values in column (2) are calculated using the formula y = aXb where a = 6,000, X = 2, 3, or 4, and b = – 0.234465, which gives when X = 2, y = 6,000 2– 0.234465 = 5,100 when X = 3, y = 6,000 3– 0.234465 = 4,637 when X = 4, y = 6,000 4– 0.234465 = 4,335

Direct materials $160,000 2; 3; 4 Direct manufacturing labor $30 11,100; 15,737; 20,072 Variable manufacturing overhead $20 11,100; 15,737; 20,072 Total variable costs

Variable Costs of Producing 2 Units 3 Units 4 Units $320,000 $ 480,000 $ 640,000 333,000

472,110

602,160

222,000 $875,000

314,740 $1,266,850

401,440 $1,643,600

2.

Incremental unit-time learning model (from requirement 1) Cumulative average-time learning model (from Exercise 10-29) Difference

Variable Costs of Producing 2 Units 4 Units $875,000 $1,643,600 830,000 1,507,000 $ 45,000 $ 136,600

Total variable costs for manufacturing 2 and 4 units are lower under the cumulative average-time learning curve relative to the incremental unit-time learning curve. Direct manufacturing labor-hours required to make additional units decline more slowly in the incremental unit-time learning curve relative to the cumulative average-time learning curve when the same 85% factor is used for both curves. The reason is that, in the incremental unit-time learning curve, as the number of units double only the last unit produced has a cost of 85% of the initial cost. In the cumulative average-time learning model, doubling the number of units causes the average cost of all the units produced (not just the last unit) to be 85% of the initial cost.


10-31 (25 min.) High-low method. 1.

Machine-Hours Highest observation of cost driver Lowest observation of cost driver Difference Maintenance costs

= a+b

Slope coefficient (b) =

140,000 95,000 45,000

Maintenance Costs $280,000 190,000 $ 90,000

Machine-hours

$90,000 = $2 per machine-hour 45,000

= $280,000 – ($2 × 140,000)

Constant (a)

= $280,000 – $280,000 = $0 or

= $190,000 – ($2 × 95,000)

Constant (a)

= $190,000 – $190,000 = $0 Maintenance costs

= $2 × Machine-hours

2. SOLUTION EXHIBIT 10-31 Plot and High-Low Line of Maintenance Costs as a Function of Machine-Hours

Solution Exhibit 10-31 presents the high-low line.


Economic plausibility. The cost function shows a positive economically plausible relationship between machine-hours and maintenance costs. There is a clear-cut engineering relationship of higher machine-hours and maintenance costs. Goodness of fit. The high-low line appears to ―fit‖ the data well. The vertical differences between the actual and predicted costs appear to be quite small. Slope of high-low line. The slope of the line appears to be reasonably steep indicating that, on average, maintenance costs in a quarter vary with machine-hours used. 3. Using the cost function estimated in 1, predicted maintenance costs would be $2 × 100,000 = $200,000. Howard should budget $200,000 in quarter 13 because the relationship between machinehours and maintenance costs in Solution 10-31 is economically plausible, has an excellent goodness of fit, and indicates that an increase in machine-hours in a quarter causes maintenance costs to increase in the quarter.


10-32 (30min.) High-low method and regression analysis.

1. See Solution Exhibit 10-32. SOLUTION EXHIBIT 10-32

2. Number of Orders per week Highest observation of cost driver (Week 9) Lowest observation of cost driver (Week 1) Difference

525 351 174

Weekly Total Costs $25,305 18,795 $ 6,510

Weekly total costs = a + b (number of orders per week)

Slope coefficient (b) Constant (a)

Weekly total costs

=

$6,510 = $37.41 per order 174

= $25,305 – ($37.41 = $18,795 – ($37.41

525) = $5,664.75 351) = $5,664.09

= $5,664 + $37.41 × (Number of Orders per week)

See high-low line in Solution Exhibit 10-32.


Solution Exhibit 10-32 presents the regression line: Weekly total costs

= $8,631 + $31.92 × (Number of Orders per week)

Economic Plausibility. The cost function shows a positive economically plausible relationship between number of orders per week and weekly total costs. Number of orders is a plausible cost driver of total weekly costs. Goodness of fit. The regression line appears to fit the data well. The vertical differences between the actual costs and the regression line appear to be quite small. Significance of independent variable. The regression line has a steep positive slope and increases by $31.92 for each additional order. Because the slope is not flat, there is a strong relationship between number of orders and total weekly costs. The regression line is the more accurate estimate of the relationship between number of orders and total weekly costs because it uses all available data points while the high-low method relies only on two data points and may therefore miss some information contained in the other data points. In addition, because the low data point falls below the regression line, the high-low method predicts a lower amount of fixed cost and a steeper slope (higher amount of variable cost per order). 4.

Profit = Total weekly revenues + Total seasonal membership fees – Total weekly costs = (Total number of orders × $40) + (800 × $50) – $228,897 = (4,467 × $40) + (800 × $50) – $228,897 = $178,680 + $40,000 – $228,897 = ($10,217). No, the club did not make a profit.

5. Let the average number of weekly orders be denoted by AWO. We want to find the value of AWO for which Fresh Harvest will achieve zero profit. Using the format in requirement 4, we want: Profit = [AWO × 10 weeks × $40] + (900 × $50) – [$8,631 + ($31.92 × AWO)] × 10 weeks = $0 $400 × AWO + $45,000 – $86,310 – $319.2 × AWO = $0 $80.8 × AWO = $41,310 AWO = $41,310 ÷ $80.8 = 511.26 So, Fresh Harvest will have to get at least 512 weekly orders in order to break even next year.


10-33 (30 40 min.) High-low method, regression analysis. 1.

Solution Exhibit 10-33 presents the plots of advertising costs on revenues.

SOLUTION EXHIBIT 10-33 Plot and Regression Line of Advertising Costs on Revenues

2. Solution Exhibit 10-33 also shows the regression line of advertising costs on revenues. We evaluate the estimated regression equation using the criteria of economic plausibility, goodness of fit, and slope of the regression line. Economic plausibility. Advertising costs appears to be a plausible cost driver of revenues. Restaurants frequently use newspaper advertising to promote their restaurants and increase their patronage. Goodness of fit. The vertical differences between actual and predicted revenues appears to be reasonably small. This indicates that advertising costs are related to restaurant revenues. Slope of regression line. The slope of the regression line appears to be relatively steep. Given the small scatter of the observations around the line, the steep slope indicates that, on average, restaurant revenues increase with newspaper advertising.


3.

The high-low method would estimate the cost function as follows:

Highest observation of cost driver Lowest observation of cost driver Difference Revenues = a + (b Slope coefficient (b) Constant (a)

or Constant (a)

Revenues 4.

=

Advertising Costs $4,000 1,000 $3,000 advertising costs)

Revenues $80,000 55,000 $25,000

$25,000 = 8.333 $3,000

= $80,000

($4,000

= $80,000

$33,332 = $46,668

= $55,000

($1,000

= $55,000

$8,333 = $46,667

= $46,667 + (8.333

8.333)

8.333)

Advertising costs)

The increase in revenues for each $1,000 spent on advertising within the relevant range is a. Using the regression equation, 8.723 $1,000 = $8,723 b. Using the high-low equation, 8.333 $1,000 = $8,333

The high-low equation does fairly well in estimating the relationship between advertising costs and revenues. However, Martinez should use the regression equation because it uses information from all observations. The high-low method, on the other hand, relies only on the observations that have the highest and lowest values of the cost driver and these observations are generally not representative of all the data.


10-34 (30 min.) Regression, activity-based costing, choosing cost drivers. 1. Both number of units inspected and inspection labor-hours are plausible cost drivers for inspection costs. The number of units inspected is likely related to test-kit usage, which is a significant component of inspection costs. Inspection labor-hours are a plausible cost driver if labor hours vary per unit inspected, because costs would be a function of how much time the inspectors spend on each unit. This is particularly true if the inspectors are paid a wage, and if they use electric or electronic machinery to test the units of product (cost of operating equipment increases with time spent). 2. Solution Exhibit 10-34 presents (a) the plots and regression line for number of units inspected versus inspection costs and (b) the plots and regression line for inspection labor-hours and inspection costs. SOLUTION EXHIBIT 10-34A Plot and Regression Line for Units Inspected versus Inspection Costs for Fitzgerald Manufacturing


SOLUTION EXHIBIT 10-34B Plot and Regression Line for Inspection Labor-Hours and Inspection Costs for Fitzgerald Manufacturing

Goodness of Fit. As you can see from the two graphs, the regression line based on number of units inspected better fits the data (has smaller vertical distances from the points to the line) than the regression line based on inspection labor-hours. The activity of inspection appears to be more closely linearly related to the number of units inspected than inspection laborhours. Hence number of units inspected is a better cost driver. This is probably because the number of units inspected is closely related to test-kit usage, which is a significant component of inspection costs. Significance of independent variable. It is hard to visually compare the slopes because the graphs are not the same size, but both graphs have steep positive slopes indicating a strong relationship between number of units inspected and inspection costs, and inspection laborhours and inspection costs. Indeed, if labor-hours per inspection do not vary much, number of units inspected and inspection labor-hours will be closely related. Overall, it is the significant cost of test-kits that is driven by the number of units inspected (not the inspection labor-hours spent on inspection) that makes units inspected the preferred cost driver. 3. At 140 inspection labor hours and 1100 units inspected, Inspection costs using units inspected = $977 + ($2.05 × 1100) = $3,232 Inspection costs using inspection labor-hours = $478 + ($20.31 × 140) = $3,321.40 If Neela uses inspection-labor-hours she will estimate inspection costs to be $3,321.40, $89.40 ($3,321.40 ─$3,232) higher than if she had used number of units inspected. If actual costs equaled, say, $3,300, Neela would conclude that Fitzgerald has performed efficiently in its inspection activity because actual inspection costs would be lower than budgeted amounts. In fact, based on the more accurate cost function, actual costs of $3,300 exceeded the budgeted amount of $3,232. Neela should find ways to improve inspection efficiency rather than mistakenly conclude that the inspection activity has been performing well. 10-27 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

10-35 (15-20 min.) Interpreting regression results, matching time periods. 1. Sascha Green is commenting about some surprising and economically-implausible regression results. In the regression, the coefficient on machine-hours has a negative sign. This implies that the greater the number of machine-hours (i.e., the longer the machines are run), the smaller will be the maintenance costs; specifically, it suggests that each extra machine hour reduces maintenance costs by $2.683. Clearly, this estimated relationship is not economically plausible. However, one would think that machine hours should have some impact on machine maintenance costs.

2. The problem statement tells us that Brickman has four peak sales periods, each lasting two months and it schedules maintenance in the intervening months, when production volume is low. To correctly understand the relationship between machine-hours and maintenance costs, Brickman should estimate the regression equation of maintenance costs on lagged (i.e., previous months’) machine-hours. The greater the machine use in one month, the greater is the expected maintenance costs in later months. By analyzing the data on a quarterly basis, the relationship between machine hours and maintenance costs becomes more economically plausible.


10-36 (30–40 min.) Cost estimation, cumulative average-time learning curve. 1.

Cost to produce the 2nd through the 7th troop deployment boats: Direct materials, 6 $200,000 Direct manufacturing labor (DML), 63,1131 $40 Variable manufacturing overhead, 63,113 $25 Other manufacturing overhead, 20% of DML costs Total costs

$1,200,000 2,524,520 1,577,825 504,904 $5,807,249

1

The direct manufacturing labor-hours to produce the second to seventh boats can be calculated in several ways, given the assumption of a cumulative average-time learning curve of 90%: Use of table format: 90% Learning Curve Cumulative Number of Units (X) (1) 1

Cumulative Average Time per Unit (y): Labor Hours (2) 15,000

2

13,500

3 4 5 6 7

12,693 12,150 11,745 11,424 11,159

= (15,000 = (13,500

0.90) 0.90)

Cumulative Total Time: Labor-Hours (3) = (1) (2) 15,000 27,000 38,079 48,600 58,725 68,544 78,113

The direct labor-hours required to produce the second through the seventh boats is 78,113 – 15,000 = 63,113 hours. Use of formula: y = aXb where a = 15,000, X

= 7, and b = – 0.152004 y = 15,000 7– 0.152004 = 11,159 hours

The total direct labor-hours for 7 units is 11,159

7 = 78,113 hours

Note: Some students will debate the exclusion of the $280,000 tooling cost. The question specifies that the tooling ―cost was assigned to the first boat.‖ Although Nautilus may well seek to ensure its total revenue covers the $1,575,000 cost of the first boat, the concern in this question is only with the cost of producing six more PT109s.


2. Cost to produce the 2nd through the 7th boats assuming linear function for direct laborhours and units produced: Direct materials, 6 $200,000 $1,200,000 Direct manufacturing labor (DML), 6 15,000 hrs. $40 3,600,000 Variable manufacturing overhead, 6 15,000 hrs. $25 2,250,000 Other manufacturing overhead, 20% of DML costs 720,000 Total costs $7,770,000 The difference in predicted costs is: Predicted cost in requirement 2 (based on linear cost function) Predicted cost in requirement 1 (based on 90% learning curve) Difference in favor of learning curve cost function

$7,770,000 5,807,249 $1,962,751

Note that the linear cost function assumption leads to a total cost that is 35% higher than the cost predicted by the learning curve model. Learning curve effects are most prevalent in large manufacturing industries such as airplanes and boats where costs can run into the millions or hundreds of millions of dollars, resulting in very large and monetarily significant differences between the two models. In the case of Nautilus, if it is in fact easier to produce additional boats as the firm gains experience, the learning curve model is the right one to use. The firm can better forecast its future costs and use that information to submit an appropriate cost bid to the Navy, as well as refine its pricing plans for other potential customers.


10-37 (20–30 min.) Cost estimation, incremental unit-time learning model. 1.

Cost to produce the 2nd through the 7th boats: Direct materials, 6 $200,000 Direct manufacturing labor (DML), 72,6711 $40 Variable manufacturing overhead, 72,671 $25 Other manufacturing overhead, 20% of DML costs Total costs

$1,200,000 2,906,840 1,816,775 581,368 $6,504,983

1

The direct labor hours to produce the second through the seventh boats can be calculated via a table format, given the assumption of an incremental unit-time learning curve of 90%: 90% Learning Curve Cumulative Number of Units (X) (1)

Individual Unit Time for Xth Unit (y)*: Labor Hours (2)

1

15,000

2 3 4 5 6 7

13,500 12,693 12,150 11,745 11,424 11,159

= (15,000

0.90)

= (13,500

0.90)

Cumulative Total Time: Labor-Hours (3) 15,000 28,500 41,193 53,343 65,088 76,512 87,671

*Calculated as y = aXb where a = 15,000, b = – 0.152004, and X = 1, 2, 3,. . .7.

The direct manufacturing labor-hours to produce the second through the seventh boat is 87,671 – 15,000 = 72,671 hours. 2. Difference in total costs to manufacture the second through the seventh boat under the incremental unit-time learning model and the cumulative average-time learning model is $6,504,983 (calculated in requirement 1 of this problem) – $5,807,249 (from requirement 1 of Problem 10-36) = $697,734, i.e., the total costs are higher for the incremental unit-time model. The incremental unit-time learning curve has a slower rate of decline in the time required to produce successive units than does the cumulative average-time learning curve (see Problem 10-36, requirement 1). Assuming the same 90% factor is used for both curves:

Cumulative Number of Units 1 2 4 7

Estimated Cumulative Direct Manufacturing Labor-Hours Cumulative AverageIncremental Unit-Time Time Learning Model Learning Model 15,000 15,000 27,000 28,500 48,600 53,343 78,113 87,671


The reason is that, in the incremental unit-time learning model, as the number of units double, only the last unit produced has a cost of 90% of the initial cost. In the cumulative average-time learning model, doubling the number of units causes the average cost of all the units produced (not just the last unit) to be 90% of the initial cost. Nautilus should examine its own internal records on past jobs and seek information from engineers, plant managers, and workers when deciding which learning curve better describes the behavior of direct manufacturing labor-hours on the production of the PT109 boats.


10-38 Regression; choosing among models. (chapter appendix) 1. Solution Exhibit 10-38A presents the regression output for (a) setup costs and number of setups and (b) setup costs and number of setup-hours. SOLUTION EXHIBIT 10-38A Regression Output for (a) Setup Costs and Number of Setups and (b) Setup Costs and Number of Setup-Hours a. SUMMARY OUTPUT Regression Statistics Multiple R 0.686023489 R Square 0.470628228 Adjusted R Square 0.395003689 Standard Error 51385.93104 Observations 9 ANOVA df Regression Residual Total

Intercept X Variable 1

1 7 8

SS MS F Significance F 16432501924 16432501924 6.223221 0.04131511 18483597365 2640513909 34916099289

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 12889.92611 61364.96556 0.210053505 0.839609 -132215.1596 157995.0118 -132215.1596 157995.0118 426.7711823 171.0753629 2.494638474 0.041315 22.24223047 831.3001341 22.24223047 831.3001341

b. SUMMARY OUTPUT Regression Statistics Multiple R 0.92242169 R Square 0.850861774 Adjusted R Square 0.829556313 Standard Error 27274.59603 Observations 9 ANOVA df Regression Residual Total

Intercept X Variable 1

1 7 8

SS MS F Significance F 29708774168 29708774168 39.93632322 0.000396651 5207325121 743903588.7 34916099289

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 6573.417913 25908.17948 0.253719792 0.807002921 -54689.69157 67836.5274 -54689.69157 67836.5274 56.27403095 8.904796227 6.319519224 0.000396651 35.21753384 77.33052805 35.21753384 77.33052805


2. Solution Exhibit 10-38B presents the plots and regression lines for (a) number of setups versus setup costs and (b) number of setup hours versus setup costs. SOLUTION EXHIBIT 10-38B Plots and Regression Lines for (a) Number of Setups versus Setup Costs and (b) Number of SetupHours versus Setup Costs

Tilbert Toys Setup Costs and Number of Setups $250,000

Setup Costs

$200,000 $150,000

$100,000 $50,000 $-

0

100

200

300

400

500

600

Number of Setups

Tilbert Toys Setup Costs and Number of Setup Hours $250,000 $200,000

$150,000 $100,000 $50,000 $-

0

1,000

2,000

3,000

4,000

5,000

Setup Hours


3. Number of Setups A positive relationship between setup costs and the number of setups is economically plausible.

Number of Setup Hours A positive relationship between setup costs and the number of setup-hours is also economically plausible, especially since setup time is not uniform, and the longer it takes to setup, the greater the setup costs, such as costs of setup labor and setup equipment.

Goodness of fit

r2 = 47% Standard error of regression =$51,386 Reasonable goodness of fit.

r2 = 85% Standard error of regression =$27,275 Excellent goodness of fit.

Significance of Independent Variables

The t-value of 2.49 is significant at the The t-value of 6.32 is highly 0.05 level. significant at the 0.05 level. In fact, the p-value of 0.0004 (< 0.01) indicates that the coefficient is significant at the 0.01 level.

Specification analysis of estimation assumptions

Based on a plot of the data, the linearity assumption holds, but the constant variance assumption may be violated. The Durbin-Watson statistic of 1.65 suggests the residuals are independent. The normality of residuals assumption appears to hold. However, inferences drawn from only 9 observations are not reliable.

Economic plausibility

Based on a plot of the data, the assumptions of linearity, constant variance, independence of residuals (Durbin-Watson = 1.50), and normality of residuals hold. However, inferences drawn from only 9 observations are not reliable.

4. The regression model using number of setup-hours should be used to estimate set up costs because number of setup-hours is a more economically plausible cost driver of setup costs (compared to number of setups). The setup time is different for different products and the longer it takes to setup, the greater the setup costs such as costs of setup-labor and setup equipment. The regression of number of setup-hours and setup costs also has a better fit, a substantially significant independent variable, and better satisfies the assumptions of the estimation technique.


10-39 (30min.) Multiple regression (continuation of 10-38). 1. Solution Exhibit 10-39 presents the regression output for setup costs using both number of setups and number of setup-hours as independent variables (cost drivers). SOLUTION EXHIBIT 10-39 Regression Output for Multiple Regression for Setup Costs Using Both Number of Setups and Number of Setup-Hours as Independent Variables (Cost Drivers) SUMMARY OUTPUT Regression Statistics Multiple R 0.924938047 R Square 0.855510391 Adjusted R Square 0.807347188 Standard Error 28997.16516 Observations 9 ANOVA df Regression Residual Total

Intercept Number of Setups Setup Hours

2. Economic plausibility

2 6 8

SS MS F Significance F 29871085766 14935542883 17.76274 0.003016545 5045013522 840835587.1 34916099289

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% -2807.097769 34850.24247 -0.080547439 0.938421 -88082.56893 82468.37339 -88082.56893 58.61773979 133.416589 0.439358705 0.675783 -267.8408923 385.0763718 -267.8408923 52.30623518 13.08375044 3.997801352 0.007137 20.29145124 84.32101912 20.29145124

Upper 95.0% 82468.37339 385.0763718 84.32101912

A positive relationship between setup costs and each of the independent variables (number of setups and number of setup-hours) is economically plausible.

Goodness of fit

r2 = 86%, Adjusted r2 = 81% Standard error of regression =$28,997 Excellent goodness of fit.

Significance of Independent Variables

The t-value of 0.44 for number of setups is not significant at the 0.05 level. The t-value of 4.00 for number of setup-hours is significant at the 0.05 level. Moreover, the p-value of 0.007 (< 0.01) indicates that the coefficient is significant at the 0.01 level.

Specification analysis of estimation assumptions

Assuming linearity, constant variance, and normality of residuals, the Durbin-Watson statistic of 1.38 suggests the residuals are independent. However, we must be cautious when drawing inferences from only 9 observations.


3. Multicollinearity is an issue that can arise with multiple regression but not simple regression analysis. Multicollinearity means that the independent variables are highly correlated. The correlation feature in Excel’s Data Analysis reveals a coefficient of correlation of 0.69 between number of setups and number of setup-hours. This is very close to the threshold of 0.70 that is usually taken as a sign of multicollinearity problems. As evidence, note the substantial drop in the t-value for setup hours from 6.32 to 4.00, despite a fairly small change in the estimated coefficient (from $56.27 to $52.31). 4. The simple regression model using the number of setup-hours as the independent variable achieves a comparable r2 to the multiple regression model. However, the multiple regression model includes an insignificant independent variable, number of setups. Adding this variable does not improve Williams’ ability to better estimate setup costs and introduces multicollinearity issues. Bebe should use the simple regression model with number of setup-hours as the independent variable to estimate costs.


10-40 (40–50 min.) Purchasing Department cost drivers, activity-based costing, simple regression analysis. The problem reports the exact t-values from the computer runs of the data. Because the coefficients and standard errors given in the problem are rounded to three decimal places, dividing the coefficient by the standard error may yield slightly different t-values. 1. Plots of the data used in Regressions 1 to 3 are in Solution Exhibit 10-40A. See Solution Exhibit 10-40B for a comparison of the three regression models. 2. Both Regressions 2 and 3 are well-specified regression models. The slope coefficients on their respective independent variables are significantly different from zero. These results support the Couture Fabrics’ presentation in which the number of purchase orders and the number of suppliers were reported to be drivers of purchasing department costs. In designing an activity-based cost system, Fashion Bling should use number of purchase orders and number of suppliers as cost drivers of purchasing department costs. As the chapter appendix describes, Fashion Bling can either (a) estimate a multiple regression equation for purchasing department costs with number of purchase orders and number of suppliers as cost drivers, or (b) divide purchasing department costs into two separate cost pools, one for costs related to purchase orders and another for costs related to suppliers, and estimate a separate relationship for each cost pool. 3. Guidelines presented in the chapter could be used to gain additional evidence on cost drivers of purchasing department costs. 1. Use physical relationships or engineering relationships to establish cause-and-effect links. Lee could observe the purchasing department operations to gain insight into how costs are driven. 2. Use knowledge of operations. Lee could interview operating personnel in the purchasing department to obtain their insight on cost drivers.


SOLUTION EXHIBIT 10-40A Regression Lines of Various Cost Drivers for Purchasing Dept. Costs for Fashion Bling


SOLUTION EXHIBIT 10-40B Comparison of Alternative Cost Functions for Purchasing Department Costs Estimated with Simple Regression for Fashion Bling

Regression 2 PDC = a + (b # of POs) Economically plausible. The higher the number of purchase orders, the more tasks undertaken.

Regression 3 PDC = a + (b # of Ss) Economically plausible. Increasing the number of suppliers increases the costs of certifying vendors and managing the Fashion Blingsupplier relationship.

2. Goodness of fit r2 = 0.08. Poor goodness of fit.

r2 = 0.43. Reasonable goodness of fit.

r2 = 0.39. Reasonable goodness of fit.

3. Significance of Independent Variables

t-value on # of POs of 2.46 t-value on # of Ss of 2.25 is significant. is significant.

Criterion 1. Economic Plausibility

4. Specification Analysis A. Linearity within the relevant range

Regression 1 PDC = a + (b MP$) Result presented at seminar by Couture Fabrics found little support for MP$ as a driver. Purchasing personnel at the Miami store believe MP$ is not a significant cost driver.

t-value on MP$ of 0.83 is insignificant.

Appears questionable Appears reasonable. but no strong evidence against linearity.

Appears reasonable.

B. Constant variance of residuals

Appears questionable, Appears reasonable. but no strong evidence against constant variance.

Appears reasonable.

C. Independence of residuals

Durbin-Watson Statistic = 2.41 Assumption of independence is not rejected.


D. Normality of residuals

Data base too small to Data base too small to make reliable make reliable inferences. inferences.


Data base too small to make reliable inferences.


10-41 (30–40 min.) Purchasing Department cost drivers, multiple regression analysis (continuation of 10-40) (chapter appendix). The problem reports the exact t-values from the computer runs of the data. Because the coefficients and standard errors given in the problem are rounded to three decimal places, dividing the coefficient by the standard error may yield slightly different t-values. 1.

Regression 4 is a well-specified regression model:

Economic plausibility: Both independent variables are plausible and are supported by the findings of the Couture Fabrics study. Goodness of fit: The r2 of 0.64 indicates an excellent goodness of fit. Significance of independent variables: The t-value on # of POs is 2.19 while the t-value on # of Ss is 1.99. These t-values are either significant or border on significance. Specification analysis: Results are available to examine the independence of residuals assumption. The Durbin-Watson statistic of 1.91 indicates that the assumption of independence is not rejected. Regression 4 is consistent with the findings in Problem 10-40 that both the number of purchase orders and the number of suppliers are drivers of purchasing department costs. Regressions 2, 3, and 4 all satisfy the four criteria outlined in the text. Regression 4 has the best goodness of fit (0.64 for Regression 4 compared to 0.43 and 0.39 for Regressions 2 and 3, respectively). Most importantly, it is economically plausible that both the number of purchase orders and the number of suppliers drive purchasing department costs. We would recommend that Lee use Regression 4 over Regressions 2 and 3. 2. Regression 5 adds an additional independent variable (MP$) to the two independent variables in Regression 4. This additional variable (MP$) has a t-value of 0.01, implying its slope coefficient is insignificantly different from zero. The r2 in Regression 5 (0.64) is the same as that in Regression 4 (0.64), implying the addition of this third independent variable adds close to zero explanatory power. In summary, Regression 5 adds very little to Regression 4. We would recommend that Lee use Regression 4 over Regression 5. 3.

Budgeted purchasing department costs for the Baltimore store next year are $484,522 + ($126.66

4,000) + ($2,903

95) = $1,266,947


4. Multicollinearity is a frequently encountered problem in cost accounting; it does not arise in simple regression because there is only one independent variable in a simple regression. One consequence of multicollinearity is an increase in the standard errors of the coefficients of the individual variables. This frequently shows up in reduced t-values for the independent variables in the multiple regression relative to their t-values in the simple regression:

Variables Regression 4: # of POs # of Ss Regression 5: # of POs # of Ss MP$

t-value in Multiple Regression

t-value from Simple Regressions in Problem 10-40

2.19 1.99

2.46 2.25

1.99 1.79 0.01

2.46 2.25 0.83

The decline in the t-values in the multiple regressions is consistent with some (but not very high) collinearity among the independent variables. Pairwise correlations between the independent variables are:

# of POs and # of Ss # of POs and MP$ # of Ss and MP$

Correlation 0.29 0.27 0.30

There is no evidence of difficulties due to multicollinearity in Regressions 4 and 5. 5. are

Decisions in which the regression results in Problems 10-40 and 10-41 could be useful

Cost management decisions: Fashion Bling could restructure relationships with the suppliers so that fewer separate purchase orders are made. Alternatively, it may aggressively reduce the number of existing suppliers. Purchasing policy decisions: Fashion Bling could set up an internal charge system for individual retail departments within each store. Separate charges to each department could be made for each purchase order and each new supplier added to the existing ones. These internal charges would signal to each department ways in which their own decisions affect the total costs of Fashion Bling. Accounting system design decisions: Fashion Bling may want to discontinue allocating purchasing department costs on the basis of the dollar value of merchandise purchased. Allocation bases better capturing cause-and-effect relations at Fashion Bling are the number of purchase orders and the number of suppliers.


Collaborative Learning Problem 10-42 (25 min.)

Interpreting regression results, matching time periods, ethics

1. SOLUTION EXHIBIT 10-42A presents the data plot for the initial analysis. The formula of Revenue = $47,801 – (1.92 × Advertising expense) indicates that there is a fixed amount of revenue each month of $47,801, which is reduced by 1.92 times that month’s advertising expense. This relationship is not economically plausible, as advertising would not reduce revenue. The data points do not appear linear, and the r-square of 0.08 indicates a very weak goodness of fit. SOLUTION EXHIBIT 10-42 A Plot and Regression Line for Advertising Expenses and Current Month Sales Revenue $60,000

Sales Revenue

$50,000 $40,000

$30,000 $20,000 $10,000 $-

$-

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

Advertising Expense

2. If Jayne were able to draw meaningful conclusions from the analysis, she would be ethically obligated to share them. However, in this case, there really are no conclusions to make, and it would be best if she were to rethink her analysis before sharing the results. 3. SOLUTION EXHIBIT 10-42 B presents the data plot for the revised analysis. The formula of Revenue = $23,538 + (5.92 × Advertising expense) indicates that there is a fixed amount of revenue each month of $23,538, which increases by 5.92 times the prior month’s advertising expense. This relationship is economically plausible. One would expect a positive correlation between advertising expense and sales revenue. In the revised analysis, there is improved linearity in the data points, and the r-square of 0.71 indicates a much stronger goodness of fit.


SOLUTION EXHIBIT 10-42B Plot and Regression Line for Advertising Expense and Following Month Sales Revenue

Sales Revenue (Following Month)

60,000

50,000 40,000

30,000 20,000 10,000 -

$-

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

Advertising Expense

4. Jayne must be very careful about making conclusions regarding cause and effect. Even a strong goodness of fit does not prove a cause and effect relationship. The independent and dependent variables could both be caused by a third factor, or the correlation could be simply coincidental. However, there is enough of a correlation in the revised analysis for Jayne to make a meaningful presentation to the store’s owner.


CHAPTER 11 DECISION MAKING AND RELEVANT INFORMATION 11-1 1. 2. 3. 4. 5.

The five steps in the decision process outlined in Exhibit 11-1 of the text are Identify the problem and uncertainties Obtain information Make predictions about the future Make decisions by choosing among alternatives Implement the decision, evaluate performance, and learn

11-2 Relevant costs are expected future costs that differ among the alternative courses of action being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternative future courses of action. 11-3 No. Relevant costs are defined as those expected future costs that differ among alternative courses of action being considered. Thus, future costs that do not differ among the alternatives are irrelevant to deciding which alternative to choose. 11-4 Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial––that is, they can be easily expressed in monetary terms. Direct materials is an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as on-time flight arrivals, cannot be easily expressed in monetary terms. Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. An example is employee morale. 11-5

Two potential problems that should be avoided in relevant cost analysis are (i) Do not assume all variable costs are relevant and all fixed costs are irrelevant. (ii) Do not use unit-cost data directly. It can mislead decision makers because a. it may include irrelevant costs, and b. comparisons of unit costs computed at different output levels lead to erroneous conclusions

11-6 No. Some variable costs may not differ among the alternatives under consideration and, hence, will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be relevant. 11-7 No. Some of the total manufacturing cost per unit of a product may be fixed, and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy decision. The key comparison is between purchase costs and the costs that will be saved if the company purchases the component parts from outside plus the additional benefits of using the resources freed up in the next best alternative use (opportunity cost). Furthermore, managers should consider nonfinancial factors such as quality and timely delivery when making outsourcing decisions. 11-8 Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.


11-9 No. When deciding on the quantity of inventory to buy, managers must consider both the purchase cost per unit and the opportunity cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quantity of inventory purchased is large, but the benefit of the lower cost may be more than offset by the high opportunity cost of the funds invested in acquiring and holding inventory. 11-10 No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availability of machine-hours). 11-11 No. For example, if the revenues that will be lost exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision. 11-12 Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be written off as depreciation is often relevant. 11-13 No. Managers often favor the alternative that makes their performance look best so they focus on the measures used in the performance-evaluation model. If the performance-evaluation model does not emphasize maximizing operating income or minimizing costs, managers will most likely not choose the alternative that maximizes operating income or minimizes costs. 11-14 The three steps in solving a linear programming problem are (i) Determine the objective function. (ii) Specify the constraints. (iii) Compute the optimal solution. 11-15 The text outlines two methods of determining the optimal solution to an LP problem: (i) Trial-and-error approach (ii) Graphic approach Most LP applications in practice use standard software packages that rely on the simplex method to compute the optimal solution.


11-16 (20 min.) Disposal of assets. 1. This is an unfortunate situation, yet the $78,000 costs are irrelevant regarding the decision to remachine or scrap. The only relevant factors are the future revenues and future costs. By ignoring the accumulated costs and deciding on the basis of expected future costs, operating income will be maximized (or losses minimized). The difference in favor of remachining is $2,000: (a) (b) Remachine Scrap Future revenues Deduct future costs Operating income

$33,000 24,500 $ 8,500

Difference in favor of remachining

$6,500 – $6,500 $2,000

2. This, too, is an unfortunate situation. But the $101,000 original cost is irrelevant to this decision. The difference in relevant costs in favor of replacing is $3,500 as follows:

New truck Deduct current disposal price of existing truck Rebuild existing truck

Difference in favor of replacing

(a) Replace

(b) Rebuild

$103,500

–

17,500 – $ 86,000

– $89,500 $89,500 $3,500

Note, here, that the current disposal price of $17,500 is relevant, but the original cost (or book value, if the truck were not brand new) is irrelevant.


11-17 (20 min.) Relevant and irrelevant costs. 1. Relevant costs Variable costs Avoidable fixed costs Purchase price Unit relevant cost

Make

Buy

$190 10 ____ $200

$260 $260

Dalton Computers should reject Peach’s offer. The $80 of fixed costs are irrelevant because they will be incurred regardless of this decision. When comparing relevant costs between the choices, Peach’s offer price is higher than the cost to continue to produce. 2. Cash operating costs (3 years) Current disposal value of old machine Cost of new machine Total relevant costs

Keep $52,500

Replace $46,500 (2,200)

Difference $6,000 2,200

_ _____ $52,500

9,000 $53,300

(9,000) $ (800)

AP Manufacturing should keep the old machine. The cost savings are less than the cost to purchase the new machine. 11-18 (15 min.) Multiple choice. 1. (b)

Special order price per unit Variable manufacturing cost per unit Contribution margin per unit Effect on operating income

$6.00 4.50 $1.50

= $1.50 20,000 units = $30,000 increase

2. (b) Costs of purchases, 20,000 units $60 Total relevant costs of making: Variable manufacturing costs, $6 + $30 + $12 Fixed costs eliminated Costs saved by not making Multiply by 20,000 units, so total costs saved are $57 20,000 Extra costs of purchasing outside Minimum overall savings for Reno Necessary relevant costs that would have to be saved in manufacturing Part No. 575

$1,200,000 $48 9 $57 1,140,000 60,000 25,000 $

85,000


11-19 1.

(30 min.) Special order, activity-based costing. Direct materials cost per unit ($262,500 7,500 units) = $35 per unit Direct manufacturing labor cost per unit ($300,000 7,500 units) = $40 per unit Variable cost per batch = $500 per batch

Award Plus’ operating income under the alternatives of accepting/rejecting the special order are: Without OneWith OneTime Only Time Only Special Order Special Order 7,500 Units 10,000 Units Revenues Variable costs: Direct materials Direct manufacturing labor Batch manufacturing costs Fixed costs: Fixed manufacturing costs Fixed marketing costs Total costs Operating income 1

$262,500 + ($35

2,500 units)

$1,125,000

Difference 2,500 Units

$1,375,000 1

262,500 300,000 75,000

350,000 2 400,000 3 87,500

87,500 100,000 12,500

275,000 275,000 175,000 175,000 1,087,500 1,287,500 $ 37,500 $ 87,500

2

$300,000 + ($40

2,500 units)

3

$75,000 + ($500

$250,000

–– –– 200,000 $ 50,000

25 batches)

Alternatively, we could calculate the incremental revenue and the incremental costs of the additional 2,500 units as follows: Incremental revenue $100 2,500 Incremental direct manufacturing costs Incremental direct manufacturing costs Incremental batch manufacturing costs Total incremental costs Total incremental operating income from accepting the special order

$35 2,500 units $40 2,500 units $500 25 batches

$250,000 87,500 100,000 12,500 200,000 $ 50,000

Award Plus should accept the one-time-only special order if it has no long-term implications because accepting the order increases Award Plus’ operating income by $50,000. If, however, accepting the special order would cause the regular customers to be dissatisfied or to demand lower prices, then Award Plus will have to trade off the $50,000 gain from accepting the special order against the operating income it might lose from regular customers.


2. Award Plus has a capacity of 9,000 medals. Therefore, if it accepts the special one-time order of 2,500 medals, it can sell only 6,500 medals instead of the 7,500 medals that it currently sells to existing customers. That is, by accepting the special order, Award Plus must forgo sales of 1,000 medals to its regular customers. Alternatively, Award Plus can reject the special order and continue to sell 7,500 medals to its regular customers. Award Plus’ operating income from selling 6,500 medals to regular customers and 2,500 medals under one-time special order follow: Revenues (6,500 $150) + (2,500 $100) Direct materials (6,500 $35) + (2,500 $35) Direct manufacturing labor (6,500 $40) + (2,500 $40) 1 Batch manufacturing costs (130 $500) + (25 $500) Fixed manufacturing costs Fixed marketing costs Total costs Operating income 1

$1,225,000 315,000 360,000 77,500 275,000 175,000 1,202,500 $ 22,500

Award Plus makes regular medals in batch sizes of 50. To produce 6,500 medals requires 130 (6,500 ÷ 50) batches.

Accepting the special order will result in a decrease in operating income of $15,000 ($37,500 – $22,500). The special order should, therefore, be rejected. A more direct approach would be to focus on the incremental effects––the benefits of accepting the special order of 2,500 units versus the costs of selling 1,000 fewer units to regular customers. Increase in operating income from the 2,500-unit special order equals $50,000 (requirement 1). The loss in operating income from selling 1,000 fewer units to regular customers equals: Lost revenue, $150 1,000 Savings in direct materials costs, $35 1,000 Savings in direct manufacturing labor costs, $40 1,000 Savings in batch manufacturing costs, $500 20 Operating income lost

$(150,000) 35,000 40,000 10,000 $ (65,000)

Accepting the special order will result in a decrease in operating income of $15,000 ($50,000 – $65,000). The special order should, therefore, be rejected. Even if operating income had increased by accepting the special order, Award Plus should consider the effect on its regular customers of accepting the special order. For example, would selling 1,000 fewer medals to its regular customers cause these customers to find new suppliers that might adversely impact Award Plus’s business in the long run. 3.

Award Plus should not accept the special order. Increase in operating income by selling 2,500 units under the special order (requirement 1) Operating income lost from existing customers ($10 7,500) Net effect on operating income of accepting special order

$ 50,000 (75,000) $(25,000)

The special order should, therefore, be rejected.


11-20 (30 min.) Make versus buy, activity-based costing. 1.

The expected manufacturing cost per unit of CMCBs in 2012 is as follows:

Direct materials, $170 10,000 Direct manufacturing labor, $45 10,000 Variable batch manufacturing costs, $1,500 Fixed manufacturing costs Avoidable fixed manufacturing costs Unavoidable fixed manufacturing costs Total manufacturing costs

80

Total Manufacturing Manufacturing Costs of CMCB Cost per Unit (1) (2) = (1) ÷ 10,000 $1,700,000 $170 450,000 45 120,000 12 320,000 800,000 $3,390,000

32 80 $339

2. The following table identifies the incremental costs in 2012 if Svenson (a) made CMCBs and (b) purchased CMCBs from Minton.

Incremental Items Cost of purchasing CMCBs from Minton Direct materials Direct manufacturing labor Variable batch manufacturing costs Avoidable fixed manufacturing costs Total incremental costs

Total Incremental Costs Make Buy $3,000,000 $1,700,000 450,000 120,000 320,000 $2,590,000 $3,000,000

Per-Unit Incremental Costs Make Buy $300 $170 45 12 32 $259 $300

$410,000

$41

Difference in favor of making

Note that the opportunity cost of using capacity to make CMCBs is zero since Svenson would keep this capacity idle if it purchases CMCBs from Minton. Svenson should continue to manufacture the CMCBs internally since the incremental costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either the make or the buy alternative and hence, are irrelevant.


3. Svenson should continue to make CMCBs. The simplest way to analyze this problem is to recognize that Svenson would prefer to keep any excess capacity idle rather than use it to make CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are less than expected incremental future costs, $2,150,000. If Svenson keeps its capacity idle, we know from requirement 2 that it should make CMCBs rather than buy them. An important point to note is that, because Svenson forgoes no contribution by not being able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero. It is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle. A longer and more detailed approach is to use the total alternatives or opportunity cost analyses shown in Exhibit 11-7 of the chapter. Choices for Svenson Make CMCBs Buy CMCBs and Do Not and Make Relevant Items Make CB3s CB3s, if Profitable TOTAL-ALTERNATIVES APPROACH TO MAKE-OR-BUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2)

$2,590,000

Because incremental future costs exceed incremental future revenues from CB3s, Svenson will make zero CB3s even if it buys CMCBs from Minton Total relevant costs

$3,000,000

0 $2,590,000

0 $3,000,000

Svenson will minimize manufacturing costs and maximize operating income by making CMCBs. OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2) Opportunity cost: profit contribution forgone because capacity will not be used to make CB3s Total relevant costs

$2,590,000

$3,000,000

0* $2,590,000

0 $3,000,000

*

Opportunity cost is 0 because Svenson does not give up anything by not making CB3s. Svenson is best off leaving the capacity idle (rather than manufacturing and selling CB3s).


11-21 (10 min.) Inventory decision, opportunity costs. 1.

Unit cost, orders of 22,000 Unit cost, order of 264,000 (0.98

$7.00 $6.86

$7.00)

Alternatives under consideration: (a) Buy 264,000 units at start of year. (b) Buy 22,000 units at start of each month. Average investment in inventory: (a) (264,000 $6.86) ÷ 2 (b) ( 22,000 $7.00) ÷ 2 Difference in average investment

$905,520 77,000 $828,520

Opportunity cost of interest forgone from 264,000-unit purchase at start of year = $828,520 0.10 = $82,852 2. No. The $82,852 is an opportunity cost rather than an incremental or outlay cost. No actual transaction records the $82,852 as an entry in the accounting system. 3.

The following table presents the two alternatives: Alternative A: Alternative B: Purchase Purchase 264,000 22,000 spark plugs at spark plugs beginning of at beginning year of each month Difference (1) (2) (3) = (1) – (2)

Annual purchase-order costs (1 $260; 12 $260) Annual purchase (incremental) costs (264,000 $6.86; 264,000 $7) Annual interest income that could be earned if investment in inventory were invested (opportunity cost) (10% $905,520; 10% $77,000) Relevant costs

$

260

$

3,120

$ (2,860)

1,811,040

1,848,000

(36,960)

90,552 $1,901,852

7,700 $1,858,820

82,852 $43,032

Column (3) indicates that purchasing 22,000 spark plugs at the beginning of each month is preferred relative to purchasing 264,000 spark plugs at the beginning of the year because the opportunity cost of holding larger inventory exceeds the lower purchasing and ordering costs. If other incremental benefits of holding lower inventory such as lower insurance, materials handling, storage, obsolescence, and breakage costs were considered, the costs under Alternative A would have been higher, and Alternative B would be preferred even more.


11-22 (20–25 min.)

Relevant costs, contribution margin, product emphasis.

1. Cola $18.75 13.75 $ 5.00

Selling price Deduct variable cost per case Contribution margin per case

Lemonade $20.50 15.60 $ 4.90

Punch $27.75 20.70 $ 7.05

Natural Orange Juice $39.30 30.40 $ 8.90

2. The argument fails to recognize that shelf space is the constraining factor. There are only 12 feet of front shelf space to be devoted to drinks. Sexton should aim to get the highest daily contribution margin per foot of front shelf space:

Contribution margin per case Sales (number of cases) per foot of shelf space per day Daily contribution per foot of front shelf space 3.

$

Cola 5.00

Lemonade $ 4.90

Punch $ 7.05

Natural Orange Juice $ 8.90

22

12

6

13

$110.00

$58.80

$42.30

$115.70

The allocation that maximizes the daily contribution from soft drink sales is:

Natural Orange Juice Cola Lemonade Punch

Feet of Shelf Space 6 4 1 1

Daily Contribution per Foot of Front Shelf Space $115.70 110.00 58.80 42.30

Total Contribution Margin per Day $ 694.20 440.00 58.80 42.30 $1,235.30

The maximum of six feet of front shelf space will be devoted to Natural Orange Juice because it has the highest contribution margin per unit of the constraining factor. Four feet of front shelf space will be devoted to Cola, which has the second highest contribution margin per unit of the constraining factor. No more shelf space can be devoted to Cola since each of the remaining two products, Lemonade and Punch (that have the second lowest and lowest contribution margins per unit of the constraining factor) must each be given at least one foot of front shelf space.


11-23 (10 min.) Selection of most profitable product. Only Model 14 should be produced. The key to this problem is the relationship of manufacturing overhead to each product. Note that it takes twice as long to produce Model 9; machine-hours for Model 9 are twice that for Model 14. Management should choose the product mix that maximizes operating income for a given production capacity (the scarce resource in this situation). In this case, Model 14 will yield a $9.50 contribution to fixed costs per machine hour, and Model 9 will yield $9.00: Model 9 Selling price Variable cost per unit* ($28 + $15 + $25 + $14; $13 + $25 + $12.50 + $10) Contribution margin per unit Relative use of machine-hours per unit of product Contribution margin per machine hour

Model 14

$100.00

$70.00

82.00 $ 18.00 ÷ 2 $ 9.00

60.50 $ 9.50 ÷ 1 $ 9.50

*Variable cost per unit = Direct material cost per unit + Direct manufacturing labor cost per unit + Variable manufacturing cost per unit + Marketing cost per unit. 11-24 (20 min.) Which center to close, relevant-cost analysis, opportunity costs. 1. The annual operating costs of $2.5 million for the Groveton center and $3 million for the Stockdale center are irrelevant because these are past costs. The future annual operating costs will be $3.5 million regardless of which ambulatory surgery center is closed. Further, one of the centers will permanently remain open while the other will be shut down. Thus, future operating costs are irrelevant. 2. Also irrelevant are the allocated common administrative costs of $800,000 for the Groveton center and $1 million for the Stockdale center because the total common administrative costs will not change and will simply be reallocated to other ambulatory centers, regardless of whether the Groveton center or the Stockdale center is closed. 3.

The only relevant revenue and cost comparisons are: a. $7 million from sale of the Stockdale center. Note that the historical cost of building the Stockdale center ($4.8 million) and the cost of renovation ($2 million) are irrelevant because these are past costs. Note that future increases in the value of the Stockdale center land is also irrelevant. One of the centers must be kept open, so if Fair Lakes decided to keep the Stockdale center open, it will not be able to sell this land at a future date. b. $1 million in savings in fixed income note if the Groveton center is closed. Again, the historical cost of building the Groveton center ($5 million) is irrelevant.

The relevant costs and benefits analysis favors closing the Stockdale center despite the objections raised by the City Council of Stockdale. The net benefit equals $6 ($7 – $1) million.


11-25 (25 30 min.) Closing and opening stores. 1. Solution Exhibit 11-25, Column 1, presents the relevant loss in revenues and the relevant savings in costs from closing the Rhode Island store. Lopez is correct that Sanchez Corporation’s operating income would increase by $7,000 if it closes down the Rhode Island store. Closing down the Rhode Island store results in a loss of revenues of $860,000 but cost savings of $867,000 (from cost of goods sold, rent, labor, utilities, and corporate costs). Note that by closing down the Rhode Island store, Sanchez Corporation will save none of the equipmentrelated costs because this is a past cost. Also note that the relevant corporate overhead costs are the actual corporate overhead costs $44,000 that Sanchez expects to save by closing the Rhode Island store. The corporate overhead of $40,000 allocated to the Rhode Island store is irrelevant to the analysis. 2. Solution Exhibit 11-25, Column 2, presents the relevant revenues and relevant costs of opening another store like the Rhode Island store. Lopez is correct that opening such a store would increase Sanchez Corporation’s operating income by $11,000. Incremental revenues of $860,000 exceed the incremental costs of $849,000 (from higher cost of goods sold, rent, labor, utilities, and some additional corporate costs). Note that the cost of equipment written off as depreciation is relevant because it is an expected future cost that Sanchez will incur only if it opens the new store. Also note that the relevant corporate overhead costs are the $4,000 of actual corporate overhead costs that Sanchez expects to incur as a result of opening the new store. Sanchez may, in fact, allocate more than $4,000 of corporate overhead to the new store but this allocation is irrelevant to the analysis. The key reason that Sanchez’s operating income increases either if it closes down the Rhode Island store or if it opens another store like it is the behavior of corporate overhead costs. By closing down the Rhode Island store, Sanchez can significantly reduce corporate overhead costs presumably by reducing the corporate staff that oversees the Rhode Island operation. On the other hand, adding another store like Rhode Island does not increase actual corporate costs by much, presumably because the existing corporate staff will be able to oversee the new store as well. SOLUTION EXHIBIT 11-25 Relevant-Revenue and Relevant-Cost Analysis of Closing Rhode Island Store and Opening Another Store Like It. (Loss in Revenues) and Savings in Costs from Closing Rhode Island Store (1) Revenues Cost of goods sold Lease rent Labor costs Depreciation of equipment Utilities (electricity, heating) Corporate overhead costs Total costs Effect on operating income (loss)

$(860,000) 660,000 75,000 42,000 0 46,000 44,000 867,000 $ 7,000

Incremental Revenues and (Incremental Costs) of Opening New Store Like Rhode Island Store (2) $ 860,000 (660,000) (75,000) (42,000) (22,000) (46,000) (4,000) (849,000) $ 11,000


11-26 (20 min.) Choosing customers. If Broadway accepts the additional business from Kelly, it would take an additional 500 machine-hours. If Broadway accepts all of Kelly’s and Taylor’s business for February, it would require 2,500 machine-hours (1,500 hours for Taylor and 1,000 hours for Kelly). Broadway has only 2,000 hours of machine capacity. It must, therefore, choose how much of the Taylor or Kelly business to accept. To maximize operating income, Broadway should maximize contribution margin per unit of the constrained resource. (Fixed costs will remain unchanged at $100,000 regardless of the business Broadway chooses to accept in February, and is, therefore, irrelevant.) The contribution margin per unit of the constrained resource for each customer in January is: Taylor Corporation $78,000 = $52 1,500

Contribution margin per machine-hour

Kelly Corporation $32,000 = $64 500

Since the $80,000 of additional Kelly business in February is identical to jobs done in January, it will also have a contribution margin of $64 per machine-hour, which is greater than the contribution margin of $52 per machine-hour from Taylor. To maximize operating income, Broadway should first allocate all the capacity needed to take the Kelly Corporation business (1,000 machine-hours) and then allocate the remaining 1,000 (2,000 – 1,000) machine-hours to Taylor.

Contribution margin per machine-hour Machine-hours to be worked Contribution margin Fixed costs Operating income

Taylor Corporation $52 1,000 $52,000

Kelly Corporation $64 1,000 $64,000

Total

$116,000 100,000 $ 16,000

An alternative approach is to use the opportunity cost approach. The opportunity cost of giving up 500 machine-hours for the Taylor Corporation jobs is the contribution margin forgone of $52 per machine-hour 500 machine-hours equal to $26,000. The contribution margin gained from using the 500 machine-hours for the Kelly Corporation business is the contribution margin per machine-hour of $64 500 machine-hours equal to $32,000. The net benefit is: Contribution margin from Kelly Corporation business Less: Opportunity cost (of giving up Taylor Corporation business) Net benefit

$32,000 (26,000) $ 6,000


11-27 (30–40 min.) Relevance of equipment costs. 1a.

Statements of Cash Receipts and Disbursements

Receipts from operations: Revenues Deduct disbursements: Other operating costs Operation of machine Purchase of ―old‖ machine Purchase of ―new‖ machine Cash inflow from sale of old machine Net cash inflow

Keep Machine Each Four Year Years Year 1 2, 3, 4 Together

Buy New Machine Each Four Year Years Year 1 2, 3, 4 Together

$150,000

$150,000

$600,000

$150,000

$150,000

$600,000

(110,000) (15,000) (20,000)*

(110,000) (15,000)

(440,000) (60,000) (20,000)

(110,000) (9,000)

$ 5,000

$ 25,000

$ 80,000

(110,000) (9,000) (20,000) (24,000) 8,000 $ (5,000)

(440,000) (36,000) (20,000) (24,000) 8,000 $ 88,000

$ 31,000

*Some students ignore this item because it is the same for each alternative. However, note that a statement for the entire year has been requested. Obviously, the $20,000 would affect only Year 1 under both the ―keep‖ and ―buy‖ alternatives.

The difference is $8,000 for four years taken together. In particular, note that the $20,000 book value of the old machine can be omitted from the comparison. Merely cross out the entire line; although the column totals are affected, the net difference is still $8,000. 1b.

Again, the difference is $8,000: Income Statements

Revenues Costs (excluding disposal): Other operating costs Depreciation Operating costs of machine Total costs (excluding disposal) Loss on disposal: Book value (―cost‖) Proceeds (―revenue‖) Loss on disposal Total costs Operating income

Keep Machine Each Four Year Years 1, 2, 3, 4 Together $150,000 $600,000 110,000 5,000 15,000 130,000

130,000 $ 20,000

440,000 20,000 60,000 520,000

520,000 $ 80,000

Buy New Machine Each Four Years Year Together Year 1 2, 3, 4 $150,000 $150,000 $600,000 110,000 6,000 9,000 125,000

110,000 6,000 9,000 125,000

440,000 24,000 36,000 500,000

20,000 (8,000) 12,000 137,000 125,000 $ 13,000 $ 25,000

20,000* (8,000) 12,000 512,000 $ 88,000

*

As in part (1), the $20,000 book value may be omitted from the comparison without changing the $8,000 difference. This adjustment would mean excluding the depreciation item of $5,000 per year (a cumulative effect of $20,000) under the ―keep‖ alternative and excluding the book value item of $20,000 in the loss on disposal computation under the ―buy‖ alternative.


1c. The $20,000 purchase cost of the old machine, the revenues of $150,000 each year, and the other operating costs of $110,000 each year are irrelevant because these amounts are common to both alternatives. 2. The net difference would be unaffected. Any number may be substituted for the original $20,000 figure without changing the final answer. Of course, the net cash outflows under both alternatives would be high. The Auto Wash manager really blundered. However, keeping the old equipment will increase the cost of the blunder to the cumulative tune of $8,000 over the next four years. 3. Book value is irrelevant in decisions about the replacement of equipment, because it is a past (historical) cost. All past costs are down the drain. Nothing can change what has already been spent or what has already happened. The $20,000 has been spent. How it is subsequently accounted for is irrelevant. The analysis in requirement (1) clearly shows that we may completely ignore the $20,000 and still have a correct analysis. The only relevant items are those expected future items that will differ among alternatives. Despite the economic analysis shown here, many managers would keep the old machine rather than replace it. Why? Because, in many organizations, the income statements of part (2) would be a principal means of evaluating performance. Note that the first-year operating income would be higher under the ―keep‖ alternative. The conventional accrual accounting model might motivate managers toward maximizing their first-year reported operating income at the expense of long-run cumulative betterment for the organization as a whole. This criticism is often made of the accrual accounting model. That is, the action favored by the ―correct‖ or ―best‖ economic decision model may not be taken because the performance-evaluation model is either inconsistent with the decision model or because the focus is on only the short-run part of the performance-evaluation model. There is yet another potential conflict between the decision model and the performance evaluation model. Replacing the machine so soon after it is purchased may reflect badly on the manager’s capabilities and performance. Why didn’t the manager search and find the new machine before buying the old machine? Replacing the old machine one day later at a loss may make the manager appear incompetent to his or her superiors. If the manager’s bosses have no knowledge of the better machine, the manager may prefer to keep the existing machine rather than alert his or her bosses about the better machine.


11-28 (30 min.)

Equipment upgrade versus replacement.

1. Based on the analysis in the table below, TechGuide will be better off by $337,500 over three years if it replaces the current equipment. Over 3 years Comparing Relevant Costs of Upgrade and Replace Alternatives Cash operating costs $150; $75 per desk 7,500 desks per yr. 3 yrs. Current disposal price One time capital costs, written off periodically as depreciation Total relevant costs

Upgrade (1)

Replace (2)

Difference in favor of Replace (3) = (1) – (2)

$3,375,000

$1,687,500 (450,000)

$1,687,50 450,000

3,000,000 $6,375,000

4,800,000 $6,037,500

(1,800,00 $ 337,500

3 = $1,080,000 would either be 5 written off as depreciation over three years under the upgrade option, or, all at once in the current year under the replace option. Its net effect would be the same in both alternatives: to increase costs by $1,080,000 over three years, hence it is irrelevant in this analysis.

Note that the book value of the current machine, $1,800,000

2. Suppose the capital expenditure to replace the equipment is $X. From requirement 1, column (2), substituting for the one-time capital cost of replacement, the relevant cost of replacing is $1,687,500 – $450,000 + $X. From column (1), the relevant cost of upgrading is $6,375,000. We want to find X such that $1,687,500 – $450,000 + $X < $6,375,000 (i.e., TechGuide will favor replacing) Solving the above inequality gives us X < $6,375,000 – $1,237,500 = $5,137,500. TechGuide would prefer to replace, rather than upgrade, if the replacement cost of the new equipment does not exceed $5,137,500. Note that this result can also be obtained by taking the original replacement cost of $4,800,000 and adding to it the $337,500 difference in favor of replacement calculated in requirement 1.


3. Suppose the units produced and sold over 3 years equal y. Using data from requirement 1, column (1), the relevant cost of upgrade would be $150y + $3,000,000, and from column (2), the relevant cost of replacing the equipment would be $75y – $450,000 + $4,800,000. TechGuide would want to upgrade when $150y + $3,000,000 < $75y – $450,000 + $4,800,000 $75y < $1,350,000 y < $1,350,000 $75 = 18,000 units That is, upgrade when y < 18,000 units (or 6,000 per year for 3 years) and replace when y > 18,000 units over 3 years. When production and sales volume is low (less than 6,000 per year), the higher operating costs under the upgrade option are more than offset by the savings in capital costs from upgrading. When production and sales volume is high, the higher capital costs of replacement are more than offset by the savings in operating costs in the replace option. 4. Operating income for the first year under the upgrade and replace alternatives are shown below: Year 1 Upgrade Replace (1) (2) Revenues (7,500 $750) $5,625,000 $5,625,000 Cash operating costs $150; $75 per desk 7,500 desks per year 1,125,000 562,500 Depreciation ($1,080,000a + $3,000,000) 3; $4,800,000 3 1,360,000 1,600,000 Loss on disposal of old equipment (0; $1,080,000 – $450,000) 0 630,000 Total costs 2,485,000 2,792,500 Operating Income $3,140,000 $2,832,500 a

The book value of the current production equipment is $1,800,000 useful life of 3 years.

5

3 = $1,080,000; it has a remaining

First-year operating income is higher by $307,500 ($3,140,000 – $2,832,500) under the upgrade alternative, and Dan Doria, with his one-year horizon and operating income-based bonus, will choose the upgrade alternative, even though, as seen in requirement 1, the replace alternative is better in the long run for TechGuide. This exercise illustrates the possible conflict between the decision model and the performance evaluation model.


11-29 (20 min.) Special Order. 1. Revenues from special order ($25 10,000 bats) Variable manufacturing costs ($161 10,000 bats) Increase in operating income if Ripkin order accepted

$250,000 (160,000) $ 90,000

1

Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable manufacturing overhead cost per unit = $12 + $3 + $1 = $16

Louisville should accept Ripkin’s special order because it increases operating income by $90,000. Since no variable selling costs will be incurred on this order, this cost is irrelevant. Similarly, fixed costs are irrelevant because they will be incurred regardless of the decision. 2a. Revenues from special order ($25 10,000 bats) Variable manufacturing costs ($16 10,000 bats) Contribution margin foregone ([$32─$181] 10,000 bats) Decrease in operating income if Ripkin order accepted

$250,000 (160,000) (140,000) $ (50,000)

1

Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable manufacturing overhead cost per unit + Variable selling expense per unit = $12 + $1 + $3 + $2 = $18

Based strictly on financial considerations, Louisville should reject Ripkin’s special order because it results in a $50,000 reduction in operating income. 2b. Louisville will be indifferent between the special order and continuing to sell to regular customers if the special order price is $30. At this price, Louisville recoups the variable manufacturing costs of $160,000 and the contribution margin given up from regular customers of $140,000 ([$160,000 + $140,000] ÷ 10,000 units = $30). That is, at the special order price of $30, Louisville recoups the variable cost per unit of $16 and the contribution margin per unit given up from regular customers of $14 per unit. An alternative approach is to recognize that Louisville needs to earn $50,000 more than the revenues of $250,000 in requirement 2a, so that the decrease in operating income of $50,000 becomes $0. Louisville will be indifferent between the special order and continuing to sell to regular customers if revenues from the special order = $250,000 + $50,000 = $300,000 or $30 per bat ($300,000 10,000 bats) Looked at a different way, Louisville needs to earn the full price of $32 less the $2 saved on variable selling costs. 2c. Louisville may be willing to accept a loss on this special order if the possibility of future long-term sales seem likely at a higher price. Moreover, Louisville should also consider the negative long-term effect on customer relationships of not selling to existing customers. Louisville cannot afford to sell bats to customers at the special order price for the long term because the $25 price is less than the full cost of the product of $27. This means that in the long term the contribution margin earned will not cover the fixed costs and result in a loss. Louisville will then be better off shutting down.


11-30 (20 min.) International outsourcing. 1.

Cost to purchase each figurine from Indonesian supplier =

27,300 IDR 9,100 IDR/$

Cost of purchasing 400,000 figurines from Indonesian supplier = $3 $1,200,000. Costs of manufacturing figurines in Cleveland facility

=

Variable manufacturing cost per unit

Quantity of figurines produced

+

$3 .

400,000 figurines =

Incremental fixed manufacturing costs

= $2.85 400,000 units + $200,000 = $1,340,000 Variable and fixed selling and distribution costs are irrelevant because they do not differ between the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing the figurines in Cleveland. Bernie’s Bears should purchase the figurines from the Indonesian supplier because the cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in Cleveland. 2.

If Bernie’s Bears enters into a forward contract to purchase 27,300 IDRs for $3.40, each figurine acquired from the Indonesian supplier will cost $3.40. Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40 400,000 figurines = $1,360,000. Cost of manufacturing 400,000 figurines in Cleveland (see requirement 1) = $1,340,000. As in requirement 1, selling and distribution costs are irrelevant.

Bernie’s Bears should manufacture the figurines in Cleveland because the relevant cost of $1,340,000 to manufacture the figurines in Cleveland is less than the cost of $1,360,000 to enter into the forward contract and purchase the figurines from the Indonesian supplier. 3. In deciding whether to purchase figurines from the Indonesian supplier, Bernie’s Bears should consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of the Indonesian Rupiah relative to the U.S. dollar, and (d) the negative public and media reaction to not providing jobs in Cleveland and instead supporting job creation in Indonesia.


11-31 (30 min.) Relevant costs, opportunity costs. 1. Easyspread 2.0 has a higher relevant operating income than Easyspread 1.0. Based on this analysis, Easyspread 2.0 should be introduced immediately:

Relevant revenues Relevant costs: Manuals, diskettes, compact discs Total relevant costs Relevant operating income

Easyspread 1.0 $160

Easyspread 2.0 $195

$ 0

$30 0 $160

30 $165

Reasons for other cost items being irrelevant are Easyspread 1.0 Manuals, diskettes—already incurred Development costs—already incurred Marketing and administrative—fixed costs of period Easyspread 2.0 Development costs—already incurred Marketing and administration—fixed costs of period Note that total marketing and administration costs will not change whether Easyspread 2.0 is introduced on July 1, 2011, or on October 1, 2011. 2.

Other factors to be considered: a. Customer satisfaction. If 2.0 is significantly better than 1.0 for its customers, a customer driven organization would immediately introduce it unless other factors offset this bias towards ―do what is best for the customer.‖ b. Quality level of Easyspread 2.0. It is critical for new software products to be fully debugged. Easyspread 2.0 must be error-free. Consider an immediate release only if 2.0 passes all quality tests and can be fully supported by the salesforce. c. Importance of being perceived to be a market leader. Being first in the market with a new product can give Basil Software a ―first-mover advantage,‖ e.g., capturing an initial large share of the market that, in itself, causes future potential customers to lean towards purchasing Easyspread 2.0. Moreover, by introducing 2.0 earlier, Basil can get quick feedback from users about ways to further refine the software while its competitors are still working on their own first versions. Moreover, by locking in early customers, Basil may increase the likelihood of these customers also buying future upgrades of Easyspread 2.0. d. Morale of developers. These are key people at Basil Software. Delaying introduction of a new product can hurt their morale, especially if a competitor then preempts Basil from being viewed as a market leader.


11-32 (20 min.) Opportunity costs. (Please alert students that in some printed versions of the book there is a typographical error in the first line of requirement 2. “Wolverine” should be replaced by “Wild Boar.”) 1. The opportunity cost to Wild Boar of producing the 3,500 units of Orangebo is the contribution margin lost on the 3,500 units of Rosebo that would have to be forgone, as computed below: Selling price $ 26 Variable costs per unit: Direct materials $5 Direct manufacturing labor 1 Variable manufacturing overhead 4 Variable marketing costs 2 12 Contribution margin per unit $ 14 Contribution margin for 3,500 units ($14

$49,000

3,500 units)

The opportunity cost is $49,000. Opportunity cost is the maximum contribution to operating income that is forgone (rejected) by not using a limited resource in its next-best alternative use. 2. Contribution margin from manufacturing 3,500 units of Orangebo and purchasing 3,500 units of Rosebo from Buckeye is $52,500, as follows: Manufacture Purchase Orangebo Rosebo Total Selling price Variable costs per unit: Purchase costs Direct materials Direct manufacturing labor Variable manufacturing costs Variable marketing overhead Variable costs per unit Contribution margin per unit Contribution margin from selling 3,500 units of Orangebo and 3,500 units of Rosebo ($9 3,500 units; $6 3,500 units)

$

20

$

– 5 1 4 1 11 9

$31,500

$

26 18

$

2 20 6

$21,000

$52,500

As calculated in requirement 1, Wild Boar’s contribution margin from continuing to manufacture 3,500 units of Rosebo is $49,000. Accepting the Miami Company and Buckeye offer will benefit Wild Boar by $3,500 ($52,500 – $49,000). Hence, Wild Boar should accept the Miami Company and Buckeye Corporation’s offers. 3. The minimum price would be any price greater than $11, the sum of the incremental costs of manufacturing and marketing Orangebo as computed in requirement 2. This follows because, if Wild Boar has surplus capacity, the opportunity cost = $0. For the short-run decision of whether to accept Orangebo’s offer, fixed costs of Wild Boar are irrelevant. Only the incremental costs need to be covered for it to be worthwhile for Wild Boar to accept the Orangebo offer. 11-21 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

11-33 (30–40 min.) Product mix, relevant costs. 1. R3 $100 60 15 75 $ 25

Selling price Variable manufacturing cost per unit Variable marketing cost per unit Total variable costs per unit Contribution margin per unit

HP6 $150 100 35 135 $ 15

Contributi on margin per hour of the constraine d resource (the regular machine)

$25 = $25 1

$15 = $30 0.5

Total contribution margin from selling only R3 or only HP6 R3: $25 50,000; HP6: $30 50,000 Less Lease costs of high-precision machine to produce and sell HP6 Net relevant benefit

$1,250,000

$1,500,000

$1,250,000

300,000 $1,200,000

Even though HP6 has the higher contribution margin per unit of the constrained resource, the fact that Pendleton must incur additional costs of $300,000 to achieve this higher contribution margin means that Pendleton is better off using its entire 50,000-hour capacity on the regular machine to produce and sell 50,000 units (50,000 hours 1 hour per unit) of R3. The additional contribution from selling HP6 rather than R3 is $250,000 ($1,500,000 $1,250,000), which is not enough to cover the additional costs of leasing the high-precision machine. Note that, because all other overhead costs are fixed and cannot be changed, they are irrelevant for the decision. Pendleton produces 50,000 units of R3, which increases operating income by $1,250,000. 2. If capacity of the regular machines is increased by 15,000 machine-hours to 65,000 machine-hours (50,000 originally + 15,000 new), the net relevant benefit from producing R3 and HP6 is as follows: R3 HP6 Total contribution margin from selling only R3 or only HP6 R3: $25 65,000; HP6: $30 65,000 Less Lease costs of high-precision machine that would be incurred if HP6 is produced and sold Less Cost of increasing capacity by 15,000 hours on regular machine Net relevant benefit

$1,625,000 $1,950,000 300,000 150,000 150,000 $1,475,000 $1,500,000

Adding 15,000 machine-hours of capacity for regular machines and using all the capacity to produce HP6 increases operating income by $1,500,000.


Investing in the additional capacity increases Pendleton’s operating income by $250,000 ($1,500,000 calculated in requirement 2 minus $1,250,000 calculated in requirement 1), so Pendleton should add 15,000 hours to the regular machine. With the extra capacity available to it, Pendleton should use its entire capacity to produce HP6. Using all 65,000 hours of capacity to produce HP6 rather than to produce R3 generates additional contribution margin of $325,000 ($1,950,000 $1,625,000) which is more than the additional cost of $300,000 to lease the highprecision machine. Pendleton should therefore produce and sell 130,000 units of HP6 (65,000 hours 0.5 hours per unit of HP6) and zero units of R3. 3. Selling price Variable manufacturing costs per unit Variable marketing costs per unit Total variable costs per unit Contribution margin per unit

Contributi on margin per hour of the constraine d resource (the regular machine)

R3

HP6

S3

$100 60 15 75 $ 25

$150 100 35 135 $ 15

$120 70 15 85 $ 35

$25 = $25 1

$15 $35 = $30 = $35 0.5 1

The first step is to compare the operating profits that Pendleton could earn if it accepted the Carter Corporation offer for 20,000 units with the operating profits Pendleton is currently earning. S3 has the highest contribution margin per hour on the regular machine and requires no additional investment such as leasing a high-precision machine. To produce the 20,000 units of S3 requested by Carter Corporation, Pendleton would require 20,000 hours on the regular machine resulting in contribution margin of $35 20,000 = $700,000. Pendleton now has 45,000 hours available on the regular machine to produce R3 or HP6. R3 Total contribution margin from selling only R3 or only HP6 R3: $25 45,000; HP6: $30 45,000 Less Lease costs of high-precision machine to produce and sell HP 6 Net relevant benefit

HP6

$1,125,000 $1,350,000 300,000 $1,125,000 $1,050,000

Pendleton should use all the 45,000 hours of available capacity to produce 45,000 units of R3. Thus, the product mix that maximizes operating income is 20,000 units of S3, 45,000 units of R3, and zero units of HP6. This optimal mix results in a contribution margin of $1,825,000 ($700,000 from S3 and $1,125,000 from R3). Relative to requirement 2, operating income increases by $325,000 ($1,825,000 minus $1,500,000 calculated in requirement 2). Hence, Pendleton should accept the Carter Corporation business and supply 20,000 units of S3.


11-34 (35–40 min.) Dropping a product line, selling more units. 1. The incremental revenue losses and incremental savings in cost by discontinuing the Tables product line follows: Difference: Incremental (Loss in Revenues) and Savings in Costs from Dropping Tables Line Revenues Direct materials and direct manufacturing labor Depreciation on equipment Marketing and distribution General administration Corporate office costs Total costs Operating income (loss)

$(500,000) 300,000 0 70,000 0 0 370,000 $(130,000)

Dropping the Tables product line results in revenue losses of $500,000 and cost savings of $370,000. Hence, Grossman Corporation’s operating income will be $130,000 lower if it drops the Tables line. Note that, by dropping the Tables product line, Home Furnishings will save none of the depreciation on equipment, general administration costs, and corporate office costs, but it will save variable manufacturing costs and all marketing and distribution costs on the Tables product line. 2. Grossman’s will generate incremental operating income of $128,000 from selling 4,000 additional tables and, hence, should try to increase table sales. The calculations follow:

Revenues Direct materials and direct manufacturing labor Cost of equipment written off as depreciation Marketing and distribution costs General administration costs Corporate office costs Operating income

Incremental Revenues (Costs) and Operating Income $500,000 (300,000) (42,000)* (30,000)† 0** 0** $128,000

*

Note that the additional costs of equipment written off as depreciation are relevant future costs for the ―selling more tables decision‖ because they represent incremental future costs that differ between the alternatives of selling and not selling additional tables. † Current marketing and distribution costs which varies with number of shipments = $750 per shipment 40 shipments = $30,000. As the sales of tables double, the number of shipments will double, resulting in incremental marketing and distribution costs of (2 $30,000) – $30,000 = $30,000. Alternatively, the cost of 40 additional shipments can be calculated as $750 per shipment 40 shipments = $30,000. ** General administration and corporate office costs will be unaffected if Grossman decides to sell more tables. Hence, these costs are irrelevant for the decision.


3. Solution Exhibit 11-34, Column 1, presents the relevant loss of revenues and the relevant savings in costs from closing the Northern Division. As the calculations show, Grossman’s operating income would decrease by $140,000 if it shut down the Northern Division (loss in revenues of $1,500,000 versus savings in costs of $1,360,000). Grossman will save variable manufacturing costs, marketing and distribution costs, and division general administration costs by closing the Northern Division but equipment-related depreciation and corporate office allocations are irrelevant to the decision. Equipment-related costs are irrelevant because they are past costs (and the equipment has zero disposal price). Corporate office costs are irrelevant because Grossman will not save any actual corporate office costs by closing the Northern Division. The corporate office costs that used to be allocated to the Northern Division will be allocated to other divisions. 4. Solution Exhibit 11-34, Column 2, presents the relevant revenues and relevant costs of opening the Southern Division (a division whose revenues and costs are expected to be identical to the revenues and costs of the Northern Division). Grossman should open the Southern Division because it would increase operating income by $40,000 (increase in relevant revenues of $1,500,000 and increase in relevant costs of $1,460,000). The relevant costs include direct materials, direct manufacturing labor, marketing and distribution, equipment, and division general administration costs but not corporate office costs. Note, in particular, that the cost of equipment written off as depreciation is relevant because it is an expected future cost that Grossman will incur only if it opens the Southern Division. Corporate office costs are irrelevant because actual corporate office costs will not change if Grossman opens the Southern Division. The current corporate staff will be able to oversee the Southern Division’s operations. Grossman will allocate some corporate office costs to the Southern Division but this allocation represents corporate office costs that are already currently being allocated to some other division. Because actual total corporate office costs do not change, they are irrelevant to the division. SOLUTION EXHIBIT 11-34 Relevant-Revenue and Relevant-Cost Analysis for Closing Northern Division and Opening Southern Division

Revenues Variable direct materials and direct manufacturing labor costs Equipment cost written off as depreciation Marketing and distribution costs Division general administration costs Corporate office costs Total costs Effect on operating income (loss)

Incremental (Loss in Revenues) Revenues and and Savings in (Incremental Costs) Costs from Closing from Opening Northern Division Southern Division (1) (2) $(1,500,000) $1,500,000 825,000 0 205,000 330,000 0 1,360,000 $ (140,000)

(825,000) (100,000) (205,000) (330,000) 0 (1,460,000) $ 40,000


11-35 (30–40 min.) Make or buy, unknown level of volume. 1.

The variable costs required to manufacture 150,000 starter assemblies are Direct materials Direct manufacturing labor Variable manufacturing overhead Total variable costs

$200,000 150,000 100,000 $450,000

The variable costs per unit are $450,000 ÷ 150,000 = $3.00 per unit. Let X = number of starter assemblies required in the next 12 months. The data can be presented in both ―all data‖ and ―relevant data‖ formats:

Variable manufacturing costs Fixed general manufacturing overhead Fixed overhead, avoidable Division 2 manager’s salary Division 3 manager’s salary Purchase cost, if bought from Tidnish Electronics Total costs

All Data Relevant Data Alternative Alternative Alternative Alternative 1: 2: 1: 2: Buy Make Buy Make $ 3X – $ 3X – 150,000 $150,000 – – 100,000 – 100,000 – 40,000 50,000 40,000 $50,000 50,000 – 50,000 – – $340,000 + $ 3X

4X $200,000 + $ 4X

– $190,000 + $ 3X

4X $50,000 + $ 4X

The number of units at which the costs of make and buy are equivalent is All data analysis: or Relevant data analysis:

$340,000 + $3X = $200,000 + $4X X = 140,000 $190,000 + $3X = $50,000 + $4X X = 140,000

Assuming cost minimization is the objective, then • If production is expected to be less than 140,000 units, it is preferable to buy units from Tidnish. • If production is expected to exceed 140,000 units, it is preferable to manufacture internally (make) the units. • If production is expected to be 140,000 units, Oxford should be indifferent between buying units from Tidnish and manufacturing (making) the units internally.


2. The information on the storage cost, which is avoidable if self-manufacture is discontinued, is relevant; these storage charges represent current outlays that are avoidable if self-manufacture is discontinued. Assume these $50,000 charges are represented as an opportunity cost of the make alternative. The costs of internal manufacture that incorporate this $50,000 opportunity cost are All data analysis: Relevant data analysis:

$390,000 + $3X $240,000 + $3X

Alternatively stated, we would add the following line to the table shown in requirement 1 causing the total costs line to change as follows:

Outside storage charges Total costs 1

All Data Alternative 1: Alternative 2: Make Buy

Relevant Data Alternative 1: Alternative 2: Make Buy

$50,000 $390,0001 + 3X

$50,000 $240,0002 + 3X

$390,000 = $340,000 + $50,000

2

$0 $200,000 + 4X

$0 $50,000 + 4X

$240,000 = $190,000 + $50,000

The number of units at which the costs of make and buy are equivalent is All data analysis: Relevant data analysis:

$390,000 + $3X X $240,000 + $3X X

= = = =

$200,000 + $4X 190,000 $ 50,000 + $4X 190,000

If production is expected to be less than 190,000, it is preferable to buy units from Tidnish. If production is expected to exceed 190,000, it is preferable to manufacture the units internally.


11-36 (30 min.) Make versus buy, activity-based costing, opportunity costs. 1.

Relevant costs under buy alternative: Purchases, 40,000 $9.25

$370,000

Relevant costs under make alternative: Direct materials Direct manufacturing labor Variable manufacturing overhead Inspection, setup, materials handling Machine rent Total relevant costs under make alternative

$200,000 100,000 50,000 4,000 8,000 $362,000

The allocated fixed plant administration, taxes, and insurance will not change if Weaver makes or buys the burners. Hence, these costs are irrelevant to the make-or-buy decision. The analysis indicates that it is less costly for Weaver to make rather than buy the burners from the outside supplier. 2.

Relevant costs under the make alternative: Relevant costs (as computed in requirement 1) Relevant costs under the buy alternative: Costs of purchases (40,000 $9.25) Additional fixed costs Additional contribution margin from using the space where the burners were made to upgrade the grills by adding rotisserie attachments, 20,000 ($30 – $24) Total relevant costs under the buy alternative

$362,000

$370,000 100,000

(120,000) $350,000

Weaver should buy the side burners from an outside vendor and use its own capacity to upgrade its grills. 3.

In this requirement, the decision on making the rotisserie attachments is irrelevant to the analysis because the rotisserie attachments increase operating income and they will be made whether the burners are purchased or made. Relevant cost of manufacturing burners: Variable costs, ($5 + $2.50 + $1.25 = $8.75) Batch costs, $100/batcha 32 batches Machine rent

Relevant cost of buying burners, $9.25 a

$4,000

32,000

32,000

$280,000 3,200 8,000 $291,200 $296,000

40 batches = $100 per batch

In this case, Weaver should make the burners.


11-37 (60 min.) Multiple choice, comprehensive problem on relevant costs. You may wish to assign only some of the parts.

Manufacturing costs: Direct materials Direct manufacturing labor Variable manufac. indirect costs Fixed manufac. indirect costs Marketing costs: Variable Fixed

1. (b) $3.50

2. (e)

Per Unit Fixed

Total $1.00 1.20 0.80 0.50 $1.50 0.90

Variable

$3.50

$0.50

$3.00

2.40 $5.90

0.90 $1.40

1.50 $4.50

Manufacturing Costs Variable $3.00 Fixed 0.50 Total $3.50

None of the above. Decrease in operating income is $16,800.

Revenues Variable costs Manufacturing Marketing and other Variable costs Contribution margin Fixed costs Manufacturing Marketing and other Fixed costs Operating income *Incremental revenue: $5.80 24,000 Deduct price reduction $0.20 240,000

240,000

Old $6.00

Differential $1,440,000+ $ 91,200*

240,000 $3.00 240,000 $1.50

720,000 + 360,000 + 1,080,000+ 360,000 –

$0.50 240,000 = $0.90 240,000

120,000 216,000 336,000 $ 24,000

72,000 264,000 36,000 264,000 108,000 16,800

New 264,000 $3.00 $1.50

–– –– –– – $ 16,800

$139,200 48,000 $ 91,200


$5.80

792,000 396,000 1,188,000 343,200 120,000 216,000

33 $

7,200

3.

(c) $3,500

If this order were not landed, fixed manufacturing overhead would be underallocated by $2,500, $0.50 per unit 5,000 units. Therefore, taking the order increases operating income by $1,000 plus $2,500, or $3,500. Another way to present the same idea follows: Revenues will increase by (5,000 $3.50 = $17,500) + $1,000 Costs will increase by 5,000 $3.00 Fixed overhead will not change Change in operating income

$18,500 (15,000) – $ 3,500

Note that this answer to (3) assumes that variable marketing costs are not influenced by this contract. These 5,000 units do not displace any regular sales. 4.

(a)

$4,000 less ($7,500 – $3,500) Alternative B: 5,000 units sold Alternative A: 5,000 units under Government Contract sold to Regular Customers As above $3,500 Sales, 5,000 $6.00 $30,000 Increase in costs: Variable costs only: Manufacturing, 5,000 $3.00 $15,000 Marketing, 5,000 $1.50 7,500 22,500 Fixed costs are not affected Change in operating income $ 7,500

5. (b)

$4.15

Differential costs: Variable: Manufacturing Shipping Fixed: $4,000 ÷ 10,000

$3.00 0.75 $3.75 0.40 $4.15

10,000 10,000 4,000 10,000 $41,500

$37,500

Selling price to break even is $4.15 per unit. 6. (e)

$1.50, the variable marketing costs. The other costs are past costs and therefore, are irrelevant.


7. (e)

None of these. The correct answer is $3.55. This part always gives students trouble. The short-cut solution below is followed by a longer solution that is helpful to students.

Short-cut solution: The highest price to be paid would be measured by those costs that could be avoided by halting production and subcontracting: Variable manufacturing costs Fixed manufacturing costs saved $60,000 ÷ 240,000 Marketing costs (0.20 $1.50) Total costs

$3.00 0.25 0.30 $3.55

Longer but clearer solution: Comparative Annual Income Statement Present Difference Proposed Revenues Variable costs: Manufacturing, 240,000 $3.00 Marketing and other, 240,000 $1.50 Variable costs Contribution margin Fixed costs: Manufacturing Marketing and other Total fixed costs Operating income

$1,440,000

$

–

$1,440,000

720,000 360,000 1,080,000 360,000

+132,000 –72,0001

852,000* 288,000 1,140,000 300,000

120,000 216,000 336,000 $ 24,000

–60,0002

60,000 216,000 276,000 $ 24,000

$

0

*

This solution is obtained by filling in the above schedule with all the known figures and working ―from the bottom up‖ and ―from the top down‖ to the unknown purchase figure. Maximum variable costs that can be incurred, $1,140,000 – $288,000 = maximum purchase costs, or $852,000. Divide $852,000 by 240,000 units, which yields a maximum purchase price of $3.55. 1 2

0.20 0.50

$360,000 = $72,000 Fixed manufacturing costs of $120,000 = $60,000


11-38 (25 min.) Closing down divisions. 1. and 2. Sales Variable costs of goods sold ($550,000 0.90; $620,000 Variable S,G & A ($120,000 0.50; $135,000 Total variable costs Contribution margin

Division A

Division B

$630,000

$632,000

0.80)

495,000

496,000

0.50)

60,000 555,000 $ 75,000

67,500 563,500 $68,500

Division A

Division B

$ 55,000

$124,000

60,000 $115,000

67,500 $191,500

$ 46,000

$ 76,600

Fixed costs of goods sold ($550,000 0.10; $620,000 0.20) Fixed S,G & A ($120,000 0.50; $135,000 0.50) Total fixed costs Fixed costs savings if shutdown ($115,000 0.40; $191,500 0.40)

Division A’s contribution margin of $75,000 more than covers its avoidable fixed costs of $46,000. The difference of $29,000 helps cover the company’s unavoidable fixed costs. Since $46,000 of Division A’s fixed costs are avoidable, the remaining $69,000 is unavoidable and will be incurred regardless of whether Division A continues to operate. Division A’s $40,000 loss is the rest of the unavoidable fixed costs ($69,000 ─ $29,000). If Division A is closed, the remaining divisions will need to generate sufficient profits to cover the entire $69,000 unavoidable fixed cost. Consequently, Division A should not be closed since it helps defray $29,000 of this cost. Division B earns a positive contribution margin of $68,500. Division B also generates $76,600 of avoidable fixed costs. Based strictly on financial considerations, Division B should be closed because the company will save $8,100 ($76,600 –$68,500). Division B is currently incurring $76,600 in fixed costs that it could have avoided while earning only $68,500 in contribution margin.


An alternative set of calculations is as follows: Division A

Division B

Total variable costs Avoidable fixed costs if shutdown Total cost savings if shutdown Loss of revenues if shutdown

$555,000 46,000 601,000 (630,000)

$563,500 76,600 640,100 (632,000)

Cost savings minus loss of revenues

$ (29,000)

$

8,100

Division A should not be shut down because loss of revenues if Division A is shut down exceeds cost savings by $29,000. Division B should be shut down because cost savings from shutting down Division B exceeds loss of revenues. 3. Before deciding to close Division B, management should consider the role that the Division’s product line plays relative to other product lines. For instance, if the product manufactured by Division B attracts customers to the company, then dropping Division B may have a detrimental effect on the revenues of the remaining divisions. Management may also want to consider the impact on the morale of the remaining employees if Division B is closed. Talented employees may become fearful of losing their jobs and seek employment elsewhere.


11-39 (25 min.) Product mix, constrained resource. 1. Selling price Variable costs: Direct materials (DM) Labor and other costs Total variable costs Contribution margin Pounds of DM per unit Contribution margin per lb.

A110 $84

B382 $ 56

C657 $70

24 28 52 $32 ÷8 lbs. $ 4 per lb.

15 27 42 $ 14 ÷5 lbs. $2.80 per lb.

9 40 49 $21 ÷ 3 lbs. $ 7 per lb.

First, satisfy minimum requirements. Minimum units Times pounds per unit Pounds needed to produce minimum units

A110 200 ×8 lb. per unit 1,600 lb.

B382 200 ×5 lb. per unit 1,000 lb.

C657 200 ×3 lb. per unit 600 lb.

Total

3,200 lb.

The remaining 1,800 pounds (5,000 ─ 3,200) should be devoted to C657 because it has the highest contribution margin per pound of direct material. Since each unit of C657 requires 3 pounds of Bistide, the remaining 1,800 pounds can be used to produce another 600 units of C657. The following combination yields the highest contribution margin given the 5,000 pounds constraint on availability of Bistide. A110: 200 units B382: 200 units C657: 800 units (200 minimum + 600 extra) 2. The demand for Westford’s products exceeds the materials available. Assuming that fixed costs are covered by the original product mix, Westford would be willing to pay up to an additional $7 per pound (the contribution margin per pound of C657) for another 1,000 pounds of Bistide. That is, Westford would be willing to pay $3 + $7 = $10 per pound of Bistide for the pounds of Bistide that will be used to produce C657.1 If sufficient demand does not exist for 333 units (1,000 pounds ÷ 3 pounds per unit) of C657, then the maximum price Westford would be willing to pay is an additional $4 per pound (the contribution margin per pound of A110) for the pounds of Bistide that will be used to produce A110. In this case Westford would be willing to pay $3 + $4 = $7 pound. If all the 1,000 pounds of Bistide are not used to satisfy the demand for C657 and A110, then the maximum price Westford would be willing to pay is an additional $2.80 per pound (the contribution margin per pound of B382) for the pounds of Bistide that will be used to produce B382. Westford would be willing to pay $2.80 + $3 = $5.80 per pound of Bistide. 1

An alternative calculation focuses on column 3 for C657 of the table in requirement 1. Selling price Variable labor and other costs (excluding direct materials) Contribution margin Divided by pounds of direct material per unit Direct material cost per pound that Westford can pay without contribution margin becoming negative

$70 40 $30 ÷3 lbs. $10


11-40 (30–40 min.) Optimal product mix. Let D represent the batches of Della’s Delight made and sold. Let B represent the batches of Bonny’s Bourbon made and sold. The contribution margin per batch of Della’s Delight is $300. The contribution margin per batch of Bonny’s Bourbon is $250.

1.

The LP formulation for the decision is: Maximize Subject to

$300D + $250 B 30D + 15B 660 (Mixing Department constraint) 15B 270 (Filling Department constraint) 10D + 15B 300 (Baking Department constraint)

2. Solution Exhibit 11-40 presents a graphical summary of the relationships. The optimal corner is the point (18, 8) i.e., 18 batches of Della’s Delights and 8 of Bonny’s Bourbons. SOLUTION EXHIBIT 11-40 Graphic Solution to Find Optimal Mix, Della Simpson, Inc. Della Simpson Production Model 50

45

0, 44 Mixing Dept. Constraint

B (batches of Bonny's Bourbons)

40

35

Equal Contribution Margin Lines

30

Optimal Corner (18,8) 25

20

Filling Dept. Constraint

3, 18 0, 18

15

10

Feasible Region 5

Baking Dept. Constraint

0 0

5

10

15

20

22, 0

25

30

D (batches of Della's Delight)


35

40

We next calculate the optimal production mix using the trial-and-error method. The corner point where the Mixing Dept. and Baking Dept. constraints intersect can be calculated as (18, 8) by solving: 30D + 15B = 660 (1) Mixing Dept. constraint 10D + 15B = 300 (2) Baking Dept. constraint Subtracting (2) from (1), we have 20D = 360 or D = 18 Substituting in (2) (10 18) + 15B = 300 that is, 15B = 300 or B = 8

180 = 120

The corner point where the Filling and Baking Department constraints intersect can be calculated as (3,18) by substituting B = 18 (Filling Department constraint) into the Baking Department constraint: 10 D + (15 18) = 300 10 D = 300 270 = 30 D= 3 The feasible region, defined by 5 corner points, is shaded in Solution Exhibit 11-40. We next use the trial-and-error method to check the contribution margins at each of the five corner points of the area of feasible solutions. Trial 1 2 3 4 5

Corner (D,B) (0,0) (22,0) (18,8) (3,18) (0,18)

Total Contribution Margin ($300 0) + ($250 0) = $0 ($300 22) + ($250 0) = $6,600 ($300 18) + ($250 8) = $7,400 ($300 3) + ($250 18) = $5,400 ($300 0) + ($250 18) = $4,500

The optimal solution that maximizes contribution margin and operating income is 18 batches of Della’s Delights and 8 batches of Bonny’s Bourbons.


11-41

(25 min.) Dropping a customer, activity-based costing, ethics.

1. VRS would not benefit from dropping Franco’s because it would lose $15,600 in revenues and save $15,480 in costs resulting in a $120 decrease in operating income. Difference: Incremental (Loss in Revenues) and Savings in Costs from Dropping Franco’s Revenues Cost of goods sold Order processing ($5,000 – 10% × $5,000) Delivery ($1,250 – 20% × $1,250) Rush orders Sales calls Total costs Effect on operating income (loss)

$

$(15,600) 9,350 4,500 1,000 330 300 15,480 (120)

2. The drop in gross margin percentage indicates that Jack may be giving Franco’s excessive discounts, perhaps in excess of company guidelines. If VRS awards bonuses based on sales rather than some measure of operating income, it may encourage sales representatives to lower margins in order to increase sales. VRS may want to consider basing bonuses on customer margin. The company may also want to enforce more stringent discounting guidelines. 3. Jack could suggest that Bob approach Franco’s about reducing the number of different orders that they place. If the orders could be placed less frequently, the company could reduce both order processing and delivery costs. Bob could also investigate the causes of the rush orders to see if they could be avoided. Jack should not rework the numbers. Referring to ―Standards of Ethical Conduct for Management Accountants,‖ in Exhibit 1-7, Jack Arnoldson should consider the request of Bob Gardner to be unethical for the following reasons. Competence Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information. Adjusting cost numbers violates the competence standard. Integrity Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives. Jack has the responsibility to act in the best interests of VRS. Communicate unfavorable as well as favorable information and professional judgments or opinions. Jack needs to communicate the proper and accurate results of the analysis, regardless of whether or not it pleases Bob Gardner.


Refrain from engaging in or supporting any activity that would discredit the profession. Falsifying the analysis would discredit Jack and the profession.

Credibility Communicate information fairly and objectively. Jack needs to perform an objective analysis of Franco’s profitability and communicate the results fairly. Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations presented. Jack needs to fully present an accurate analysis. Confidentiality Not affected by this decision. Jack should indicate to Bob that the costs he has derived are correct. If Bob still insists on making the changes to lower the costs to serve Franco’s Pizza, Jack should raise the matter with Bob’s superior, after informing Bob of his plans. If, after taking all these steps, there is a continued pressure to understate costs, Jack should consider resigning from the company, rather than engage in unethical conduct.


11-42 (30 min.)

Equipment replacement decisions and performance evaluation.

1. Operating income for the first year under the keep and replace alternatives are shown below: Denote the current direct manufacturing labor costs by $X and the current electricity costs by $Y. Year 1

Replace (1) Cash operating costs Direct manufacturing labor Electricity Depreciation ($180,000 2; $60,000) Loss on disposal of old machine ($120,000 – $72,000; $0) Total costs

Cost Difference by Replacing (3) = (1) – (2)

Keep (2)

$X–$30,000 $Y–$35,000

$ $

X Y

–$30,000 –$35,000

$

90,000

$ 60,000

+$30,000

$ $ +$

48,000 X + $Y 73,000

$ 0 $X + $Y +$60,000

+$48,000 +$13,000

First-year costs are lower by $13,000 under the keep machine alternative, and Bob Moody, with his one-year horizon and operating income-based bonus, will choose to keep the machine. 2. Based on the analysis in the table below, George Manufacturing will be better off by $22,000 over two years if it replaces the current equipment.

Comparing Relevant Costs of Replace and Keep Alternatives Cash operating costs Direct manufacturing labor Electricity Current disposal price One time capital costs, written off periodically as depreciation Total relevant cashflow

Over 2 Years Replace Keep (1) (2)

Cash Outflow By Replacing (3) = (1) – (2)

$X – $60,000 $Y – $70,000 –$72,000

$X $Y $0

–$ 60,000 –$ 70,000 –$ 72,000

+$180,000 $Y + $X – $22,000

$0 $X + $Y

+$180,000 –$ 22,000

Note that the book value of the current machine ($120,000) would either be written off as depreciation over three years under the keep option, or, all at once in the current year under the replace option. Its net effect would be the same in both alternatives: to increase costs by $120,000 over two years, hence it is irrelevant in this analysis. This problem illustrates the conflict between the decision model and the performance evaluation model. From the perspective of George Manufacturing the old machine should be replaced. Over the longer two-year horizon, replacing the old machine with the new equipment


saves George Manufacturing $22,000. From a performance evaluation perspective, Bob Moody prefers to keep the old machine because operating income in the first year will be $13,000 higher if he keeps rather than replaces the old machine. Chapter 23 describes methods that companies use to reduce the conflict between the decision model and the performance evaluation model. 3. Moody would be willing to purchase the new equipment if the effect on operating income in the first year would be zero or positive, that is, if the cost of operating the new equipment in the first year were lower than the cost of operating the old machine. From requirement 1, the cost difference in the first year from replacing the old machine needs to be reduced by $13,000. This means that depreciation on the new equipment must be $13,000 less than it is, so $90,000 – $13,000 = $77,000. The new equipment is being depreciated over a two-year period with zero residual value so the cost of the equipment equals $77,000 2 = $154,000. If the new equipment can be purchased for $154,000 or less, Bob Moody will be willing to purchase it because the performance evaluation model would be consistent with the decision model. Note that over the two-year period, George Manufacturing will be better off purchasing the new equipment for $154,000 by $48,000 as the following presentation of the analysis done in requirement 2 shows: Cash Outflow by Replacing Cash operating costs Direct manufacturing labor Electricity Current disposal price One-time capital costs, written off periodically as depreciation Total relevant cash flow

–$ 60,000 –$ 70,000 –$ 72,000 +$154,000 –$ 48,000


CHAPTER 12 PRICING DECISIONS AND COST MANAGEMENT 12-1 The three major influences on pricing decisions are 1. Customers 2. Competitors 3. Costs 12-2 Not necessarily. For a one-time-only special order, the relevant costs are only those costs that will change as a result of accepting the order. In this case, full product costs will rarely be relevant. It is more likely that full product costs will be relevant costs for long-run pricing decisions. 12-3 1. 2.

Two examples of pricing decisions with a short-run focus: Pricing for a one-time-only special order with no long-term implications. Adjusting product mix and volume in a competitive market.

12-4 Activity-based costing helps managers in pricing decisions in two ways. 1. It gives managers more accurate product-cost information for making pricing decisions. 2. It helps managers to manage costs during value engineering by identifying the cost impact of eliminating, reducing, or changing various activities. 12-5 Two alternative starting points for long-run pricing decisions are 1. Market-based pricing, an important form of which is target pricing. The market-based approach asks, ―Given what our customers want and how our competitors will react to what we do, what price should we charge?‖ 2. Cost-based pricing which asks, ―What does it cost us to make this product and, hence, what price should we charge that will recoup our costs and achieve a target return on investment?‖ 12-6 A target cost per unit is the estimated long-run cost per unit of a product (or service) that, when sold at the target price, enables the company to achieve the targeted operating income per unit. 12-7 Value engineering is a systematic evaluation of all aspects of the value-chain business functions, with the objective of reducing costs while satisfying customer needs. Value engineering via improvement in product and process designs is a principal technique that companies use to achieve target cost per unit. 12-8 A value-added cost is a cost that customers perceive as adding value, or utility, to a product or service. Examples are costs of materials, direct labor, tools, and machinery. A nonvalue-added cost is a cost that customers do not perceive as adding value, or utility, to a product or service. Examples of nonvalue-added costs are costs of rework, scrap, expediting, and breakdown maintenance. 12-9 No. It is important to distinguish between when costs are locked in and when costs are incurred, because it is difficult to alter or reduce costs that have already been locked in.


12-10 Cost-plus pricing is a pricing approach in which managers add a markup to cost in order to determine price. 12-11 Cost-plus pricing methods vary depending on the bases used to calculate prices. Examples are (a) variable manufacturing costs; (b) manufacturing function costs; (c) variable product costs; and (d) full product costs. 12-12 Two examples where the difference in the costs of two products or services is much smaller than the differences in their prices follow: 1. The difference in prices charged for a telephone call, hotel room, or car rental during busy versus slack periods is often much greater than the difference in costs to provide these services. 2. The difference in costs for an airplane seat sold to a passenger traveling on business or a passenger traveling for pleasure is roughly the same. However, airline companies price discriminate. They routinely charge business travelers––those who are likely to start and complete their travel during the same week excluding the weekend––a much higher price than pleasure travelers who generally stay at their destinations over at least one weekend. 12-13 Life-cycle budgeting is an estimate of the revenues and costs attributable to each product from its initial R&D to its final customer servicing and support. 12-14 Three benefits of using a product life-cycle reporting format are: 1. The full set of revenues and costs associated with each product becomes more visible. 2. Differences among products in the percentage of total costs committed at early stages in the life cycle are highlighted. 3. Interrelationships among business function cost categories are highlighted. 12-15 Predatory pricing occurs when a business deliberately prices below its costs in an effort to drive competitors out of the market and restrict supply, and then raises prices rather than enlarge demand. Under U.S. laws, dumping occurs when a non-U.S. company sells a product in the United States at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the United States. Collusive pricing occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade.


12-16 (20–30 min.) 1.

Relevant-cost approach to pricing decisions, special order.

Relevant revenues, $4.00 1,000 Relevant costs Direct materials, $1.60 1,000 Direct manufacturing labor, $0.90 1,000 Variable manufacturing overhead, $0.70 1,000 Variable selling costs, 0.05 $4,000 Total relevant costs Increase in operating income

$4,000 $1,600 900 700 200 3,400 $ 600

This calculation assumes that: a. The monthly fixed manufacturing overhead of $150,000 and $65,000 of monthly fixed marketing costs will be unchanged by acceptance of the 1,000 unit order. b. The price charged and the volumes sold to other customers are not affected by the special order. Chapter 12 uses the phrase ―one-time-only special order‖ to describe this special case. 2.

The president’s reasoning is defective on at least two counts: a. The inclusion of irrelevant costs––assuming the monthly fixed manufacturing overhead of $150,000 will be unchanged; it is irrelevant to the decision. b. The exclusion of relevant costs––variable selling costs (5% of the selling price) are excluded.

3.

Key issues are: a. Will the existing customer base demand price reductions? If this 1,000-tape order is not independent of other sales, cutting the price from $5.00 to $4.00 can have a large negative effect on total revenues. b. Is the 1,000-tape order a one-time-only order, or is there the possibility of sales in subsequent months? The fact that the customer is not in Dill Company’s ―normal marketing channels‖ does not necessarily mean it is a one-time-only order. Indeed, the sale could well open a new marketing channel. Dill Company should be reluctant to consider only short-run variable costs for pricing long-run business.


12-17 (20–30 min.) Relevant-cost approach to short-run pricing decisions. 1.

Analysis of special order: Sales, 3,000 units $75 Variable costs: Direct materials, 3,000 units $35 Direct manufacturing labor, 3,000 units $10 Variable manufacturing overhead, 3,000 units Other variable costs, 3,000 units $5 Sales commission Total variable costs Contribution margin

$225,000

$6

$105,000 30,000 18,000 15,000 8,000 176,000 $ 49,000

Note that the variable costs, except for commissions, are affected by production volume, not sales dollars. If the special order is accepted, operating income would be $1,000,000 + $49,000 = $1,049,000. 2. Whether McMahon’s decision to quote full price is correct depends on many factors. He is incorrect if the capacity would otherwise be idle and if his objective is to increase operating income in the short run. If the offer is rejected, San Carlos, in effect, is willing to invest $49,000 in immediate gains forgone (an opportunity cost) to preserve the long-run selling-price structure. McMahon is correct if he thinks future competition or future price concessions to customers will hurt San Carlos’s operating income by more than $49,000. There is also the possibility that Abrams could become a long-term customer. In this case, is a price that covers only short-run variable costs adequate? Would Holtz be willing to accept a $8,000 sales commission (as distinguished from her regular $33,750 = 15% $225,000) for every Abrams order of this size if Abrams becomes a long-term customer?


12-18 (15-20 min.) Short-run pricing, capacity constraints. 1. Per kilogram of hard cheese: Milk (8 liters $2.00 per liter) Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing cost allocated Total manufacturing cost

$16 5 4 6 $31

If Colorado Mountains Dairy can get all the Holstein milk it needs, and has sufficient production capacity, then the minimum price per kilo it should charge for the hard cheese is the variable cost per kilo = $16 + $5 + $4 = $25 per kilo. 2. If milk is in short supply, then each kilo of hard cheese displaces 2 kilos of soft cheese (8 liters of milk per kilo of hard cheese versus 4 liters of milk per kilo of soft cheese). Then, for the hard cheese, the minimum price Colorado Mountains should charge is the variable cost per kilo of hard cheese plus the contribution margin from 2 kilos of soft cheese, or, $25 + (2

$10 per kilo) = $45 per kilo

That is, if milk is in short supply, Colorado Mountains should not agree to produce any hard cheese unless the buyer is willing to pay at least $45 per kilo.

12-19 (25–30 min.) Value-added, nonvalue-added costs. 1. Category Value-added costs Nonvalue-added costs

Gray area

Examples a. Materials and labor for regular repairs b. Rework costs c. Expediting costs caused by work delays g. Breakdown maintenance of equipment Total d. Materials handling costs e. Materials procurement and inspection costs f. Preventive maintenance of equipment Total

$800,000 $ 75,000 60,000 55,000 $190,000 $ 50,000 35,000 15,000 $100,000

Classifications of value-added, nonvalue-added, and gray area costs are often not clear-cut. Other classifications of some of the cost categories are also plausible. For example, some students may include materials handling, materials procurement, and inspection costs and preventive maintenance as value-added costs (costs that customers perceive as adding value and as being necessary for good repair service) rather than as in the gray area. Preventive maintenance, for instance, might be regarded as value-added because it helps prevent nonvalue-adding breakdown maintenance.


2. Total costs in the gray area are $100,000. Of this, we assume 65%, or $65,000, are valueadded and 35%, or $35,000, are nonvalue-added. Total value-added costs: $800,000 + $65,000 $ 865,000 Total nonvalue-added costs: $190,000 + $35,000 225,000 Total costs $1,090,000 Nonvalue-added costs are $225,000 ÷ $1,090,000 = 20.64% of total costs. Value-added costs are $865,000 ÷ $1,090,000 = 79.36% of total costs. 3. Program (a) Quality improvement programs to • reduce rework costs by 75% (0.75 $75,000) • reduce expediting costs by 75% (0.75 $60,000) • reduce materials and labor costs by 5% (0.05 $800,000) Total effect (b) Working with suppliers to • reduce materials procurement and inspection costs by 20% (0.20 $35,000) • reduce materials handling costs by 25% (0.25 $50,000) Total effect Transferring 65% of gray area costs (0.65 $19,500 = $12,675) as value-added and 35% (0.35 $19,500 = $6,825) as nonvalue-added Effect on value-added and nonvalue-added costs (c) Maintenance programs to • increase preventive maintenance costs by 50% (0.50 $15,000) • decrease breakdown maintenance costs by 40% (0.40 $55,000) Total effect Transferring 65% of gray area costs (0.65 $7,500 = $4,875) as value-added and 35% (0.35 $7,500 = $2,625) as nonvalue-added Effect on value-added and nonvalue-added costs Total effect of all programs Value-added and nonvalue-added costs calculated in requirement 2 Expected value-added and nonvalue-added costs as a result of implementing these programs

Effect on Costs Classified as ValueNonvalueGray Added Added Area –$ 56,250 – –$ 40,000 –$ 40,000

45,000

–$101,250

–$ 7,000 – 12,500 – 19,500 –$ 12,675 –$ 12,675

–$ –$

6,825 6,825

+ 19,500 $ 0

+$ 7,500 –$ 22,000 – 22,000

+$ 4,875 +$ 4,875 –$ 47,800

+ 2,625 –$ 19,375 –$127,450

865,000

225,000

$817,200

$ 97,550

+

7,500

– $

7,500 0

If these programs had been implemented, total costs would have decreased from $1,090,000 (requirement 2) to $817,200 + $97,550 = $914,750, and the percentage of nonvalue-added costs would decrease from 20.64% (requirement 2) to $97,550 ÷ 914,750 = 10.66%. These are significant improvements in Marino’s performance. 12-6 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

12-20 (25 30 min.) Target operating income, value-added costs, service company. 1. The classification of total costs in 2012 into value-added, nonvalue-added, or in the gray area in between follows: Value Gray NonvalueTotal Added Area added (4) = (1) (2) (3) (1)+(2)+(3) Doing calculations and preparing drawings 77% × $390,000 $300,300 $300,300 Checking calculations and drawings 3% × $390,000 $11,700 11,700 Correcting errors found in drawings 8% × $390,000 $31,200 31,200 Making changes in response to client requests 5% × $390,000 19,500 19,500 Correcting errors to meet government building code, 7% × $390,000 27,300 27,300 Total professional labor costs 319,800 11,700 58,500 390,000 Administrative and support costs at 44% ($171,600 ÷ $390,000) of professional labor costs 140,712 5,148 25,740 171,600 Travel 15,000 — 15,000 Total $475,512 $16,848 $84,240 $576,600 Doing calculations and responding to client requests for changes are value-added costs because customers perceive these costs as necessary for the service of preparing architectural drawings. Costs incurred on correcting errors in drawings and making changes because they were inconsistent with building codes are nonvalue-added costs. Customers do not perceive these costs as necessary and would be unwilling to pay for them. Calvert should seek to eliminate these costs by making sure that all associates are well-informed regarding building code requirements and by training associates to improve the quality of their drawings. Checking calculations and drawings is in the gray area (some, but not all, checking may be needed). There is room for disagreement on these classifications. For example, checking calculations may be regarded as value added. 2.

Reduction in professional labor-hours by a. Correcting errors in drawings (8% × 7,500) b. Correcting errors to conform to building code (7% × 7,500) Total Cost savings in professional labor costs (1,125 hours × $52) Cost savings in variable administrative and support costs (44% × $58,500) Total cost savings Current operating income in 2012 Add cost savings from eliminating errors Operating income in 2012 if errors eliminated

600 hours 525 hours 1,125 hours $ 58,500 25,740 $ 84,240 $124,650 84,240 $208,890


3. Currently 85% × 7,500 hours = 6,375 hours are billed to clients generating revenues of $701,250. The remaining 15% of professional labor-hours (15% × 7,500 = 1,125 hours) is lost in making corrections. Calvert bills clients at the rate of $701,250 ÷ 6,375 = $110 per professional labor-hour. If the 1,125 professional labor-hours currently not being billed to clients were billed to clients, Calvert’s revenues would increase by 1,125 hours × $110 = $123,750 from $701,250 to $825,000 ($701,250 + $123,750). Costs remain unchanged Professional labor costs Administrative and support (44% × $390,000) Travel Total costs Calvert’s operating income would be Revenues Total costs Operating income

$390,000 171,600 15,000 $576,600 $825,000 576,600 $248,400


12-21 (25–30 min.) Target prices, target costs, activity-based costing. 1.

Snappy’s operating income in 2011 is as follows: Total for 250,000 Tiles Per Unit (1) (2) = (1) ÷ 250,000 $1,000,000 $4.00 750,000 3.00 25,000 0.10 120,000 0.48 60,000 0.24 955,000 3.82 $ 45,000 $0.18

Revenues ($4 250,000) Purchase cost of tiles ($3 250,000) Ordering costs ($50 500) Receiving and storage ($30 4,000) Shipping ($40 1,500) Total costs Operating income

2. Price to retailers in 2012 is 95% of 2011 price = 0.95 96% of 2011 cost = 0.96 $3 = $2.88.

$4 = $3.80; cost per tile in 2012 is

Snappy’s operating income in 2012 is as follows:

Revenues ($3.80 250,000) Purchase cost of tiles ($2.88 250,000) Ordering costs ($50 500) Receiving and storage ($30 4,000) Shipping ($40 1,500) Total costs Operating income

Total for 250,000 Tiles (1) $950,000 720,000 25,000 120,000 60,000 925,000 $ 25,000

Per Unit (2) = (1) ÷ 250,000 $3.80 2.88 0.10 0.48 0.24 3.70 $0.10

3. Snappy’s operating income in 2012, if it makes changes in ordering and material handling, will be as follows: Total for 250,000 Tiles Per Unit (1) (2) = (1) ÷ 250,000 $950,000 $3.80 Revenues ($3.80 250,000) 720,000 2.88 Purchase cost of tiles ($2.88 250,000) 5,000 0.02 Ordering costs ($25 200) 87,500 0.35 Receiving and storage ($28 3,125) 60,000 0.24 Shipping ($40 1,500) 872,500 3.49 Total costs $ 77,500 $0.31 Operating income Through better cost management, Snappy will be able to achieve its target operating income of $0.30 per tile despite the fact that its revenue per tile has decreased by $0.20 ($4.00 – $3.80), while its purchase cost per tile has decreased by only $0.12 ($3.00 – $2.88). 12-9 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

12-22 (20 min.) Target costs, effect of product-design changes on product costs. 1. and 2. Manufacturing costs of HJ6 in 2010 and 2011 are as follows: 2010 Total (1) Direct materials, $1,200 × 3,500; $1,100 × 4,000 $4,200,000 Batch-level costs, $8,000 × 70; $7,500 × 80 560,000 Manuf. operations costs, $55 × 21,000; $50 × 22,000 1,155,000 Engineering change costs, $12,000 × 14; $10,000 × 10 168,000 Total $6,083,000

3.

Per Unit (2) = (1) ÷ 3,500 $1,200 160

2011 Per Unit Total (4) = (3) (3) ÷ 4,000 $4,400,000 $1,100 600,000 150

330

1,100,000

275

48 $1,738

100,000 $6,200,000

25 $1,550

Target manufacturing cost Manufacturing cost per unit of HJ6 in 2011 = per unit in 2010 × 90%

= $1,738 × 0.90 = $1,564.20 Actual manufacturing cost per unit of HJ6 in 2011 was $1,550. Hence, Medical Instruments did achieve its target manufacturing cost per unit of $1,564.20 4. To reduce the manufacturing cost per unit in 2011, Medical Instruments reduced the cost per unit in each of the four cost categories—direct materials costs, batch-level costs, manufacturing operations costs, and engineering change costs. It also reduced machine-hours and number of engineering changes made—the quantities of the cost drivers. In 2010, Medical Instruments used 6 machine-hours per unit of HJ6 (21,000 machine-hours 3,500 units). In 2011, Medical Instruments used 5.5 machine-hours per unit of HJ6 (22,000 machine-hours 4,000 units). Medical Instruments reduced engineering changes from 14 in 2010 to 10 in 2011. Medical Instruments achieved these gains through value engineering activities that retained only those product features that customers wanted while eliminating nonvalue-added activities and costs.


12-23 (20 min.) Cost-plus target return on investment pricing. 1.

Target operating income = target return on investment invested capital Target operating income (25% of $900,000) $225,000 Total fixed costs 375,000 Target contribution margin $600,000 Target contribution per room-night, ($600,000 ÷ 15,000) Add variable costs per room-night Price to be charged per room-night Proof Total room revenues ($45 15,000 room-nights) Total costs: Variable costs ($5 15,000) Fixed costs Total costs Operating income

$40 5 $45

$675,000 $ 75,000 375,000 450,000 $225,000

The full cost of a room = variable cost per room + fixed cost per room The full cost of a room = $5 + ($375,000 ÷ 15,000) = $5 + $25 = $30 = Rental price per room – Full cost of a room = $45 – $30 = $15 Markup percentage as a fraction of full cost = $15 ÷ $30 = 50% Markup per room

2.

If price is reduced by 10%, the number of rooms Beck could rent would increase by 10%. The new price per room would be 90% of $45 $ 40.50 The number of rooms Beck expects to rent is 110% of 15,000 16,500 The contribution margin per room would be $40.50 – $5 $ 35.50 Contribution margin ($35.50 16,500) $585,750

Because the contribution margin of $585,750 at the reduced price of $40.50 is less than the contribution margin of $600,000 at a price of $45, Blodgett should not reduce the price of the rooms. Note that the fixed costs of $375,000 will be the same under the $45 and the $40.50 price alternatives and hence, are irrelevant to the analysis.


12-24 (20 25 min.) Cost-plus, target pricing, working backwards. 1.

Investment Return on investment Operating income (18% $8,400,000) Operating income per unit of XR500 ($1,512,000 1,500) Full cost per unit of XR500 (1,008 ÷ 0.09) Selling price (($11,200 + $1,008)) Markup percentage on variable cost ($1,008 $8,450)

$8,400,000 18% $1,512,000 $1,008 $11,200 $12,208 11.93%

Total fixed costs = (Full cost per unit – Variable cost per unit) Units sold = ($11,200 – $8,450) 1,500 units = $4,125,000 2.

Contribution margin per unit = $12,208 – $8,450 = $3,758 Increase in sales = $10% 1,500 units = 150 units Increase in contribution margin = $3,758 150 units = Less: Advertising costs Increase in operating income

$563,700 500,000 $ 63,700

Road Warrior should spend $500,000 in advertising because it increases operating income by $63,700. 3. Revenues ($12,208 × 1,400 units) Target full cost at 9% markup ($17,091,200 ÷ 1.09) Less: Target total fixed costs ($4,125,000 – $125,000) Target total variable costs Divided by number of units Target variable cost per unit

$17,091,200 $15,680,000 4,000,000 $11,680,000 ÷ 1,400 units $ 8,342.86


12-25 (20 min.) Life-cycle product costing. 1.

Variable cost per unit = Production cost per unit + Mktg and distribn. cost per unit = $20 + $5 = $25

Contribution margin per unit = Selling price – Variable cost per unit = $50 – $25 = $25 Marketing and Total fixed Design Production distribution costs over life = + + fixed costs fixed costs fixed costs of robot = $650,000 + $3,560,000 + $2,225,000 = $6,435,000 BEP in units =

2a.

2b.

Fixed costs Contribution margin per unit

$6, 435, 000 $25

257, 400 units

Option A: Revenues ($50 500,000 units) Variable costs ($25 500,000 units) Fixed costs Operating income

$25,000,000 12,500,000 6,435,000 $ 6,065,000

Option B: Revenues Year 2 ($70 100,000 units) Years 3 & 4 ($40 600,000 units) Total revenues Variable costs ($25 700,000 units) Fixed costs Operating income

$ 7,000,000 24,000,000 31,000,000 17,500,000 6,435,000 $ 7,065,000

Over the product’s life-cycle, Option B results in an overall higher operating income of $1,000,000 ($7,065,000 – $6,065,000).


12-26 (30 min.) 1.

Relevant-cost approach to pricing decisions.

Revenues (1,000 crates at $117 per crate) Variable costs: Manufacturing Marketing Total variable costs Contribution margin Fixed costs: Manufacturing Marketing Total fixed costs Operating income

$117,000 $35,000 17,000 52,000 65,000 $30,000 13,000 43,000 $ 22,000

Normal markup percentage: $65,000 ÷ $52,000 = 125% of total variable costs. 2. Only the manufacturing-cost category is relevant to considering this special order; no additional marketing costs will be incurred. Variable manufacturing cost per crate = $35,000 ÷ 1,000 crates = $35 per crate. The relevant manufacturing costs for the 200-crate special order are: Variable manufacturing cost per unit $35 200 crates Special packaging Relevant manufacturing costs

$ 7,000 3,000 $10,000

Any price above $50 per crate ($10,000 ÷ 200) will make a positive contribution to operating income. Therefore, based on financial considerations, Stardom should accept the 200-crate special order at $55 per crate that will generate revenues of $11,000 ($55 200) and relevant (incremental) costs of $10,000. The reasoning based on a comparison of $55 per crate price with the $65 per crate absorption cost ignores monthly cost-volume-profit relationships. The $65 per crate absorption cost includes a $30 per crate cost component that is irrelevant to the special order. The relevant range for the fixed manufacturing costs is from 500 to 2,000 crates per month; the special order will increase production from 1,000 to 1,200 crates per month. Furthermore, the special order requires no incremental marketing costs. 3. If the new customer is likely to remain in business, Burst should consider whether a strictly short-run focus is appropriate. For example, what is the likelihood of demand from other customers increasing over time? If Burst accepts the 200-crate special offer for more than one month, it may preclude accepting other customers at prices exceeding $55 per crate. Moreover, the existing customers may learn about Burst’s willingness to set a price based on variable cost plus a small contribution margin. The longer the time frame over which Burst keeps selling 200 crates of canned peaches at $55 a crate, the more likely it is that existing customers will approach Burst for their own special price reductions. If the new customer wants the contract to extend over a longer time period, Burst should negotiate a higher price.


12-27 (25–30 min.) Considerations other than cost in pricing decisions. 1. Guest nights on weeknights: 18 weeknights × 100 rooms × 90% = 1,620 Guest nights on weekend nights: 12 weekend nights × 100 rooms × 20% = 240 Total guest nights in April = 1,620 + 240 = 1,860 Breakfasts served: 1,620 weeknight guest nights ×1.0 = 1,620 240 weekend guest nights × 2.5 = 600 Total breakfasts served in April = 1,620 + 600 = 2,220 Total costs for April: Depreciation Administrative costs Fixed housekeeping and supplies Variable housekeeping and supplies (1,860 × $25) Fixed breakfast costs Variable breakfast costs (2,220 × $5) Total costs for April Cost per guest night ($129,600 ÷ 1,860) Revenue for April ($68 × 1,860) Total costs for April Operating income/(loss)

$ 20,000 35,000 12,000 46,500 5,000 11,100 $129,600 $69.68 $126,480 129,600 $ (3,120)

2.

New weeknight guest nights 18 weeknights × 100 rooms × 85% = 1,530 New weekend guest nights 12 weeknights × 100 rooms × 50% = 600 Total guest nights in April = 1,530 + 600 = 2,130 Breakfasts served: 1,530 weeknight guest nights × 1.0 = 1,530 600 weekend guest nights × 2.5 = 1,500 Total breakfasts served in April = 1,530 + 1,500 = 3,030 Total costs for April: Depreciation Administrative costs Fixed housekeeping and supplies Variable housekeeping and supplies (2,130 × $25) Fixed breakfast costs Variable breakfast costs (3,030 × $5) Total costs

$20,000 35,000 12,000 53,250 5,000 15,150 $140,400

Revenue [(1,530 × $80) + (600 × $50)] Total costs for April Operating income

$152,400 140,400 $ 12,000


Yes, this pricing arrangement would increase operating income by $15,120 from an operating loss of $3,120 to an operating income of $12,000 ($12,000 + $3,120 = $15,120). 3. The weeknight guests are business travelers who have to stay at the hotel on weeknights to conduct business for their organizations. They are probably not paying personally for their hotel stays, and they are more interested in the hotel’s location in the business park than the price of the stay, as long as it is reasonable. The demand of business travelers is inelastic. In contrast, the weekend guests are families who are staying at the hotel for pleasure and are paying for the hotel from their personal incomes. They are willing to consider other hotel options or even not travel at all if the price is high and unaffordable. The demand of pleasure travelers is elastic. Because of the differences in preferences of the weeknight and weekend guests, Executive Suites can price discriminate between these guests by charging $30 more on weeknights than on weekends and still have weeknight travelers stay at the hotel. 4. Executive Suites would need to charge a minimum of $35 per night for the last-minute rooms, an amount equal to the variable cost per room. Variable cost per room night = $25 per room night + $5 × 2 breakfasts = $35. Any price above $35 would increase Executive Suites operating income.


12-28 (25 min.) Cost-plus, target pricing, working backward. 1.

In the following table, work backwards from operating income to calculate the selling price Selling price $ 10.14 (plug) Less: Variable cost per unit 3.75 Unit contribution margin $ 6.39 Number of units produced and sold × 500,000 units Contribution margin $3,195,000 Less: Fixed costs 3,000,000 Operating income $ 195,000 a) Total sales revenue = $10.14 500,000 units = $5,070,000 b) Selling price = $10.14 (from above)

Alternatively, Operating income Add fixed costs Contribution margin Add variable costs ($3.75 × 500,000 units) Sales revenue Selling price =

Sales revenue Units sold

c) Rate of return on investment = d) Markup % on full cost Total cost = ($3.75 Unit cost =

2.

3.

$10.14

Operating income Total investment in assets

$195,000 $2, 000, 000

9.75%

500,000 units) + $3,000,000 = $4,875,000

$4,875,000 500,000 units

$9.75

$10.14 $9.75 $9.75

4%

$5, 070, 000 $4,875, 000 $4,875, 000

4%

Markup % = Or

$5, 070, 000 500, 000

$ 195,000 3,000,000 3,195,000 1,875,000 $5,070,000

New fixed costs New variable costs New total costs New total sales (5% markup) New selling price Alternatively, New unit cost New selling price

=$3,000,000 – $200,000 = $2,800,000 = $3.75 – $0.60 = $3.15 = ($3.15 × 500,000 units) + $2,800,000 = $4,375,000 = $4,375,000 1.04 = $4,550,000 = $4,550,000 ÷ 500,000 units = $9.10 = $4,375,000 ÷ 500,000 units = $8.75 = $8.75 1.04 = $9.10

New units sold = 500,000 units × 90% = $450,000 units


Budgeted Operating Income for the Year Ending December 31, 20xx Revenues ($9.10 450,000 units) Variable costs ($3.15 450,000 units) Contribution margin Fixed costs Operating income (loss)

$4,095,000 1,417,500 2,677,500 2,800,000 $ (122,500)


12-29 (40–45 min.) Target prices, target costs, value engineering, cost incurrence, locked-in cost, activity-based costing. 1.

Direct materials costs Direct manufacturing labor costs Machining costs Testing costs Rework costs Ordering costs Engineering costs Total manufacturing costs

Old CE100 $182,000 28,000 31,500 35,000 14,000 3,360 21,140 $315,000

Cost Change $2.20 7,000 = $15,400 less $0.50 7,000 = $3,500 less Unchanged because capacity same (20% 2.5 7,000) × $2 = $7,000 (See Note 1) (See Note 2) Unchanged because capacity same

New CE100 $166,600 24,500 31,500 28,000 5,600 2,100 21,140 $279,440

Note 1: 10% of old CE100s are reworked. That is, 700 (10% of 7,000) CE100s made are reworked. Rework costs = $20 per unit reworked 700 = $14,000. If rework falls to 4% of New CE100s manufactured, 280 (4% of 7,000) New CE100s manufactured will require rework. Rework costs = $20 per unit 280 = $5,600. Note 2 : Ordering costs for New CE100 = 2 orders/month = $2,100

50 components

$21/order

Unit manufacturing costs of New CE100 = $279,440 ÷ 7,000 = $39.92 2.

Total manufacturing cost reductions based on new design

= $315,000 – $279,440 = $35,560

Reduction in unit manufacturing costs based on new design

= $35,560 ÷ 7,000 = $5.08 per unit.

The reduction in unit manufacturing costs based on the new design can also be calculated as Unit cost of old design, $45 ($315,000 ÷ 7,000 units) – Unit cost of new design, $39.92 = $5.08 Therefore, the target cost reduction of $6 per unit is not achieved by the redesign. 3. Changes in design have a considerably larger impact on costs per unit relative to improvements in manufacturing efficiency ($5.08 versus $1.50). One explanation is that many costs are locked in once the design of the radio-cassette is completed. Improvements in manufacturing efficiency cannot reduce many of these costs. Design choices can influence many direct and overhead cost categories, for example, by reducing direct materials requirements, by reducing defects requiring rework, and by designing in fewer components that translate into fewer orders placed and lower ordering costs.


12-30 (25 min.) Cost-plus, target return on investment pricing. 1. Target operating income = Return on capital in dollars = $13,000,000 10% = $1,300,000 2. Revenues* Variable costs [($3.50 + $1.50) 500,000 cases Contribution margin Fixed costs ($1,000,000 + $700,000 + $500,000) Operating income (from requirement 1) * solve backwards for revenues $6,000,000 500,000 cases Markup % on full cost

Selling price =

$6,000,000 2,500,000 3,500,000 2,200,000 $1,300,000

$12 per case.

Full cost = $2,500,000 + $2,200,000 = $4,700,000 Unit cost = $4,700,000 ÷ 500,000 cases = $9.40 per case Markup % on full cost =

$12 - $9.40 27.66% $9.40

3. Budgeted Operating Income For the year ending December 31, 20xx Revenues ($14 475,000 cases*) $6,650,000 Variable costs ($5 475,000 cases) 2,375,000 Contribution margin 4,275,000 Fixed costs 2,200,000 Operating income $2,075,000 *New units = 500,000 cases 95% = 475,000 cases Return on investment =

$2,075,000 $13,000,000

15.96%

Yes, increasing the selling price is a good idea because operating income increases without increasing invested capital, which results in a higher return on investment. The new return on investment exceeds the 10% target return on investment.


12-31 (20 min.) Cost-plus, time and materials, ethics. 1. As shown in the table below, Garrison will tell Briggs that she will have to pay $460 to get the air conditioning system repaired and $440 to get it replaced. COST Repair option (5 hrs. $30 per hr.; $100) Replace option (2 hrs. $30 per hr.; $200)

Labor Materials Total Cost $150 $100 $250 60 200 260

PRICE (100% markup on labor cost; 60% markup on materials) Repair option ($150 2; $100 1.6) Replace option ($60 2; $200 1.6)

Labor Materials $300 $160 120 320

Total Price $460 440

2. If the repair and replace options are equally effective, Briggs will choose to get the air conditioning system replaced for $440 (rather than spend $460 on repairing it). 3. R&C Mechanical will earn a greater contribution toward overhead in the repair option ($210 = $460 – $250) than in the replace option ($180 = $440 – $260). Therefore, Garrison will recommend the repair option to Briggs which is not the one she would prefer. Recognizing this conflict, Garrison may even present only the repair option to Ashley Briggs. Of course, he runs the risk of Briggs walking away and thinking of other options (at which point, he could present the replace option as a compromise). The problem is that Garrison has superior information about the repairs needed but his incentives may cause him to not reveal his information and instead use it to his advantage. It is only the seller’s desire to build a reputation, to have a long-term relationship with the customer, and to have the customer recommend the seller to other potential buyers of the service that encourages an honest discussion of the options. The ethical course of action would be to honestly present both options to Briggs and have her choose. To have their employees act ethically, organizations do not reward employees on the basis of the profits earned on various jobs. They also develop codes of conduct and core values and beliefs that specify appropriate and inappropriate behaviors.


12-32 (25 min.) Cost-plus and market-based pricing. 1.

California Temps’ full cost per hour of supplying contract labor is Variable costs Fixed costs ($168,000 ÷ 84,000 hours) Full cost per hour Price per hour at full cost plus 20% = $15

2.

$13 2 $15 1.20 = $18 per hour.

Contribution margins for different prices and demand realizations are as follows:

Price per Hour (1) $16 17 18 19 20

Variable Cost per Hour (2) $13 13 13 13 13

Contribution Margin per Hour (3) = (1) – (2) $3 4 5 6 7

Demand in Hours (4) 124,000 104,000 84,000 74,000 61,000

Total Contribution (5) = (3) × (4) $372,000 416,000 420,000 444,000 427,000

Fixed costs will remain the same regardless of the demand realizations. Fixed costs are, therefore, irrelevant since they do not differ among the alternatives. The table above indicates that California Temps can maximize contribution margin ($444,000) and operating income by charging a price of $19 per hour. 3. The cost-plus approach to pricing in requirement 1 does not explicitly consider the effect of prices on demand. The approach in requirement 2 models the interaction between price and demand and determines the optimal level of profitability using concepts of relevant costs. The two different approaches lead to two different prices in requirements 1 and 2. As the chapter describes, pricing decisions should consider both demand or market considerations and supply or cost factors. The approach in requirement 2 is the more balanced approach. In most cases, of course, managers use the cost-plus method of requirement 1 as only a starting point. They then modify the cost-plus price on the basis of market considerations—anticipated customer reaction to alternative price levels and the prices charged by competitors for similar products.


12-33 Cost-plus and market-based pricing. 1. Single rate =

$1, 262, 460 106,000 testing hours

$11.91 per test-hour (TH)

Hourly billing rate for HTT and ACT = $11.91 1.45 = $17.27 2. Labor and supervision =

$ 491,840 = $4.64 per test-hour 106,000 test-hours

Setup and facility costs =

Utilities =

$402,620 = $503.275 per setup-hour 800 setup hours

$368,000 = $36.80 per machine-hour (MH) 10,000 machine-hours

3. Labor and supervision ($4.64×63, 600; 42,400 testhours)1 Setup and facility cost ($503.275×200; 600 setuphours)2 Utilities ($36.80×5,000; 5,000 machinehours)3 Total cost Number of testing hours (TH) Cost per testing hour Mark-up Billing rate per testing hour

HTT

ACT

$295,104

$196,736

$ 491,840

100,655

301,965

402,620

184,000

368,000

184,000 $579,759 ÷ 63,600 TH $9.12 per TH × 1.45 $ 13.22 per TH

$682,701 ÷ 42,400 TH $ 16.10 per TH × 1.45 $ 23.35 per TH

Total

$1,262,460

1

106,000 test-hours 60% = 63,600 test-hours; 106,000 test-hours 40% = 42,400 test-hours 800 setup-hours × 25% = 200 setup-hours; 800 setup-hours × 75% = 600 setup-hours 3 10,000 machine-hours × 50% = 5,000 machine-hours; 10,000 machine-hours × 50% = 5,000 machine-hours 2

The billing rates based on the activity-based cost structure make more sense. These billing rates reflect the ways the testing procedures consume the firm’s resources. 4. To stay competitive, Best Test needs to be more efficient in arctic testing. Roughly 44% of 301,965 44% occurs in setups and facility costs. Perhaps the setup arctic testing’s total cost 682, 701 activity can be redesigned to achieve cost savings. Best Test should also look for savings in the labor and supervision cost per test-hour and the total number of test-hours used in arctic testing, as well as the utility cost per machine-hour and the total number of machine hours used in arctic testing. This may require redesigning the test, redesigning processes, and achieving efficiency and 12-23 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

productivity improvements.


12-34 (25–30 min.) Life-cycle costing. 1.

Total Project Life-Cycle Costs Variable costs: Metal extraction and processing ($100 per ton × 50,000 tons) Fixed costs: Metal extraction and processing ($4,000 × 24 months) Rent on temporary buildings ($2,000 × 27 months) Administration ($5,000 × 27 months) Clean-up ($30,000 × 3 months) Land restoration Selling land Total life-cycle cost

$5,000,000 96,000 54,000 135,000 90,000 475,000 150,000 $6,000,000

2. Projected Life Cycle Income Statement Revenue ($150 per ton 50,000 tons) Sale of land (plug after inputting other numbers) Total life-cycle cost Life-cycle operating income ($40 per ton × 50,000 tons) Mark-up percentage on project life-cycle cost =

$7,500,000 500,000 (6,000,000) $2,000,000

Life cycle operating income Total live-cycle cost

$2, 000, 000 = 33⅓% $6, 000, 000

3. Revenue ($140 per ton 50,000 tons) Sale of land Total revenue Total life-cycle cost at mark-up of 33⅓% ($7,400,000 ÷ 1.333333) New Life would need to reduce total life-cycle costs by ($6,000,000 – $5,550,000) Check Revenue Sale of land Total life-cycle cost Life-cycle operating income Mark-up percentage =

$7,000,000 400,000 $7,400,000 $5,550,000 $ 450,000 $7,000,000 400,000 (5,550,000) $1,850,000

$1,850, 000 = 33⅓% $5,550, 000


12-35 (30 min.) Airline pricing, considerations other than cost in pricing. 1.

If the fare is $500, a. Air Eagle would expect to have 200 business and 100 pleasure travelers. b. Variable costs per passenger would be $65. c. Contribution margin per passenger = $500 – $65 = $435. If the fare is $2,100, a. Air Eagle would expect to have 180 business and 20 pleasure travelers. b. Variable costs per passenger would be $175. c. Contribution margin per passenger = $2,100 – $175 = $1,925. Contribution margin from business travelers at prices of $500 and $2,100, respectively,

follow: At a price of $500: $435 × 200 passengers At a price of $2,100: $1,925 × 180 passengers

= $ 87,000 = $346,500

Air Eagle would maximize contribution margin and operating income by charging business travelers a fare of $2,100. Contribution margin from pleasure travelers at prices of $500 and $2,100, respectively, follow: At a price of $500: $435 × 100 passengers At a price of $2,100: $1,925 × 20 passengers

= $43,500 = $38,500

Air Eagle would maximize contribution margin and operating income by charging pleasure travelers a fare of $500. Air Eagle would maximize contribution margin and operating income by a price differentiation strategy, where business travelers are charged $2,100 and pleasure travelers $500. In deciding between the alternative prices, all other costs such as fuel costs, allocated annual lease costs, allocated ground services costs, and allocated flight crew salaries are irrelevant. Why? Because these costs will not change whatever price Air Eagle chooses to charge. 2. The elasticity of demand of the two classes of passengers drives the different demands of the travelers. Business travelers are relatively price insensitive because they must get to their destination during the week (exclusive of weekends) and their fares are paid by their companies. A 320% increase in fares from $500 to $2,100 will deter only 10% of the business passengers from flying with Air Eagle. In contrast, a similar fare increase will lead to an 80% drop in pleasure travelers who are paying for their own travels, unlike business travelers, and who may have alternative vacation plans they could pursue instead. 3. Since business travelers often want to return within the same week, while pleasure travelers often stay over weekends, a requirement that a Saturday night stay is needed to qualify for the $500 discount fare would discriminate between the passenger categories. This price discrimination is legal because airlines are service companies rather than manufacturing companies and because these practices do not, nor are they intended to, destroy competition. 12-26 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

12-36 (25 min.) Ethics and pricing. 1. The $500 spent on the basketball tickets is a sunk (past) cost, and is therefore irrelevant to the bid decision. Apex will incur the $500 cost whether it bids, loses the bid, or wins the bid. 2. The original cost of framing materials per unit was $80 ($40,000 ÷ 500 units). If the target price is $145,000 and the markup is 25% of full cost, the target full cost is $116,000 ($145,000 ÷ 1.25). The difference in full cost is $5,000 ($121,000 - $116,000). Therefore, the target cost of framing materials is $35,000 ($40,000 - $5,000). The target cost of framing materials per unit equals $70 ($35,000 ÷ 500) 3. It was unethical for Grant to use the basketball tickets to get the tip out of the purchasing agent. Knowing about Grant’s action and suggesting a way to use it is unethical on the part of Gomes. In assessing the situation, the specific ―Standards of Ethical Conduct for Management Accountants,‖ described in Chapter 1 that the management accountant should consider are listed below. Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Using unethically gathered information to compromise a sealed bid arrangement is clearly a violation of this standard. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. In this regard, both Grant’s and Gomes’s behavior could be viewed as unethical. Credibility The Standards of Ethical Conduct for Management Accountants require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, revising a bid based on this kind of information violates both of these precepts.

Grant and Gomes should leave the bid as it was originally produced, without using the unethically obtained inside information. The company should clarify its policy on business entertainment.


12-37 (30 min.) Value engineering, target pricing, and locked-in costs. 1. Design cost Direct materials Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing overhead Marketing Total cost

$

5,000 120,000 142,000 64,000 46,500 15,000 $ 392,500

Cost per unit ($392,500 ÷ 200) $1,962.50 Target cost per unit ($2,000 × 0.90) $1,800.00 The cost estimate developed by Hoover does not meet Pacific’s requirements. Value engineering will be needed to reduce the cost per unit to the target cost. 2. Total costs (requirement 1) Less: Reduction in material costs ($120,000 × 40%) Add: Increase in design costs Total costs of redesigned table

$ 392,500 (48,000) 6,000 $ 350,500

Revised cost per unit ($350,500 ÷ 200 tables)

$1,752.50

Revised target cost per unit ($1,950 × 0.90)

$1,755.00

The design change allows the table to meet Pacific’s requirements for target costing. The cost of materials are a locked-in cost once the design is finalized. 3. Revised total cost ($392,500 + $7,000) Revised cost per unit ($399,500 ÷ 200) Revised target cost per unit ($2,200 × 0.90)

$ 399,500 $1,997.50 $1,980.00

No, this proposal does not allow the table to meet Pacific’s requirements for target costing. 4. Revenue ($1,950 × 200; $2,200 × 200) Total costs Operating income

Requirement 2 $390,000 350,500 $ 39,500

Requirement 3 $440,000 399,500 $ 40,500

Even without value engineering, Pacific Decor should implement the actions in requirement 3. It should spend $7,000 on marketing if it can achieve a higher price of $2,200 even though it does not achieve the target cost because it earns a higher overall operating income. Doing value engineering will help it increase operating income even more relative to requirement 2. 12-28 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

CHAPTER 13 STRATEGY, BALANCED SCORECARD, AND STRATEGIC PROFITABILITY ANALYSIS 13-1 Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives. 13-2 The five key forces to consider in industry analysis are: (a) competitors, (b) potential entrants into the market, (c) equivalent products, (d) bargaining power of customers, and (e) bargaining power of input suppliers. 13-3 Two generic strategies are (1) product differentiation, an organization’s ability to offer products or services perceived by its customers to be superior and unique relative to the products or services of its competitors and (2) cost leadership, an organization’s ability to achieve lower costs relative to competitors through productivity and efficiency improvements, elimination of waste, and tight cost control. 13-4 A customer preference map describes how different competitors perform across various product attributes desired by customers, such as price, quality, customer service and product features. 13-5 Reengineering is the fundamental rethinking and redesign of business processes to achieve improvements in critical measures of performance such as cost, quality, service, speed, and customer satisfaction. 13-6 The four key perspectives in the balanced scorecard are: (1) Financial perspective—this perspective evaluates the profitability of the strategy and the creation of shareholder value, (2) Customer perspective—this perspective identifies the targeted customer and market segments and measures the company’s success in these segments, (3) Internal business process perspective—this perspective focuses on internal operations that further both the customer perspective by creating value for customers and the financial perspective by increasing shareholder value, and (4) Learning and growth perspective—this perspective identifies the capabilities the organization must excel at to achieve superior internal processes that create value for customers and shareholders. 13-7 A strategy map is a diagram that describes how an organization creates value by connecting strategic objectives in explicit cause-and-effect relationships with each other in the financial, customer, internal business process, and learning and growth perspectives. 13-8 1. 2.

3.

4.

A good balanced scorecard design has several features: It tells the story of a company’s strategy by articulating a sequence of cause-and-effect relationships. It helps to communicate the strategy to all members of the organization by translating the strategy into a coherent and linked set of understandable and measurable operational targets. It places strong emphasis on financial objectives and measures in for-profit companies. Nonfinancial measures are regarded as part of a program to achieve future financial performance. It limits the number of measures to only those that are critical to the implementation of strategy. 13-1


5.

It highlights suboptimal tradeoffs that managers may make when they fail to consider operational and financial measures together.

13-9 1.

Pitfalls to avoid when implementing a balanced scorecard are: Don’t assume the cause-and-effect linkages are precise; they are merely hypotheses. An organization must gather evidence of these linkages over time. Don’t seek improvements across all of the measures all of the time. Don’t use only objective measures in the balanced scorecard. Don’t fail to consider both costs and benefits of different initiatives before including these initiatives in the balanced scorecard. Don’t ignore nonfinancial measures when evaluating managers and employees.

2. 3. 4. 5.

13-10 Three key components in doing a strategic analysis of operating income are: 1. The growth component which measures the change in operating income attributable solely to the change in quantity of output sold from one year to the next. 2. The price-recovery component which measures the change in operating income attributable solely to changes in the prices of inputs and outputs from one year to the next. 3. The productivity component which measures the change in costs attributable to a change in the quantity and mix of inputs used in the current year relative to the quantity and mix of inputs that would have been used in the previous year to produce current year output. 13-11 An analyst can incorporate other factors such as the growth in the overall market and reductions in selling prices resulting from productivity gains into a strategic analysis of operating income. By doing so, the analyst can attribute the sources of operating income changes to particular factors of interests. For example, the analyst will combine the operating income effects of strategic price reductions and any resulting growth with the productivity component to evaluate a company’s cost leadership strategy. 13-12 Engineered costs result from a cause-and-effect relationship between the cost driver, output, and the (direct or indirect) resources used to produce that output. Discretionary costs arise from periodic (usually annual) decisions regarding the maximum amount to be incurred. They have no measurable cause-and-effect relationship between output and resources used. 13-13 Downsizing (also called rightsizing) is an integrated approach configuring processes, products, and people to match costs to the activities that need to be performed to operate effectively and efficiently in the present and future. Downsizing is an attempt to eliminate unused capacity. 13-14 A partial productivity measure is the quantity of output produced divided by the quantity of an individual input used (e.g., direct materials or direct manufacturing labor). 13-15 No. Total factor productivity (TFP) and partial productivity measures work best together because the strengths of one offset weaknesses in the other. TFP measures are comprehensive, consider all inputs together, and explicitly consider economic substitution among inputs. Physical partial productivity measures are easier to calculate and understand and, as in the case of labor productivity, relate directly to employees’ tasks. Partial productivity measures are also easier to compare across different plants and different time periods. 13-2 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

13-16 (15 min.) Balanced scorecard. 1. Ridgecrest’s 2012 strategy is a cost leadership strategy. Ridgecrest plans to grow by producing high-quality boxes at a low cost delivered to customers in a timely manner. Ridgecrest’s boxes are not differentiated, and there are many other manufacturers who produce similar boxes. To succeed, Ridgecrest must produce high-quality boxes at lower costs relative to competitors through productivity and efficiency improvements. 2. Solution Exhibit 13-16A shows the customer preference map for corrugated boxes for Ridgecrest and Mesa on price, timeliness, quality and design. SOLUTION EXHIBIT 13-16A Customer Preference Map for Corrugated Boxes

Ridgecrest

Product Attributes

Price Kearney Delivery Time Quality

Design

1

2

3

4

Poor

5 Very good

Attribute Rating


3. Solution Exhibit 13-16B presents the strategy map for Ridgecrest for 2012. SOLUTION EXHIBIT 13-16B Strategy Map for Ridgecrest for 2012

FINANCIAL PERSPECTIVE

Reduce Costs

Increase operating income from productivity

Grow operating income

CUSTOMER PERSPECTIVE

Increase customer satisfaction

Increase new customers

Increase market share in corrugated boxes market

Improve productivity

Improve quality

Deliver on-time

Improve manufacturing processes

Align employee and organization goals

Develop process skill

INTERNALBUSINESSPROCESS PERSPECTIVE

LEARNINGAND GROWTHPERSPECTIVE

4.

Measures that we would expect to see on a Ridgecrest’s balanced scorecard for 2012 are

Financial Perspective (1) Operating income from productivity gain, (2) operating income from growth, (3) cost reductions in key areas. These measures evaluate whether Ridgecrest has successfully reduced costs and generated growth through cost leadership. Customer Perspective (1) Market share in corrugated boxes market, (2) number of new customers, (3) customer satisfaction index. The logic is that improvements in these customer measures are leading indicators of whether Ridgecrest’s cost leadership strategy is succeeding with its customers and helping it to achieve superior financial performance. (2) Internal Business Process Perspective (1) Productivity, (2) order delivery time, (3) on-time delivery, (4) number of major process improvements. Improvements in these measures are key drivers of achieving cost leadership and are expected to lead to more satisfied customers and in turn to superior financial performance 13-4 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Learning and Growth Perspective (1) Percentage of employees trained in process and quality management, (2) employee satisfaction ratings. Improvements in these measures aim to improve Ridgecrest’s ability to achieve cost leadership and have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.

13-17 (20 min.) Analysis of growth, price-recovery, and productivity components (continuation of 13-16). 1. Ridgecrest’s operating income gain is consistent with the cost leadership strategy identified in requirement 1 of Exercise 13-16. The increase in operating income in 2012 was driven by the $150,000 gain in productivity in 2012. Ridgecrest took advantage of its productivity gain to reduce the prices of its boxes and to fuel growth. It increased market share by growing even though the total market size was unchanged. 2. The productivity component measures the change in costs attributable to a change in the quantity and mix of inputs used in a year relative to the quantity and mix of inputs that would have been used in a previous year to produce the current year output. It measures the amount by which operating income increases and costs decrease through the productive use of input quantities. When comparing productivities across years, the productivity calculations use current year input prices in all calculations. Hence, the productivity component is unaffected by input price changes. The productivity component represents savings in both variable costs and fixed costs. With respect to variable costs, such as direct materials, productivity improvements immediately translate into cost savings. In the case of fixed costs, such as fixed manufacturing conversion costs, productivity gains result only if management takes actions to reduce unused capacity. For example, reengineering manufacturing processes will decrease the capacity needed to produce a given level of output, but it will lead to a productivity gain only if management reduces the unused capacity by, say, selling off the excess capacity.


13-18 (20 min.) Strategy, balanced scorecard, merchandising operation. (Please alert students that in some printed versions of the book there is a typographical error in line 8 of the table. It should read “Administrative cost per customer (Row 7 Row 6)” and not “(Row 8 Row 7).” 1. Roberto & Sons follows a product differentiation strategy. Roberto’s designs are ―trendsetting,‖ its T-shirts are distinctive, and it aims to make its T-shirts a ―must have‖ for each and every teenager. These are all clear signs of a product differentiation strategy, and, to succeed, Roberto must continue to innovate and be able to charge a premium price for its product. 2. Possible key elements of Roberto’s balance scorecard, given its product differentiation strategy: Financial Perspective (1) Increase in operating income from charging higher margins, (2) price premium earned on products. These measures will indicate whether Roberto has been able to charge premium prices and achieve operating income increases through product differentiation. Customer Perspective (1) Market share in distinctive, name-brand T-shirts, (2) customer satisfaction, (3) new customers, (4) number of mentions of Roberto’s T-shirts in the leading fashion magazines Roberto’s strategy should result in improvements in these customer measures that help evaluate whether Roberto’s product differentiation strategy is succeeding with its customers. These measures are, in turn, leading indicators of superior financial performance.

Internal Business Process Perspective (1) Quality of silk-screening (number of colors, use of glitter, durability of the design), (2) frequency of new designs, (3) time between concept and delivery of design Improvements in these measures are expected to result in more distinctive and trendsetting designs delivered to its customers and in turn, superior financial performance. Learning and Growth Perspective (1) Ability to attract and retain talented designers (2) improvements in silk-screening processes, (3) continuous education and skill levels of marketing and sales staff, (4) employee satisfaction. Improvements in these measures are expected to improve Roberto’s capabilities to produce distinctive designs that have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.


13-19 (25–30 min.) Strategic analysis of operating income (continuation of 13-18). 1.

Operating Income Statement Revenues ($25 Costs

198,000; $26

T-shirts purchased ($10 Administrative costs Total costs Operating income

246,700)

200,000; $8.50

250,000)

2010 $4,950,000

2011 $6,414,200

2,000,000 1,200,000 3,200,000 $1,750,000

2,125,000 1,162,500 3,287,500 $3,126,700

Change in operating income

2.

$1,376,700 F

The Growth Component

Revenue effect of growth

= =

Cost effect of growth for variable costs

=

Actual units of output sold in 2011

(246,700


198,000)

Units of input required to produce 2011 output in 2010

Cost effect of = growth for fixed costs

Selling price in 2010

×

$25 = $1,217,500 F Actual units of input used to produce 2010 ouput

×

Actual units of capacity in 2010 because adequate capacity exists to produce 2011 output in 2010

Input price in 2010

Actual units of capacity in 2010

×

Price per unit of capacity in 2010

Direct materials (purchased T-shirts) that would be required in 2011 to sell 246,700 T-shirts instead of the 198,000 sold in 2010, assuming the 2010 input-output relationship continued into 246,700 200,000 . Administrative capacity will not 2011, equal 249,192 purchased T-shirts 198,000 change since adequate capacity exists in 2010 to support year 2011 output and customers. The cost effects of growth component are Direct materials costs Administrative costs Cost effect of growth

(249,192 200,000) (4,000 – 4,000)

$10 $300

= =

$491,920 U 0 $491,920 U

In summary, the net increase in operating income as a result of the growth component equals: Revenue effect of growth $1,217,500 F Cost effect of growth Change in operating income due to growth

$

491,920 U 725,580 F


The Price-Recovery Component Revenue effect of Selling price price-recovery = in 2011

= ($26 $25)

Input Cost effect of price-recovery for = price in variable costs 2011 Cost effect of price-recovery for = fixed costs




246,700 = $246,700 F

Input Units of input required price in × to produce 2011 2010 output in 2010 Price per unit of capacity in 2010

Actual units of capacity in 2010 because adequate × capacity exists to produce 2011 output in 2010

Direct materials costs ($8.50 $10) Administrative costs ($310 $300) Total cost effect of price-recovery component

249,192 = 4,000 =

$373,788 F 40,000 U $333,788 F

In summary, the net increase in operating income as a result of the price-recovery component equals: Revenue effect of price-recovery $246,700 F Cost effect of price-recovery 333,788 F Change in operating income due to price-recovery $580,488 F


The Productivity Component Cost effect of productivity for = variable costs

Actual units of input used to produce 2011 output

Actual Cost effect of units of productivity for = capacity fixed costs in 2011

Units of input required to produce 2011 ouput in 2010

Input price in 2011


The productivity component of cost changes are Direct materials costs (250,000 249,192) Administrative costs (3,750 4,000) Change in operating income due to productivity


$8.50 = $310 =

$ 6,868 U 77,500 F $70,632 F

The change in operating income between 2010 and 2011 can be analyzed as follows:

Revenues Costs Operating income

Income Income Revenue and Revenue and Cost Effect Statement Statement Cost Effects Cost Effects of of Amounts Amounts of Growth Price-Recovery Productivity in 2011 in 2010 in 2011 in 2011 in 2011 (5) = (1) (2) (3) (4) (1) + (2) + (3) + (4) $4,950,000 $1,217,500 F $246,700 F $6,414,200 3,200,000

491,920 U

333,788 F

$70,632 F

3,287,500

$1,750,000

$ 725,580 F

$580,488 F

$70,632 F

$3,126,700

$1,376,700 F

Change in operating income 3. The analysis of operating income indicates that growth, price-recovery, and productivity all resulted in favorable changes in operating income in 2011. Further, a significant amount of the increase in operating income resulted from Roberto’s product differentiation strategy. The company was able to continue to charge a premium price while growing sales. It was also able to earn additional operating income by improving its productivity.


13-20 (20 min.) Analysis of growth, price-recovery, and productivity components (continuation of 13-19). Effect of the industry-market-size factor on operating income Of the 48,700-unit (246,700 – 198,000) increase in sales between 2010 and 2011, 19,800 (10% 198,000) units are due to growth in market size, and 28,900 units are due to an increase in market share. The change in Roberto’s operating income from the industry-market size factor rather than from specific strategic actions is: 19,800 $725,580 (the growth component in Exercise 13-19) $ 295,000 F 48,700 Effect of product differentiation on operating income The change in operating income due to: Increase in the selling price (revenue effect of price recovery) $ 246,700 F Increase in price of inputs (cost effect of price recovery) 333,788 F Growth in market share due to product differentiation $725,580 (the growth component in Exercise 13-19)

28,900 48,700

430,580 F

Change in operating income due to product differentiation Effect of cost leadership on operating income The change in operating income from cost leadership is: Productivity component

$1,011,068 F

$

70,632 F

The change in operating income between 2010 and 2011 can be summarized as follows: Change due to industry-market-size Change due to product differentiation Change due to cost leadership Change in operating income

$ 295,000 F 1,011,068 F 70,632 F $1,376,700 F

Roberto has been very successful in implementing its product differentiation strategy. Nearly 73% ($1,011,068 $1,376,700) of the increase in operating income during 2011 was due to product differentiation, i.e., the distinctiveness of its T-shirts. It was able to raise prices of its products despite a decline in the cost of the T-shirts purchased. Roberto’s operating income increase in 2011 was also helped by a growth in the overall market and a small productivity improvement, which it did not pass on to its customers in the form of lower prices.


13-21 (15 min.) Identifying and managing unused capacity (continuation of 13-18). 1. The amount and cost of unused capacity at the beginning of year 2011 based on year 2011 production follows: Amount of Cost of Unused Unused Capacity Capacity Administrative, 4,000 3,500; (4,000 – 3,500) $310 500 $155,000 2. Roberto can reduce administrative capacity by another 250 customers (3,750 – 250 = 3,500 actual customers. Roberto will save another 250 $310 = $77,500. This is the maximum amount of costs Roberto can save in 2011, in addition to the $77,500 ($310 250 customers) that Roberto already saved when downsizing from 4,000 customers to 3,750 customers. 3. Before Roberto downsizes administrative capacity, it should consider whether sales increases in the future would lead to a greater demand for and utilization of capacity as new customers are drawn to Roberto’s distinctive products—at that point, customer service may be the key to new customer retention and further growth. Also, the market feedback often provided by customer service staff is probably key to Roberto’s cutting-edge fashion strategy; some of this may be lost if administrative capacity is cut back. Additionally, significant reductions in capacity usually means laying off people which can hurt employee morale.


13-22 (15 min.)

Strategy, balanced scorecard.

1. Stanmore Corporation follows a product differentiation strategy in 2011. Stanmore’s D4H machine is distinct from its competitors and generally regarded as superior to competitors’ products. To succeed, Stanmore must continue to differentiate its product and charge a premium price. 2.

Balanced Scorecard measures for 2011 follow:

Financial Perspective (1) Increase in operating income from charging higher margins, (2) price premium earned on products. These measures indicate whether Stanmore has been able to charge premium prices and achieve operating income increases through product differentiation. Customer Perspective (1) Market share in high-end special-purpose textile machines, (2) customer satisfaction, (3) new customers. Stanmore’s strategy should result in improvements in these customer measures that help evaluate whether Stanmore’s product differentiation strategy is succeeding with its customers. These measures are leading indicators of superior financial performance. Internal Business Process Perspective (1) Manufacturing quality and reduced wastage of direct materials, (2) new product features added, (3) order delivery time. Improvements in these measures are expected to result in more distinctive products delivered to its customers and in turn superior financial performance. Learning and Growth Perspective (1) Development time for designing new machines, (2) improvements in manufacturing processes, (3) employee education and skill levels, (4) employee satisfaction. Improvements in these measures are likely to improve Stanmore’s capabilities to produce distinctive products that have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.


13-23 (30 min.) Strategic analysis of operating income (continuation of 13-22). 1.

Operating income for each year is as follows:

Revenue ($40,000

200; $42,000

2010 2011 $8,000,000 $8,820,000

210)

Costs Direct materials costs ($8 300,000; $8.50 310,000) Manufacturing conversion costs ($8,000 250; 8,100 250) Selling & customer service costs ($10,000 100; $9,900 95) Total costs 5,600,500 Operating income

2,400,0002,635,000 2,000,0002,025,000 1,000,000 940,500 5,400,000 $2,600,000 $3,219,500 $619,500 F

Change in operating income 2.

The Growth Component Revenue effect = of growth

=

Actual units of output sold in 2011 (210

Cost effect of growth for = variable costs

Cost effect of = growth for fixed costs

200)



$40,000 = $400,000 F


Actual units of inputs used to produce 2010 ouput



Input price in 2010

×


Kilograms of direct materials that would be required in 2011 to produce 210 units instead of the 200 units produced in 2010, assuming the 2010 input-output relationship continued into 2011, 300,000 equal 315,000 kilograms 210 . Manufacturing conversion costs and selling and 200 customer-service capacity will not change since adequate capacity exists in 2010 to support year 2011 output and customers.


The cost effects of growth component are: Direct materials costs Manufacturing conversion costs Selling & customer-service costs Cost effect of growth

(315,000 300,000) (250 250) (100 100)

$8 = $8,000 = $25,000 =

$120,000 U 0 0 $120,000 U

In summary, the net increase in operating income as a result of the growth component equals: Revenue effect of growth $400,000 F Cost effect of growth 120,000 U Change in operating income due to growth $280,000 F The Price-Recovery Component Revenue effect of Selling price = price-recovery in 2011

= ($42,000 Cost effect of price-recovery for = variable costs

Input price in 2011

Cost effect of price-recovery for = fixed costs


Direct materials costs Manufacturing conversion costs Selling & customer-service costs Cost effect of price-recovery


$40,000)

Input price in 2010

×



210 = $420,000 F



($8.50 $8) ($8,100 $8,000) ($9,900 $10,000)

315,000 = 250 = 100 =

$157,500 U 25,000 U 10,000 F $172,500 U

In summary, the net increase in operating income as a result of the price-recovery component equals:

Revenue effect of price-recovery Cost effect of price-recovery Change in operating income due to price-recovery

$420,000 F 172,500 U $247,500 F






Input price in 2011


The productivity component of cost changes are Direct materials costs (310,000 315,000) Manufacturing conversion costs (250 250) Selling & customer-service costs (95 100) Change in operating income due to productivity


$8.50 = $8,100 = $9,900 =

$42,500 F 0 49,500 F $92,000 F



Income Statement Amounts in 2010 (1) $8,000,000

Revenue and Revenue and Cost Effect Cost Effects Cost Effects of of of Growth Price-Recovery Productivity Component Component Component in 2011 in 2011 in 2011 (2) (3) (4) $400,000 F $420,000 F

Income Statement Amounts in 2011 (5) = (1) + (2) + (3) + (4) $8,820,000

5,400,000

120,000 U

172,500 U

$92,000 F

5,600,500

$2,600,000

$280,000 F

$247,500 F

$92,000 F

$3,219,500

$619,500 F

Change in operating income 3. The analysis of operating income indicates that a significant amount of the increase in operating income resulted from Stanmore’s product differentiation strategy. The company was able to continue to charge a premium price while growing sales. Stanmore was also able to earn additional operating income by improving its productivity. The productivity gains may be important from the standpoint of funding the product differentiation strategy and innovation (as has been the case with the pharmaceutical industry in recent years) but Stanmore’s strategic focus has to be on differentiating its products.


13-24 (20 min.)Analysis of growth, price-recovery, and (continuation of 13-23).

productivity components

Effect of the industry-market-size factor on operating income Of the 10-unit increase in sales from 200 to 210 units, 3% or 6 (3% 200) units is due to growth in market size, and 4 (10 6) units is due to an increase in market share. The change in Stanmore’s operating income from the industry-market size factor rather than from specific strategic actions is: 6 $280,000 (the growth component in Exercise 13-23) $168,000 F 10 Effect of product differentiation on operating income The change in operating income due to: Increase in the selling price of D4H (revenue effect of price recovery) $420,000 F Increase in price of inputs (cost effect of price recovery) 172,500 U Growth in market share due to product differentiation $280,000 (the growth component in Exercise 13-23)

4 10

112,000 F

Change in operating income due to product differentiation

$359,500 F

Effect of cost leadership on operating income The change in operating income from cost leadership is: Productivity component

$ 92,000 F

The change in operating income between 2010 and 2011 can be summarized as follows: Change due to industry-market-size Change due to product differentiation Change due to cost leadership Change in operating income

$168,000 F 359,500 F 92,000 F $619,500 F

Stanmore has been successful in implementing its product differentiation strategy. More than 58% ($359,500 $619,500) of the increase in operating income during 2011 was due to product differentiation, i.e., the distinctiveness of its machines. It was able to raise the prices of its machines faster than the costs of its inputs and still grow market share. Stanmore’s operating income increase in 2011 was also helped by a growth in the overall market and some productivity improvements.


13-25 (15 min.) Identifying and managing unused capacity (continuation of 13-22). 1. The amount and cost of unused capacity at the beginning of year 2011 based on year 2011 production follows:

Manufacturing, 250 210; (250 – 210) $8,100 Selling and customer service, 100 – 80; (100 – 80)

$9,900

Amount of Unused Capacity 40 20

Cost of Unused Capacity $324,000 198,000

2. Stanmore can reduce manufacturing capacity from 250 units to 220 (250 30) units. Stanmore will save 30 $8,100 = $243,000. This is the maximum amount of costs Stanmore can save in 2011. It cannot reduce capacity further (by another 30 units to 190 units) because it would then not have enough capacity to manufacture 210 units in 2011 (units that contribute significantly to operating income). 3. Stanmore may choose not to downsize because it projects sales increases that would lead to a greater demand for and utilization of capacity. Stanmore may have also decided not to downsize because downsizing requires a significant reduction in capacity. For example, Stanmore may have chosen to downsize some more manufacturing capacity if it could do so in increments of say, 10, rather than 30 units. Also, Stanmore may be focused on product differentiation, which is key to its strategy, rather than on cost reduction. Not reducing significant capacity also helps to boost and maintain employee morale.


13-26 (15 min.) Strategy, balanced scorecard, service company. 1. Westlake Corporation’s strategy in 2011 is cost leadership. Westlake’s consulting services for implementing sales management software is not distinct from its competitors. The market for these services is very competitive. To succeed, Westlake must deliver quality service at low cost. Improving productivity while maintaining quality is key. 2.

Balanced Scorecard measures for 2011 follow:

Financial Perspective (1) Increase operating income from productivity gains and growth, (2) revenues per employee, (3) cost reductions in key areas, for example, software implementation and overhead costs. These measures indicate whether Westlake has been able to reduce costs and achieve operating income increases through cost leadership. Customer Perspective (1) Market share, (2) new customers, (3) customer responsiveness, (4) customer satisfaction. Westlake’s strategy should result in improvements in these customer measures that help evaluate whether Westlake’s cost leadership strategy is succeeding with its customers. These measures are leading indicators of superior financial performance. Internal Business Process Perspective (1) Time to complete customer jobs, (2) time lost due to errors, (3) quality of job (Is system running smoothly after job is completed?) Improvements in these measures are key drivers of achieving cost leadership and are expected to lead to more satisfied customers, lower costs, and superior financial performance. Learning and Growth Perspective (1) Time required to analyze and design implementation steps, (2) time taken to perform key steps implementing the software, (3) skill levels of employees, (4) hours of employee training, (5) employee satisfaction and motivation. Improvements in these measures are likely to improve Westlake’s ability to achieve cost leadership and have a cause-and-effect relationship with improvements in internal business processes, customer satisfaction, and financial performance.


13-27 1.

(30 min.)

Strategic analysis of operating income (continuation of 13-26).

Operating income for each year is as follows: 2010 2011 $3,000,000 $3,360,000

Revenues ($50,000 60; $48,000 70) Costs Software implementation labor costs ($60 30,000; $63 32,000) Software implementation support costs ($4,000 90; $4,100 90) Total costs Operating income Change in operating income 2.

1,800,000

2,016,000

360,000 369,000 2,160,000 2,385,000 $ 840,000 $ 975,000 $135,000 F

The Growth Component Revenue effect of growth

= =

Cost effect of growth for variable costs

Cost effect of growth for fixed costs

=

=

Actual units of output sold in 2011 (70 – 60)



$50,000 = $500,000 F



Actual units of input used to produce 2010 output Actual units of capacity in 2010

Input price in 2010

Price per × unit of capacity in 2010

Software implementation labor-hours that would be required in 2011 to produce 70 units instead of the 60 units produced in 2010, assuming the 2010 input-output relationship continued 30, 000 into 2011, equal 35,000 70 labor-hours. Software implementation support capacity 60 would not change since adequate capacity exists in 2010 to support year 2011 output and customers. The cost effects of growth component are Software implementation labor costs (35,000 – 30,000) Software implementation support costs (90 – 90) Cost effect of growth

$60 = $4,000 =

$300,000 U 0 $300,000 U

In summary, the net increase in operating income as a result of the growth component equals: Revenue effect of growth $500,000 F Cost effect of growth 300,000 U Change in operating income due to growth $200,000 F


The Price-Recovery Component Revenue effect of = price-recovery

=


($48,000 – $50,000)

Cost effect of price-recovery for = variable costs


Input price in 2011


Software implementation labor costs Software implementation support costs Cost effect of price recovery

Actual units of output sold in 2011 70 = $140,000 U


Input price in 2010




($63 – $60) $105,000 U ($4,100 – $4,000)

35,000 90

=

=

9,000 U $114,000 U

In summary, the net decrease in operating income as a result of the price-recovery component equals: Revenue effect of price-recovery $140,000 U Cost effect of price-recovery 114,000 U Change in operating income due to price recovery $254,000 U






Input price in 2011


The productivity component of cost changes are: Software implementation labor costs (32,000 – 35,000) Software implementation support costs (90 – 90) Change in operating income due to productivity

$63 $4,100

= =

$189,000 F 0 $189,000 F


The change in operating income between 2010 and 2011 can be analyzed as follows: Income Statement Amounts in 2010 (1)


Revenue and Cost Effects of Growth Component in 2011 (2)

Revenue and Income Cost Effects of Cost Effect of Statement Price-Recovery Productivity Amounts Component Component in 2011 in 2011 in 2011 (5) = (3) (4) (1) + (2) + (3) + (4)

$3,000,000

$500,000 F

$140,000 U

$3,360,000

2,160,000

300,000 U

114,000 U

$189,000 F

2,385,000

$ 840,000

$200,000 F

$254,000 U

$189,000 F

$ 975,000

$135,000 F Change in operating income 3. The analysis of operating income indicates that a significant amount of the increase in operating income resulted from Westlake’s productivity improvements in 2011. The company had to reduce selling prices while labor costs were increasing but it was able to increase operating income by improving its productivity. The productivity gains also allowed Westlake to be competitive and grow the business. The unfavorable price recovery component indicates that Westlake could not pass on increases in labor-related wages via price increases to its customers, very likely because its product was not differentiated from competitors’ offerings.


13-28 (25 min.) Analysis of growth, price-recovery, and productivity components (continuation of 13-27). Effect of industry-market-size factor on operating income Of the 10-unit increase in sales from 60 to 70 units, 5% or 3 units (5% 60) are due to growth in market size, and 7 (10 3) units are due to an increase in market share. The change in Westlake’s operating income from the industry market-size factor rather than from specific strategic actions is: 3 $200,000 (the growth component in Exercise 13-27) $ 60,000 F 10 Effect of product differentiation on operating income Increase in prices of inputs (cost effect of price recovery) $114,000 U Effect of cost leadership on operating income Productivity component Effect of strategic decision to reduce selling price, $2,000 Growth in market share due to productivity improvement and strategic decision to reduce selling price $200,000 (the growth component in Exercise 13-27) Change in operating income due to cost leadership

70

$189,000 F 140,000 U

7 10

140,000 F $189,000 F

The change in operating income between 2010 and 2011 can then be summarized as Change due to industry-market-size Change due to product differentiation Change due to cost leadership Change in operating income

$ 60,000 F 114,000 U 189,000 F $135,000 F

Westlake has been very successful in implementing its cost leadership strategy. Despite the increase in the cost of software-implementation labor and software-implementation support, Westlake strategically decreased the selling price of a job by $2,000. That is, Westlake took advantage of its productivity gains to reduce price, gain market share, and increase operating income.


13-29 (20 min.) Identifying and managing unused capacity (continuation of 13-26). 1. The amount and cost of unused capacity at the beginning of year 2011 based on work done in year 2011 follows:

Software implementation support, 90

70; (90

70)

$4,100

Amount of Unused Capacity 20

Cost of Unused Capacity $82,000

2. Westlake can reduce software implementation support capacity from 90 jobs to 75 (90 15) jobs. Westlake will save 15 $4,100 = $61,500. This is the maximum amount of costs Westlake can save by downsizing in 2011. It cannot reduce capacity further (by another 15 jobs to 60 jobs) because it would then not have enough capacity to do 70 jobs in 2011 (jobs that contribute significantly to operating income). 3. Westlake may have chosen not to downsize because it projects sales increases in the near term that would lead to greater demand for and utilization of capacity. Westlake may have also decided not to downsize because downsizing requires a significant reduction in capacity. For example, Westlake may have chosen to downsize additional software implementation support capacity if it could do so in, say, increments of 5, rather than 15 units. Not reducing significant capacity by laying off employees boosts employee morale and keeps employees more motivated and productive.


13-30 (30 min.) Balanced scorecard and strategy. 1. Solution Exhibit 13-30A shows the customer preference map for MP3 players for Music Master Company and Vantage Manufacturing on price, storage capacity, and quality. SOLUTION EXHIBIT 13-30A Customer Preference Map for MP3 Players

Product Attributes

Vantage Manufacturing

Music Master

Price

Storage Capacity

Quality

1

2

3

4

Poor

5 Very good

Attribute Rating

2. Music Master currently follows a cost leadership strategy, which is reflected in its lower price compared to Vantage Manufacturing. The Mini MP3 player is similar to products offered by competitors.


3. Solution Exhibit 13-30B presents Music Master’s strategy map explaining cause-and-effect relationships in its balanced scorecard. SOLUTION EXHIBIT 13-30B Strategy Map for Music Master Company

FINANCIAL PERSPECTIVE

Increase operating income from productivity and quality

Grow revenues

Grow operating income

CUSTOMER PERSPECTIVE

Increase customer satisfaction

Increase customers

Increase market share

INTERNALBUSINESSPROCESS PERSPECTIVE

LEARNINGAND GROWTHPERSPECTIVE

Improve quality

Improve manufacturing processes

Align employee and organization goals

Develop process skill

Improve manufacturing feedback

Empower workers


4. In the internal-business-process perspective, Music Master needs to set targets for decreasing the percentage of defective products sold and then identify measures that would be leading indicators of achieving this goal. For example, in the learning and growth perspective, Music Master may want to measure the percentage of employees trained in quality management and the percentage of manufacturing processes with real-time feedback. The logic is that improvements in these measures will drive quality improvements and so reduce the percentage of defective products sold. To achieve its goals, items that Music Master could include under each perspective of the balanced scorecard follows: Financial Perspective

Operating income from productivity and quality improvement Operating income from growth Revenue growth

Customer Perspective

Market share Number of additional customers Customer-satisfaction ratings

Internal-BusinessProcess Perspective

Percentage of defective products sold Number of major improvements in manufacturing process

Learning-and-Growth Perspective

Employee-satisfaction ratings Percentage of employees trained in quality management Percentage of line workers empowered to manage processes Percentage of manufacturing processes with real-time feedback


13-31 (25-30 min.) Strategic analysis of operating income (continuation of 13-30) 1.


Revenue ($45 8,000; $43 9,000) Costs Direct materials costs ($3.50 32,000; $3.50 Conversion costs Selling & customer service costs Total costs Operating income Change in operating income 2.

2010 $360,000 33,000)

2011 $387,000

112,000 156,000 45,000 313,000 $ 47,000 $32,000 F

115,500 143,000 49,500 308,000 $ 79,000

The Growth Component Revenue effect = of growth

=

Actual units of output sold in 2011 (9,000

Cost effect of growth for = variable costs Cost effect of = growth for fixed costs


8,000)


$45 = $45,000 F


Actual units of inputs used to produce 2010 ouput



Input price in 2011

×


Ounces of direct materials that would be required in 2011 to produce 9,000 units instead of the 8,000 units produced in 2010, assuming the 2010 input-output relationship continued into 2011, 32,000 9,000 equal 36,000 ounces . That is, the number of ounces to produce 9,000 units 8,000 is 32,000 ounces 8,000 units = 4 ounces per unit 9,000 units = 36,000 ounces. Conversion costs and selling and customer-service capacity will not change since adequate capacity exists in 2010 to support year 2011 output and customers. The cost effects of growth component are: Direct materials costs (36,000 32,000) $3.50 = $14,000 U Conversion costs (12,000 12,000) $ 13 = 0 Selling & customer-service costs (90 90) $ 500 = 0 Cost effect of growth $14,000 U In summary, the net increase in operating income as a result of the growth component equals: Revenue effect of growth $45,000 F Cost effect of growth 14,000 U 13-27 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Change in operating income due to growth

$31,000 F

The Price-Recovery Component Revenue effect of Selling price = price-recovery in 2011

= ($43 Cost effect of price-recovery for = variable costs

Input price in 2011



Direct materials costs Conversion costs Selling & customer-service costs Cost effect of price-recovery

$45)



9,000 = $18,000 U

Input price in 2010

Units of input required to × produce 2011 output in 2010



($3.50 – $3.50) ($ 13 $ 13) ($ 550 $500)

36,000 = 12,000 = 90 =

$

0 0 4,500 U $4,500 U

In summary, the net increase in operating income as a result of the price-recovery component equals: Revenue effect of price-recovery $18,000 U Cost effect of price-recovery 4,500 U Change in operating income due to price-recovery $22,500 U The Productivity Component Cost effect of productivity for = variable costs





The productivity component of cost changes are Direct materials costs (33,000 36,000) Conversion costs (11,000 – 12,000) Selling & customer-service costs (90 90) Change in operating income due to productivity

Input price in 2011


$3.50 = $ 13 = $ 550 =

$10,500 F 13,000 F 0 $23,500 F




Revenue and Revenue and Cost Effect Income Income Cost Effects Cost Effects of of Statement Statement of Growth Price-Recovery Productivity Amounts Amounts Component Component Component in 2011 in 2010 in 2011 in 2011 in 2011 (5) = (1) (2) (3) (4) (1) + (2) + (3) + (4) $360,000 $45,000 F $18,000 U $387,000 313,000

14,000 U

4,500 U

$23,500 F

308,000

$ 47,000

$31,000 F

$22,500 U

$23,500 F

$ 79,000

$32,000 F

Change in operating income 3. The analysis of operating income indicates that a significant amount of the increase in operating income resulted from Music Master’s cost leadership strategy. The company was able to improve quality and grow sales. The price recovery component indicates that Music Master reduced prices to be competitive in the market but Music Master also improved direct material productivity and reduced conversion cost capacity as rework decreased. Lower prices and higher quality boosted sales. .


13-32 (20 min.) Analysis of growth, price-recovery, and productivity components (continuation of 13-31) Effect of the industry-market-size factor on operating income Of the 1,000-unit increase in sales from 8,000 to 9,000 units, 3% or 240 (3% 8,000) units are due to growth in market size, and 760 (1,000 240) units are due to an increase in market share. The change in Music Master’s operating income from the industry-market size factor rather than from specific strategic actions is: 240 $31,000 (the growth component in Exercise 13-31) $ 7,440 F 1, 000 Effect of product differentiation on operating income The change in operating income due to: Increase in price of inputs (cost effect of price recovery) $ 4,500 U Effect of cost leadership on operating income The change in operating income from cost leadership is: Productivity component Decrease in selling price (revenue effect of price recovery) Growth in market share due to cost leadership $31,000 (the growth component in Exercise 13-31) Change in operating income due to cost leadership

$23,500 F 18,000 U 760 1, 000

23,560 F $29,060 F

The change in operating income between 2010 and 2011 can be summarized as follows: Change due to industry market-size Change due to product differentiation Change due to cost leadership Change in operating income

$ 7,440 F 4,500 U 29,060 F $32,000 F

Music Master has been successful in implementing its cost leadership strategy. The increase in operating income during 2011 was due to cost leadership through quality improvements and sales growth. Music Master’s operating income increase in 2011 was also helped by a growth in the overall market size.


13-33 (20 min.) Identifying and managing unused capacity (continuation of 13-31) 1. The amount and cost of unused capacity at the beginning of year 2011 based on year 2011 production follows: Amount of Cost of Unused Unused Capacity Capacity 3,000 $39,000 Manufacturing, 12,000 9,000; (12,000 – 9,000) $13 10 Selling and customer service, 90 – 80; (90– 80) $550 $ 5,500 2. Music Master can reduce selling and customer-service capacity by another 10 customers (90 – 80 = 10 customers). Music Master will save another 10 $550 = $5,500. This is the maximum amount of costs Music Master can save in 2011. 3. Music Master may have chosen not to downsize because it projects sales increases in the near term that would lead to greater demand for and utilization of selling and customer-service capacity. It is difficult to reduce and then immediately increase capacity. Not reducing significant capacity by laying off employees boosts employee morale and keeps employees more motivated and productive.

.


13-34 (20–30 min.) Balanced scorecard.

Perspectives ▪ Financial

Strategic Objectives

Performance Measures

▪ Increase shareholder value

▪ Increase profit generated by each salesperson

▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪

Earnings per share Net income Return on assets Return on sales Return on equity Product cost per unit Customer cost per unit Profit per salesperson

▪ Customer

▪ Acquire new customers ▪ Retain customers ▪ Develop profitable customers

▪ Number of new customers ▪ Percentage of customers retained ▪ Customer profitability

▪ Internal Business Process

▪ Improve manufacturing quality ▪ Introduce new products

▪ Percentage of defective product units

▪ Minimize invoice error rate ▪ On-time delivery by suppliers

▪ Percentage of error-free invoices ▪ Percentage of on-time deliveries by suppliers ▪ Number of patents

▪ Increase proprietary products ▪ Learning and Growth

▪ Increase information system capabilities ▪ Enhance employee skills

▪ Percentage of processes with real-time feedback ▪ Employee turnover rate ▪ Average job-related training hours per employee

13-35 (20 min.) Balanced scorecard. 1. Caltex’s strategy is to focus on ―service-oriented customers‖ who are willing to pay a higher price for services. Even though gasoline is largely a commodity product, Caltex wants to differentiate itself through the service it provides at its retailing stations. Does the scorecard represent Caltex’s strategy? By and large it does. The focus of the scorecard is on measures of process improvement, quality, market share, and financial success from product differentiation and charging higher prices for customer service. There are some deficiencies that the subsequent assignment questions raise but, abstracting from these concerns for the moment, the scorecard does focus on implementing a product differentiation strategy. Having concluded that the scorecard has been reasonably well designed, how has Caltex performed relative to its strategy in 2011? It appears from the scorecard that Caltex was successful in implementing its strategy in 2011. It achieved all targets in the financial, internal business, and learning and growth perspectives. The only target it missed was the market share target in the customer perspective. At this stage, students may raise some questions about


whether this is a good scorecard measure. Requirement 3 gets at this issue in more detail. The bottom line is that measuring ―market share in the overall gasoline market‖ rather than in the ―service-oriented customer‖ market segment is not a good scorecard measure, so not achieving this target may not be as big an issue as it may seem at first. 2. Yes, Caltex should include some measure of employee satisfaction and employee training in the learning and growth perspective. Caltex’s differentiation strategy and ability to charge a premium price is based on customer service. The key to good, fast, and friendly customer service is well trained and satisfied employees. Untrained and dissatisfied employees will have poor interactions with customers and cause the strategy to fail. Hence, training and employee satisfaction are very important to Caltex for implementing its strategy. These measures are leading indicators of whether Caltex will be able to successfully implement its strategy and should be measured on the balanced scorecard. 3. Caltex’s strategy is to focus on the 60% of gasoline consumers who are service-oriented, not on the 40% price-shopper segment. To evaluate if it has been successful in implementing its strategy, Caltex needs to measure its market share in its targeted market segment, ―serviceoriented customer,‖ not its market share in the overall market. Given Caltex’s strategy, it should not be concerned if its market share in the price-shopper segment declines. In fact, charging premium prices will probably cause its market share in this segment to decline. Caltex should replace ―market share in overall gasoline market‖ with ―market share in the service-oriented customer segment‖ in its balanced scorecard customer measure. Caltex may also want to consider putting a customer satisfaction measure on the scorecard. This measure should capture an overall evaluation of customer reactions to the facility, the convenience store, employee interactions, and quick turnaround. The customer satisfaction measure would serve as a leading indicator of market share in the service-oriented customer segment. 4. Although there is a cause-and-effect link between internal business process measures and customer measures on the current scorecard, Caltex should add more measures to tighten this linkage. In particular, the current scorecard measures focus exclusively on refinery operations and not on gas station operations. Caltex should add measures of gas station performance such as cleanliness of the facility, turnaround time at the gas pumps, the shopping experience at the convenience store, and the service provided by employees. Many companies do random audits of their facilities to evaluate how well their branches and retail outlets are performing. These measures would serve as leading indicators of customer satisfaction and market share in Caltex’s targeted segments. 5. Caltex is correct in not measuring changes in operating income from productivity improvements on its scorecard under the financial perspective. Caltex’s strategy is to grow by charging premium prices for customer service. The scorecard measures focus on Caltex’s success in implementing this strategy. Productivity gains per se are not critical to Caltex’s strategy and therefore, should not be measured on the scorecard.


13-36 (30 min.) Balanced scorecard. 1. The market for color laser printers is competitive. Lee’s strategy is to produce and sell high quality laser printers at a low cost. The key to achieving higher quality is reducing defects in its manufacturing operations. The key to managing costs is dealing with the high fixed costs of Lee’s automated manufacturing facility. To reduce costs per unit, Lee would have to either produce more units or eliminate excess capacity. The scorecard correctly measures and evaluates Lee’s broad strategy of growth through productivity gains and cost leadership. There are some deficiencies, of course, that subsequent assignment questions will consider. It appears from the scorecard that Lee was not successful in implementing its strategy in 2011. Although it achieved targeted performance in the learning and growth and internal business process perspectives, it significantly missed its targets in the customer and financial perspectives. Lee has not had the success it targeted in the market and has not been able to reduce fixed costs. 2. Lee’s scorecard does not provide any explanation of why the target market share was not met in 2011. Was it due to poor quality? Higher prices? Poor post-sales service? Inadequate supply of products? Poor distribution? Aggressive competitors? The scorecard is not helpful for understanding the reasons underlying the poor market share. Lee may want to include some measures in the customer perspective (and internal business process perspective) that get at these issues. These measures would then serve as leading indicators (based on cause-and-effect relationships) for lower market share. For example, Lee should measure customer satisfaction with its printers on various dimensions of product features, quality, price, service, and availability. It should measure how well its printers match up against other color laser printers on the market. This is critical information for Lee to successfully implement its strategy. 3. Lee should include a measure of employee satisfaction to the learning and growth perspective and a measure of new product development to the internal business process perspective. The focus of its current scorecard measures is on processes and not on people and innovation. Lee considers training and empowering workers as important for implementing its highquality, low-cost strategy. Therefore employee training and employee satisfaction should appear in the learning and growth perspective of the scorecard. Lee can then evaluate if improving employee-related measures results in improved internal-business process measures, market share and financial performance. Adding new product development measures to internal business processes is also important. As Lee reduces defects, Lee’s costs will not automatically decrease because many of Lee’s costs are fixed. Instead, Lee will have more capacity available to it. The key question is how Lee will obtain value from this capacity. One important way is to use the capacity to produce and sell new models of its products. Of course if this strategy is to work, Lee must develop new products at the same time that it is improving quality. Hence, the scorecard should contain some measure to monitor progress in new product development. Improving quality without developing and selling new products (or downsizing) will result in weak financial performance.


4. Improving quality and significantly downsizing to eliminate unused capacity is difficult. Recall that the key to improving quality at Lee Corporation is training and empowering workers. As quality improvements occur, capacity will be freed up, but because costs are fixed, quality improvements will not automatically lead to lower costs. To reduce costs, Lee’s management must take actions such as selling equipment and laying off employees. But how can management lay off the very employees whose hard work and skills led to improved quality? If it did lay off employees now, will the remaining employees ever work hard to improve quality in the future? For these reasons, Lee’s management should first focus on using the newly available capacity to sell more product. If it cannot do so and must downsize, management should try to downsize in a way that would not hurt employee morale, such as through retirements and voluntary severance.


13-37 (20 min.) Partial productivity measurement. 1.

Gerhart Company’s partial productivity ratios in 2012 are as follows:

Direct materials partial productivity

=

Conversion costs partial productivity

=

Quantity of output produced in 2012 Yards of direct materials used in 2012 Quantity of output produced in 2012 Units of manuf. capacity in 2012

=

=

2, 646, 000 1, 764, 000 2, 646, 000 2, 700, 000

=

1.5 wallets per yard 0.98 wallets

= per unit of capacity

To compare partial productivities in 2012 with partial productivities in 2011, we first calculate the inputs that would have been used in 2011 to produce year 2012’s 2,646,000 units of output assuming the year 2011 relationship between inputs and outputs. Direct materials

=

2,000,000 yards (2011)

2,646,000 output units in 2012

2,520,000 output units in 2011 1.05 = 2,100,000 yards

= 2,000,000 yards Alternatively, we can calculate direct materials that would have been used in year 2011 to produce

year 2012’s 2,646,000 output as 2,000,000 yards 2,520,000 units = 0.79365 yards per unit Manufacturing capacity

=

2,646,000 units = 2,100,000 yards.

3,307,500 units of capacity, because manufacturing capacity is fixed, and adequate capacity existed in 2011 to produce year 2012 output.

Partial productivity calculations for 2011 based on year 2012 output (to make the partial productivities comparable across the two years): Direct materials partial productivity

=

Conversion costs partial productivity

=

Quantity of output produced in 2012 Yards of direct materials that would have been used in 2011 to produce year 2012 output

Quantity of output produced in 2012 Units of manufacturing capacity that would have been used in 2011 to produce year 2012 output

=

=

2, 646, 000 2,100, 000 2, 646, 000 3, 307, 500

wallets = 1.26 per yard

0.8 wallets per = unit of capacity

The calculations indicate that Gerhart improved the partial productivity of direct materials and conversion costs between 2011 and 2012 via efficiency improvements and by reducing unused manufacturing capacity. 2. Gerhart Company management can use the partial productivity measures to set targets for the next year. Partial productivity measures can easily be compared over multiple periods. For example, they may specify bonus payments if partial productivity of direct materials increases to 1.95 units of output per yard and if partial productivity of conversion costs improves to 1.25 units of output per unit of capacity. A major advantage of partial productivity measures is that they focus on a single input; hence, they are simple to calculate and easy to understand at the operations level. Managers and operators can also examine these numbers to understand the reasons underlying productivity changes from one period to the next—better training of workers, lower labor turnover, better incentives, or improved methods. Management can then implement and sustain these factors in the future.


13-38 (25 min.) Total factor productivity (continuation of 13-37)

1.

Total factor productivity for 2012 using 2012 prices

=

= = =

Quantity of output produced in 2012 Costs of inputs used in 2012 based on 2012 prices 2,646,000 (1,764,000 $3.70) + (8, 370, 000) 2, 646, 000 2,646,000 $6, 526,800 $8,370,000 $14,896,800 0.1776 units of output per dollar of input

2. By itself, the 2012 TFP of 0.1776 units per dollar of input is not particularly helpful. We need something to compare the 2012 TFP against. We use, as a benchmark, TFP calculated using the inputs that Gerhart would have used in 2011 to produce 2,648,000 units of output calculated in requirement 1 at 2012 prices. Using the current year’s (2012) prices in both calculations controls for input price differences and focuses the analysis on the adjustments the manager made in the quantities of inputs in response to changes in prices. Cost of capacity in 2012 $8,370, 000 2012 price of capacity = $3.10 per unit of capacity Capacity in 2012 2, 700, 000 units Benchmark TFP

=

Quantity of output produced in 2012 Costs of inputs that would have been used in 2011 to produce 2012 output at year 2012 input prices =

=

= =

2,646,000 (2,100,000

$3.70) + (3,307,500

$3.10)

2,646,000 $7,770,000 + $10,253,250 2,646,000 $18,023,250

0.1468 units of output per dollar of input

Using year 2012 prices, total factor productivity increased 21.0% [(0.1776 0.1468) 0.1468] from 2011 to 2012. 3. Total factor productivity increased because Gerhart produced more output per dollar of input in 2012 relative to 2011, measured in both years using 2012 prices. The change in partial productivity of direct materials and conversion costs tells us that Gerhart used less materials and capacity in 2012 relative to output, than in 2011. A major advantage of TFP over partial productivity measures is that TFP combines the productivity of all inputs and so measures gains from using fewer physical inputs and substitution among inputs. Partial productivities cannot be combined to indicate the overall effect on cost as a result of these individual improvements. The TFP measure allows managers to evaluate the change in overall productivity by simultaneously combining all inputs to measure gains from using fewer physical inputs as well as substitution among inputs.


13-39 (35 min.) Strategic analysis of operating income. 1. Halsey is following a product differentiation strategy. Halsey offers a wide selection of clothes and excellent customer service. Halsey’s strategy is to distinguish itself from its competitors and to charge a premium price. 2.


Revenues ($60

40,000; $59

2010 2011 $2,400,000 $2,360,000

40,000)

Costs Costs of goods sold ($40 40,000; $41 40,000) Selling & customer service costs ($7 51,000); $6.90 Purchasing & admin. costs ($250 980; $240 850) Total costs 2,140,700 Operating income Change in operating income

3.

1,600,000 1,640,000 357,000 296,700 245,000 204,000 2,202,000

43,000)

$ 198,000 $ 219,300 $21,300 F

The Growth Component Revenue effect of growth

=


= (40,000 Cost effect of growth for = variable costs

Cost effect of growth for fixed costs

=


40,000)



$60 = $0

Actual units of inputs used to produce 2010 output


×


Input price in 2010

Price per × unit of capacity in 2010

Pieces of clothing that would be required to be purchased in 2011 would be the same as that required in 2010 because output is the same between 2010 and 2011. Selling and customerservice capacity and purchasing and administrative capacity will not change since adequate capacity exists in 2010 to support year 2011 customers and output. The cost effects of growth component are: Costs of goods sold Selling & customer-service costs Purchasing & administrative costs Cost effect of growth

(40,000 40,000) (51,000 51,000) (980 980)

$40 = $0 $7 = 0 $250 = 0 $0

In summary, the net effect on operating income as a result of the growth component equals:


Revenue effect of growth Cost effect of growth Change in operating income due to growth

$0 0 $0

The Price-Recovery Component Revenue effect of price-recovery

= Cost effect of price-recovery for variable costs

Actual units of output sold in 2011 40,000 = $40,000 U

Selling price Selling price in 2011 in 2010

=

($59

$60)

Input price in 2011

=



Costs of goods sold Selling & customer-service costs Purchas. & administrative costs Cost effect of price-recovery


Input price in 2010 Price per unit of capacity in 2010


($41 $40) ($6.90 $7) ($240 $250)

40,000 = 51,000 = 980 =

$40,000 U 5,100 F 9,800 F $25,100 U

In summary, the net decrease in operating income as a result of the price-recovery component equals: Revenue effect of price-recovery Cost effect of price-recovery Change in operating income due to price-recovery

$40,000 U 25,100 U $65,100 U

The Productivity Component Cost effect of productivity for variable costs Cost effect of productivity for = fixed costs

Actual units of input used to produce 2011 output Actual units of capacity in 2011

Units of input requried to produce 2011 output in 2010


The productivity component of cost changes are: Costs of goods sold (40,000 40,000) Selling & customer-service costs (43,000 51,000) Purchasing & admin. costs (850 980) Change in operating income due to productivity

Input price in 2011


$41 $6.90 $240

= = =

$

0 55,200 F 31,200 F $86,400 F


The change in operating income between 2010 and 2011 can be analyzed as follows: Income Statement Amounts in 2010 (1)


Revenue and Cost Effects of Growth Component in 2011 (2)

Revenue and Cost Effect Income Cost Effects of of Statement Price-Recovery Productivity Amounts Component Component in 2011 in 2011 in 2011 (5) = (3) (4) (1) + (2) + (3) + (4)

$2,400,000

$0

$40,000 U

$2,360,000

2,202,000

0

25,100 U

$86,400 F

2,140,700

$ 198,000

$0

$65,100 U

$86,400 F

$ 219,300

$21,300 F Change in operating income 4. The analysis of operating income indicates that a significant amount of the increase in operating income resulted from productivity gains rather than product differentiation. The company was unable to charge a premium price for its clothes. Thus, the strategic analysis of operating income indicates that Halsey has not been successful at implementing its premium price, product differentiation strategy, despite the fact that operating income increased by more than 10% between 2010 and 2011. Halsey could not pass on increases in purchase costs to its customers via higher prices. Halsey must either reconsider its product-differentiation strategy or focus managers on increasing margins and growing market share by offering better product variety and superb customer service.


CHAPTER 14 COST ALLOCATION, CUSTOMER-PROFITABILITY ANALYSIS, AND SALES-VARIANCE ANALYSIS 14-1 Disagree. Cost accounting data plays a key role in many management planning and control decisions. The division president will be able to make better operating and strategy decisions by being involved in key decisions about cost pools and cost allocation bases. Such an understanding, for example, can help the division president evaluate the profitability of different customers. 14-2 1. 2. 3. 4.

Exhibit 14-1 outlines four purposes for allocating costs: To provide information for economic decisions. To motivate managers and other employees. To justify costs or compute reimbursement amounts. To measure income and assets.

14-3 Exhibit 14-2 lists four criteria used to guide cost allocation decisions: 1. Cause and effect. 2. Benefits received. 3. Fairness or equity. 4. Ability to bear. The cause-and-effect criterion and the benefits-received criterion are the dominant criteria when the purpose of the allocation is related to the economic decision purpose or the motivation purpose. 14-4 Disagree. In general, companies have three choices regarding the allocation of corporate costs to divisions: allocate all corporate costs, allocate some corporate costs (those ―controllable‖ by the divisions), and allocate none of the corporate costs. Which one of these is appropriate depends on several factors: the composition of corporate costs, the purpose of the costing exercise, and the time horizon, to name a few. For example, one can easily justify allocating all corporate costs when they are closely related to the running of the divisions and when the purpose of costing is, say, pricing products or motivating managers to consume corporate resources judiciously. 14-5 Disagree. If corporate costs allocated to a division can be reallocated to the indirect cost pools of the division on the basis of a logical cause-and-effect relationship, then it is in fact preferable to do so—this will result in fewer division indirect cost pools and a more costeffective cost allocation system. This reallocation of allocated corporate costs should only be done if the allocation base used for each division indirect cost pool has the same cause-and-effect relationship with every cost in that indirect cost pool, including the reallocated corporate cost. Note that we observe such a situation with corporate human resource management (CHRM) costs in the case of CAI, Inc., described in the chapter—these allocated corporate costs are included in each division’s five indirect cost pools. (On the other hand, allocated corporate treasury cost pools are kept in a separate cost pool and are allocated on a different cost-allocation base than the other division cost pools.)


14-6 Customer profitability analysis highlights to managers how individual customers differentially contribute to total profitability. It helps managers to see whether customers who contribute sizably to total profitability are receiving a comparable level of attention from the organization. 14-7 Companies that separately record (a) the list price and (b) the discount have sufficient information to subsequently examine the level of discounting by each individual customer and by each individual salesperson. 14-8 No. A customer-profitability profile highlights differences in current period's profitability across customers. Dropping customers should be the last resort. An unprofitable customer in one period may be highly profitable in subsequent future periods. Moreover, costs assigned to individual customers need not be purely variable with respect to short-run elimination of sales to those customers. Thus, when customers are dropped, costs assigned to those customers may not disappear in the short run. 14-9 Five categories in a customer cost hierarchy are identified in the chapter. The examples given relate to the Spring Distribution Company used in the chapter: Customer output-unit-level costs—costs of activities to sell each unit (case) to a customer. An example is product-handling costs of each case sold. Customer batch-level costs—costs of activities that are related to a group of units (cases) sold to a customer. Examples are costs incurred to process orders or to make deliveries. Customer-sustaining costs—costs of activities to support individual customers, regardless of the number of units or batches of product delivered to the customer. Examples are costs of visits to customers or costs of displays at customer sites. Distribution-channel costs—costs of activities related to a particular distribution channel rather than to each unit of product, each batch of product, or specific customers. An example is the salary of the manager of Spring’s retail distribution channel. Corporate-sustaining costs—costs of activities that cannot be traced to individual customers or distribution channels. Examples are top management and general administration costs. 14-10 Charting cumulative profits by customer or product type generates a whale curve. This provides information on the profitability of your customers and clearly identifies the most profitable from the least profitable. 14-11 Using the levels approach introduced in Chapter 7, the sales-volume variance is a Level 2 variance. By sequencing through Level 3 (sales-mix and sales-quantity variances) and then Level 4 (market-size and market-share variances), managers can gain insight into the causes of a specific sales-volume variance caused by changes in the mix and quantity of the products sold as well as changes in market size and market share. 14-12 The total sales-mix variance arises from differences in the budgeted contribution margin of the actual and budgeted sales mix. The composite unit concept enables the effect of individual product changes to be summarized in a single intuitive number by using weights based on the mix of individual units in the actual and budgeted mix of products sold.


14-13 A favorable sales-quantity variance arises because the actual units of all products sold exceed the budgeted units of all products sold. 14-14 The sales-quantity variance can be decomposed into (a) a market-size variance (which arises when the actual total market size in units is different from the budgeted market size in units), and (b) a market share variance (which arises when the actual market share of a company is different from its budgeted market share). Both variances use the budgeted average contribution margin per unit. 14-15 The direct materials efficiency variance is a Level 3 variance. Further insight into this variance can be gained by moving to a Level 4 analysis where the effect of mix and yield changes are quantified. The mix variance captures the effect of a change in the relative percentage use of each input relative to that budgeted. The yield variance captures the effect of a change in the total number of inputs required to obtain a given output relative to that budgeted. 14-16 (15-20 min.) Cost allocation in hospitals, alternative allocation criteria. 1.

Direct costs = $2.40 Indirect costs ($11.52 – $2.40) = $9.12 Overhead rate

2.

= Error!= 380%

The answers here are less than clear-cut in some cases. Overhead Cost Item Allocation Criteria Processing of paperwork for purchase

Cause and effect

Supplies room management fee

Benefits received

Operating-room and patient-room handling costs Cause and effect Administrative hospital costs

Benefits received

University teaching-related costs

Ability to bear

Malpractice insurance costs

Ability to bear or benefits received

Cost of treating uninsured patients

Ability to bear

Profit component

None. This is not a cost.

3. Assuming that Meltzer’s insurance company is responsible for paying the $4,800 bill, Meltzer probably can only express outrage at the amount of the bill. The point of this question is to note that even if Meltzer objects strongly to one or more overhead items, it is his insurance company that likely has the greater incentive to challenge the bill. Individual patients have very little power in the medical arena. In contrast, insurance companies have considerable power and may decide that certain costs are not reimbursable—for example, the costs of treating uninsured patients.


14-17 (15 min.) Cost Allocation and Decision Making 1. Allocations based on revenues. Arizona Colorado 1. Revenues 7,800,000 8,500,000 2. % revenues (7,800,000; 8,500,000; 6,200,000; 5,500,000 ÷ 28,000,000) 27.86% 30.36% 3. Allocated headquarter cost (Row 2 × $5,600,000) $1,560,160 $1,700,160

Segment margin Less: Headquarter costs Division margin

Arizona $2,500,000 1,560,160 $ 939,840

Colorado $4,400,000 1,700,160 $2,699,840

Allocations based on direct costs. Arizona Colorado 1. Direct Costs $5,300,000 $4,100,000 2. % direct costs $5,300,000; $4,100,000; $4,300,000; $4,600,000 ÷ $18,300,000 28.96% 22.40% 3. Allocated headquarter cost (Row 2 × $5,600,000) $1,621,760 $1,254,400


Arizona $2,500,000 1,621,760 $ 878,240

Colorado $4,400,000 1,254,400 $3,145,600

Allocations based on segment margin. Arizona Colorado 1. Segment Margins $2,500,000 $4,400,000 2. % segment margins $2,500,000; $4,400,000; $1,900,000; $900,000 ÷ $9,700,000 25.77% 45.36% 3. Allocated headquarter cost (Row 2 × $5,600,000) $1,443,120 $2,540,160

Delaware 6,200,000

22.14%

Florida 5,500,000

19.64%

Total 28,000,000

100%

$1,239,840

$1,099,840

$5,600,000

Delaware $1,900,000 1,239,840 $ 660,160

Florida $ 900,000 1,099,840 $ (199,840)

Total $9,700,000 5,600,000 $4,100,000

Delaware $4,300,000

Florida $4,600,000

Total $18,300,000

23.50%

25.14%

100%

$1,316,000

$1,407,840

Delaware $1,900,000 1,316,000 $ 584,000

Florida $ 900,000 1,407,840 $ (507,840)

Total $9,700,000 5,600,000 $4,100,000

Delaware $1,900,000

Florida $900,000

Total $9,700,000

19.59% $1,097,040

$ 5,600,000

9.28% $519,680

100% $5,600,000



Arizona $2,500,000 1,443,120 $1,056,880

Colorado $4,400,000 2,540,160 $1,859,840

Allocations based on number of employees. Arizona Colorado 1. Number of Employees 2,000 4,000 2. % segment margins $2,000; $4,000; $1,500; 500 ÷ $8,000 25% 50% 3. Allocated headquarter cost (Row 2 × $5,600,000) $1,400,000 $2,800,000


Arizona $2,500,000 1,400,000 $1,100,000

Colorado $4,400,000 2,800,000 $1,600,000

Delaware $1,900,000 1,097,040 $ 802,960

Florida $900,000 519,680 $380,320

Total $9,700,000 5,600,000 $4,100,000

Delaware 1,500

Florida 500

Total 8,000

18.75%

6.25%

100%

$1,050,000

$350,000

$5,600,000

Delaware $1,900,000 1,050,000 $ 850,000

Florida $900,000 350,000 $550,000

Total $9,700,000 5,600,000 $4,100,000

2.

The Florida Division manager will prefer the number of employees as the allocation base because it results in the highest operating margin for the division.

3.

The Arizona Division and the Delaware Division receive roughly the same percentage allocation of headquarter costs regardless of the allocation base used (Arizona range = 25%-29%; Delaware range = 18.75%-23.5%). However, the Colorado Division and the Florida Division vary widely (Colorado range = 22.4%-50%; Florida range = 6.25%25.1%). All four methods are reasonable options, but none clearly meets the cause-andeffect criterion for selecting the allocation base. If larger divisions tend to consume more of headquarters’ resources, then using division revenues or number of employees seem to be the best choices. Without compelling reason to change, Greenbold should stay with the division revenues as the allocation base. Another alternative is to use segment margin as the allocation base on the grounds that this best captures the ability of different divisions to bear corporate overhead costs.

4.

If Greenbold elects to use direct costs as the allocation base, the Florida Division will appear to have a $507,840 operating loss. Even so, the Florida Division generates a $900,000 segment margin before allocating the cost of the corporate headquarters. As seen in the analysis in requirement 1, different allocation bases yield different operating incomes for the Florida Division, with the direct cost allocation base being the lowest. The Florida Division should not be closed because 1) the choice of allocation base is not based on a cause-and-effect relation (i.e., it is arbitrary), and 2) the division earns positive segment margin which contributes to covering the cost of the corporate headquarters. The Florida Division should only be closed if closing it will save more than $507,840 in corporate headquarter costs – a highly unlikely scenario.


14-18 (30 min.) Cost allocation to divisions. 1. Revenue Direct costs Segment margin Fixed overhead costs Income before taxes Segment margin %

Hotel $16,425,000 9,819,260 $ 6,605,740

40.22%

Restaurant Casino $5,256,000 $12,340,000 3,749,172 4,248,768 $1,506,828 $ 8,091,232

28.67%

Rembrandt $34,021,000 17,817,200 16,203,800 14,550,000 $ 1,653,800

65.57%

2. Direct costs Direct cost % Square footage Square footage % Number of employees Number of employees %

Hotel $9 819 260 55.11% 80,000 50.00% 200 40.00%

Restaurant $3 749 172 21.04% 16,000 10.00% 50 10.00%

Casino $4 248 768 23.85% 64,000 40.00% 250 50.00%

Rembrandt $17 817 200 100.00% 160,000 100.00% 500 100.00%

A: Cost allocation based on direct costs: Restaurant $ 5,256,000 3,749,172 1,506,828 3,061,320 $(1,554,492) -29.58%

Casino $12,340,000 4,248,768 8,091,232 3,470,175 $ 4,621,057 37.45%

Rembrandt $34,021,000 17,817,200 16,203,800 14,550,000 $ 1,653,800

Hotel $ 7,275,000 $ (669,260) -4.07%

Restaurant $ 1,455,000 $ 51,828 0.99%

Casino $ 5,820,000 $ 2,271,232 18.41%

Rembrandt $14,550,000 $ 1,653,800

C: Cost allocation based on number of employees Hotel Allocated fixed overhead costs $ 5,820,000 Segment pre-tax income $ 785,740 Segment pre-tax income % of rev. 4.78%

Restaurant $ 1,455,000 $ 51,828 0.99%

Casino $ 7,275,000 $ 816,232 6.61%

Rembrandt $14,550,000 $ 1,653,800

Revenue Direct costs Segment margin Allocated fixed overhead costs Segment pre-tax income Segment pre-tax income % of rev.

Hotel $16,425,000 9,819,260 6,605,740 8,018,505 $ (1,412,765) -8.60%

B: Cost allocation based on floor space: Allocated fixed overhead costs Segment pre-tax income Segment pre-tax income % of rev.


3. Requirement 2 shows the dramatic effect of the choice of cost allocation base on segment pre-tax income as a percentage of revenues:

Allocation Base Direct costs Floor space Number of employees

Pre-tax Income Percentage Hotel Restaurant Casino –8.60% –29.58% 37.45% –4.07 0.99 18.41 4.78 0.99 6.61

The decision context should guide (a) whether costs should be allocated, and (b) the preferred cost allocation base. Decisions about, say, performance measurement, may be made on a combination of financial and nonfinancial measures. It may well be that Rembrandt may prefer to exclude allocated costs from the financial measures to reduce areas of dispute. Where cost allocation is required, the cause-and-effect and benefits-received criteria are recommended in Chapter 14. The $14,550,000 is a fixed overhead cost. This means that on a short-run basis, the cause-and-effect criterion is not appropriate but Rembrandt could attempt to identify the cost drivers for these costs in the long run when these costs are likely to be more variable. Rembrandt should look at how the $14,550,000 cost benefits the three divisions. This will help guide the choice of an allocation base in the short run. 4. The analysis in requirement 2 should not guide the decision on whether to shut down any of the divisions. The overhead costs are fixed costs in the short run. It is not clear how these costs would be affected in the long run if Rembrandt shut down one of the divisions. Also, each division is not independent of the other two. A decision to shut down, say, the restaurant, likely would negatively affect the attendance at the casino and possibly the hotel. Rembrandt should examine the future revenue and future cost implications of different resource investments in the three divisions. This is a future-oriented exercise, whereas the analysis in requirement 2 is an analysis of past costs.


14-19 (25 min.) Cost allocation to divisions. Percentages for various allocation bases (old and new):

(1) Division margin percentages $2,400,000; $7,100,000; $9,500,000 $19,000,000 (2) Share of employees $350; 250; 400 1,000 (3) Share of floor space 35,000; 24,000; 66,000 125,000 (4) Share of total division administrative costs $2,000,000; $1,800,000; $3,200,000 $7,000,000

Pulp

Paper

Fibers

12.63157%

37.36843%

35.0

25.0

40.0

100.0

28.0

19.2

52.8

100.0

28.57142

25.71428

50.0%

45.71428

Total

100.0%

100.0

1. (5) Division margin (6) Corporate overhead allocated on segment margins = (1) $9,000,000

Pulp Paper Fibers Total $2,400,000 $ 7,100,000 $ 9,500,000 $19,000,000

1,136,842

3,363,158

4,500,000

9,000,000

(7) Operating margin with division-margin-based allocation = (5) – (6) $1,263,158 $ 3,736,842 $ 5,000,000 $10,000,000 (8) Revenues $8,500,000 $17,500,000 $24,000,000 $50,000,000 Operating margin as a percentage of revenues 14.9% 21.3% 20.8% 20.0%

2. (5) Division margin HRM costs (alloc. base: no. of employees) = (2) $1,800,000 Facility costs (alloc. base: floor space) = (3) $2,700,000 Corp. admin (alloc. base: div. admin costs) = (4) $4,500,000 Corp. overhead allocated to each division Operating margin with cause-and-effect allocation (8) Revenues Operating margin as a percentage of revenues

Pulp Paper Fibers Total $2,400,000 $ 7,100,000 $ 9,500,000 $19,000,000

630 ,000

450,000

720,000

1,800,000

756,000

518,400

1,425,600

2,700,000

1,285,714 2,671,714

1,157,143 2,125,543

2,057,143 4,202,743

4,500,000 9,000,000

$(271,714) $ 4,974,457 $ 5,297,257 $10,000,000 $8,500,000 $17,500,000 $24,000,000 $50,000,000 -3.2%

28.4%

22.1%

20.0 %


3. When corporate overhead is allocated to the divisions on the basis of division margins (requirement 1), each division is profitable (has positive operating margin) and the Paper division is the most profitable (has the highest operating margin percentage) by a slim margin, while the Pulp division is the least profitable. When Bardem’s suggested bases are used to allocate the different types of corporate overhead costs (requirement 2), we see that, in fact, the Pulp division is not profitable (it has a negative operating margin). Paper continues to be the most profitable and, in fact, it is significantly more profitable than the Fibers division. If division performance is linked to operating margin percentages, Pulp will resist this new way of allocating corporate costs, which causes its operating margin of nearly 15% (in the old scheme) to be transformed into a -3.2% operating margin. The new cost allocation methodology reveals that, if the allocation bases are reasonable, the Pulp division consumes a greater share of corporate resources than its share of segment margins would indicate. Pulp generates 12.6% of the segment margins, but consumes almost 29.7% ($2,671,714 $9,000,000) of corporate overhead resources. Paper will welcome the change—its operating margin percentage rises the most, and Fiber’s operating margin percentage remains practically the same. Note that in the old scheme, Paper was being penalized for its efficiency (smallest share of administrative costs), by being allocated a larger share of corporate overhead. In the new scheme, its efficiency in terms of administrative costs, employees, and square footage is being recognized. 4. The new approach is preferable because it is based on cause-and-effect relationships between costs and their respective cost drivers in the long run. Human resource management costs are allocated using the number of employees in each division because the costs for recruitment, training, etc., are mostly related to the number of employees in each division. Facility costs are mostly incurred on the basis of space occupied by each division. Corporate administration costs are allocated on the basis of divisional administrative costs because these costs are incurred to provide support to divisional administrations. To overcome objections from the divisions, Bardem may initially choose not to allocate corporate overhead to divisions when evaluating performance. He could start by sharing the results with the divisions, and giving them—particularly the Pulp division—adequate time to figure out how to reduce their share of cost drivers. He should also develop benchmarks by comparing the consumption of corporate resources to competitors and other industry standards.


14-20 (30 min.) Customer profitability, customer-cost hierarchy. 1.

Revenues at list prices Price discounts Revenues (at actual prices) Cost of goods sold Gross margin Customer-level operating costs Delivery Order processing Sales visit Total customer-level oper. costs Customer-level operating. income

All amounts in thousands of U.S. dollars Wholesale Retail North America South America Big Sam World Wholesaler Wholesaler Stereo Market $435,000 $550,000 $150,000 $115,000 30,000 44,000 7,200 520 405,000 506,000 142,800 114,480 330,000 475,000 123,000 84,000 75,000 31,000 19,800 30,480 475 750 5,400 6,625 $ 68,375

690 1,020 2,500 4,210 $ 26,790

220 175 2,500 2,895 $ 16,905

130 120 1,400 1,650 $ 28,830


2.

Revenues (at actual prices) Customer-level costs Customer-level operating income Distribution-channel costs Distribution-channel-level oper. income Corporate-sustaining costs Operating income a

Customer Distribution Channels (all amounts in $000s) Wholesale Customers Retail Customers Total Total North America South America Total Big Sam (all customers) Wholesale Wholesaler Wholesaler Retail Stereo (1) = (2) + (5) (2) = (3) + (4) (3) (4) (5) = (6) + (7) (6) $1,168,280 $911,000 $405,000 $506,000 $257,280 $142,800 a a 1,027,380 815,835 336,625 479,210 211,545 125,895 a 140,900 95,165 $ 68,375 $ 26,790 45,735 $ 16,905 39,000 34,000 5,000 101,900 $ 61,165 $ 40,735 61,000 $ 40,900

Cost of goods sold + Total customer-level operating costs from Requirement 1

3. If corporate costs are allocated to the channels, the retail channel will show an operating profit of $27,735,000 ($40,735,000 – $13,000,000), and the wholesale channel will show an operating profit of $13,165,000 ($61,165,000 – $48,000,000). The overall operating profit, of course, is still $40,900,000, as in requirement 2. There is, however, no cause-and-effect or benefits-received relationship between corporate costs and any allocation base, i.e., the allocation of $48,000,000 to the wholesale channel and $13,000,000 to the retail channel is arbitrary and not useful for decision-making. Therefore, the management of Orsack Electronics should not base any performance evaluations or investment/disinvestment decisions based on these channel-level operating income numbers. They may want to take corporate costs into account, however, when making long-run pricing decisions.

14-11


Wor Mark (7) $1 8 $

(20 30 min.) Customer profitability, service company.

14-21 1.

Revenues Technician and equipment cost Gross margin Service call handling ($75 150; 240; 40; 120; 180) Web-based parts ordering ($80 120; 210; 60; 150; 150) Billing/Collection ($50 30; 90; 90; 60; 120) Database maintenance ($10 150; 240; 40; 120; 180) Customer-level operating income

2.

Avery $260,000 182,000 78,000

Okie $200,000 175,000 25,000

Wizard $322,000 225,000 97,000

Grainger $122,000 107,000 15,000

Duran $212,000 178,000 34,000

11,250

18,000

3,000

9,000

13,500

9,600

16,800

4,800

12,000

12,000

1,500

4,500

4,500

3,000

6,000

1,500 $ 54,150

2,400 400 $ (16,700) $ 84,300

1,200 1,800 $(10,200) $ 700

Customers Ranked on Customer-Level Operating Income

Customer Code Wizard Avery Duran Grainger Okie

Customer-Level Operating Customer Income Revenue (1) (2) $ 84,300 $ 322,000 54,150 260,000 700 212,000 (10,200) 122,000 (16,700) 200,000 $112,250 $1,116,000

Customer-Level Cumulative Operating Income Customer-Level as a % of Revenue Operating Income (3) = (1) (2) (4) 26.18% $ 84,300 20.83% 138,450 0.33% 139,150 -8.36% 128,950 -8.35% 112,250

Cumulative Customer-Level Operating Income as a % of Total Customer-Level Operating Income (5) = (4) $112,250 75% 123% 124% 115% 100%


Customer-Level Operating Income $100,000 $84,300

Customer-Level Operating Income

$80,000

$60,000

$54,150 Wizard

$40,000 Avery Duran

$20,000

Grainger

Okie

$700 $0 $(10,200) -$20,000

$(16,700)

-$40,000

Customers

The above table and graph present the summary results (a whale curve could also be drawn using the numbers in the last column of the table). Wizard, the most profitable customer, provides 75% of total operating income. The three best customers provide 124% of IS’s operating income, and the other two, by incurring losses for IS, erode the extra 24% of operating income down to IS’s operating income. 3.

The options that Instant Service should consider include: a. Increase the attention paid to Wizard and Avery. These are ―key customers,‖ and every effort has to be made to ensure they retain IS. IS may well want to suggest a minor price reduction to signal how important it is in their view to provide a costeffective service to these customers. b. Seek ways of reducing the costs or increasing the revenues of the problem accounts— Okie and Grainger. For example, are the copying machines at those customer locations outdated and in need of repair? If yes, an increased charge may be appropriate. Can IS provide better on-site guidelines to users about ways to reduce breakdowns? c. As a last resort, IS may want to consider dropping particular accounts. For example, if Grainger (or Okie) will not agree to a fee increase but has machines continually breaking down, IS may well decide that it is time not to bid on any more work for that customer. But care must then be taken to otherwise use or get rid of the excess fixed capacity created by ―firing‖ unprofitable customers.


14-22 (20 25 min.) Customer profitability, distribution. 1.

The activity-based costing for each customer is:

1. 2. 3. 4. 5.

Charleston Pharmacy

Chapel Hill Pharmacy

$ 520

$ 400

351

540

350

500

154

200

Order processing, $40 × 13; $40 × 10 Line-item ordering, $3 × (13 × 9; 10 × 18) Store deliveries, $50 × 7; $50 ×10 Carton deliveries, $1 × (7 × 22; 10 × 20) Shelf-stocking, $16 × (7 × 0; 10 × 0.5) Operating costs

0 $1,375

80 $1,720

The operating income of each customer is: Charleston Pharmacy Revenues, $2,400 × 7; $1,800 × 10 Cost of goods sold, $2,100 × 7; $1,650 × 10 Gross margin Operating costs Operating income

$

Chapel Hill Pharmacy

$16,800

$18,000

14,700 2,100 1,375 725

16,500 1,500 1,720 $ (220)

Chapel Hill Pharmacy has a lower gross margin percentage than Charleston (8.33% vs. 12.50%) and consumes more resources to obtain this lower margin. Serving Chapel Hill necessitates more deliveries and delivery of more items in each order, albeit lower-priced ones that don’t contribute much to Figure Four’s income. Overall, Charleston is a profitable customer while Chapel Hill is not. 2. a.

b.

c.

Ways Figure Four could use this information include: Pay increased attention to the top 20% of the customers. This could entail asking them for ways to improve service. Alternatively, you may want to highlight to your own personnel the importance of these customers; e.g., it could entail stressing to delivery people the importance of never missing delivery dates for these customers. Work out ways internally at Figure Four to reduce the rate per cost driver; e.g., reduce the cost per order by having better order placement linkages with customers. This cost reduction by Figure Four will improve the profitability of all customers. Work with customers so that their behavior reduces the total ―system-wide‖ costs. At a minimum, this approach could entail having customers make fewer orders and fewer line items. This latter point is controversial with students; the rationale is that a reduction in the number of line items (diversity of products) carried by Ma and Pa stores may reduce the diversity of products Figure Four carries. 14-14 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

There are several options here: Simple verbal persuasion by showing customers cost drivers at Figure Four. Explicitly pricing out activities like cartons delivered and shelf-stocking so that customers pay for the costs they cause. Restricting options available to certain customers, e.g., customers with low revenues could be restricted to one free delivery per week. An even more extreme example is working with customers so that deliveries are easier to make and shelf-stocking can be done faster. d.

Offer salespeople bonuses based on the operating income of each customer rather than the gross margin of each customer.

Some students will argue that the bottom 40% of the customers should be dropped. This action should be only a last resort after all other avenues have been explored. Moreover, an unprofitable customer today may well be a profitable customer tomorrow, and it is myopic to focus on only a 1-month customer-profitability analysis to classify a customer as unprofitable.


14-23 (30–40 min.) Variance analysis, multiple products. 1.

Sales-volume,variance = Lower-tier tickets Upper-tier tickets All tickets

2.

Actual sales – Budgeted sales quantity in units quantity in units

= (3,300 – 4,000) = (7,700 – 6,000)

Budgeted average contributi on margin per unit

= = =

$20 = $ 5 =

Budgeted contributi on margin per ticket

$14,000 U 8,500 F $ 5,500 U

(4,000 $20) (6,000 $5) 10,000 $80,000 $30,000 $110 ,000 = 10,000 10,000 $11 per unit (seat sold)

Sales-mix percentages: Lower-tier

Upper-tier

Budgeted 4,000 = 0.40 10,000

Actual 3,300 = 0.30 11,000

6,000 = 0.60 10,000

7,700 = 0.70 11,000

Solution Exhibit 14-23 presents the sales-volume, sales-quantity, and sales-mix variances for lower-tier tickets, upper-tier tickets, and in total for Detroit Penguins in 2012. The sales-quantity variances can also be computed as: Actual units Budgeted units Sales-quantity,variance = of all tickets of all tickets sold sold

Budgeted sales - mix percentage

Budgeted cont. margin per ticket

The sales-quantity variances are: Lower-tier tickets = (11,000 – 10,000) × 0.40 × $20 = $ 8,000 F Upper-tier tickets = (11,000 – 10,000) × 0.60 × $ 5 = 3,000 F All tickets $11,000 F The sales-mix variance can also be computed as: Actual units Actual Budgeted Sales-mix,variance = of all tickets × sales-mix sales-mix sold percentage percentage The sales-mix variances are Lower-tier tickets = 11,000 × (0.30 – 0.40) × $20 Upper-tier tickets = 11,000 × (0.70 – 0.60) × $ 5 All tickets

Budgeted contribution margin per ticket

= $22,000 U = 5,500 F $16,500 U

3. The Detroit Penguins increased average attendance by 10% per game. However, there was a sizable shift from lower-tier seats (budgeted contribution margin of $20 per seat) to the upper-tier seats (budgeted contribution margin of $5 per seat). The net result: the actual contribution margin was $5,500 below the budgeted contribution margin. 14-16 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

SOLUTION EXHIBIT 14-23 Columnar Presentation of Sales-Volume, Sales-Quantity and Sales-Mix Variances for Detroit Penguins Flexible Budget: Actual Units of All Products Sold × Actual Sales Mix × Budgeted Contribution Margin per Unit (1) Panel A: Lower-tier

a

(11,000 × 0.30 ) × $20 3,300 × $20 $66,000

Actual Units of All Products Sold × Budgeted Sales Mix × Budgeted Contribution Margin per Unit (2) b

(11,000 × 0.40 ) × $20 4,400 × $20 $88,000

Static Budget: Budgeted Units of All Products Sold × Budgeted Sales Mix × Budgeted Contribution Margin per Unit (3) b

(10,000 × 0.40 ) × $20 4,000 × $20 $80,000

$22,000U Sales-mix variance

$8,000 F Sales-quantity variance $14,000 U Sales-volume variance

Panel B: Upper-tier

c

(11,000 × 0.70 ) × $5 7,700 × $5 $38,500

d

(11,000 × 0.60 ) × $5 6,600 × $5 $33,000

$5,500 F Sales-mix variance

d

(10,000 × 0.60 ) × $5 6,000 × $5 $30,000

$3,000 F Sales-quantity variance


Panel C: All Tickets (Sum of Lowertier and Uppertier tickets)

e

$104,500

f

$121,000

g

$110,000

$16,500 U $11,000 F Total sales-mix variance Total sales-quantity variance $5,500 U Total sales-volume variance

F = favorable effect on operating income; U = unfavorable effect on operating income. Actual Sales Mix: a Lower-tier = 3,300 ÷ 11,000 c Upper-tier = 7,700 ÷ 11,000 e $66,000 + $38,500 = $104,500

= 30% = 70%

Budgeted Sales Mix: b Lower-tier = 4,000 ÷ 10,000 = 40% d Upper-tier = 6,000 ÷ 10,000 = 60% f $88,000 + $33,000 = $121,000 g $80,000 + $30,000 = $110,000


14-24 (30 min.) Variance analysis, working backward. 1. and 2. Solution Exhibit 14-24 presents the sales-volume, sales-quantity, and sales-mix variances for the Plain and Chic wine glasses and in total for Jinwa Corporation in June 2011. The steps to fill in the numbers in Solution Exhibit 14-24 follow: Step 1 Consider the static budget column (Column 3): Static budget total contribution margin Budgeted units of all glasses to be sold Budgeted contribution margin per unit of Plain Budgeted contribution margin per unit of Chic

$ $

$11,000 2,000 4 10

Suppose that the budgeted sales-mix percentage of Plain is y. Then the budgeted salesmix percentage of Chic is (1 – y). Therefore, (2,000y

$4) + (2,000 (1 – y) $10) $8,000y + $20,000 – $20,000y $12,000y y 1–y

= = = = =

$11,000 $11,000 $ 9,000 0.75 or 75% 25%

Jinwa’s budgeted sales mix is 75% of Plain and 25% of Chic. We can then fill in all the numbers in Column 3. Step 2 Next, consider Column 2 of Solution Exhibit 14-24. The total of Column 2 in Panel C is $8,800 (the static budget total contribution margin of $11,000 – the total sales-quantity variance of $2,200 U which was given in the problem). We need to find the actual units sold of all glasses, which we denote by q. From Column 2, we know that (q

0.75

$4) + (q

0.25 $10) $3q + $2.5q $5.5q q

= = = =

$8,800 $8,800 $8,800 1,600 units

So, the total quantity of all glasses sold is 1,600 units. This computation allows us to fill in all the numbers in Column 2.


Step 3 Next, consider Column 1 of Solution Exhibit 14-24. We know actual units sold of all glasses (1,600 units), the actual sales-mix percentage (given in the problem information as Plain, 60%; Chic, 40%), and the budgeted unit contribution margin of each product (Plain, $4; Chic, $10). We can therefore determine all the numbers in Column 1. Solution Exhibit 14-24 displays the following sales-quantity, sales-mix, and sales-volume variances: Sales-Volume Variance Plain $2,160 U Chic 1,400 F All Glasses $ 760 U Sales-Mix Variances Plain $ 960 U Chic 2,400 F All Glasses $1,440 F

Sales-Quantity Variances Plain $ 1,200 U Chic 1,000 U All Glasses $ 2,200 U

3. Jinwa Corporation shows an unfavorable sales-quantity variance because it sold fewer wine glasses in total than was budgeted. This unfavorable sales-quantity variance is partially offset by a favorable sales-mix variance because the actual mix of wine glasses sold has shifted in favor of the higher contribution margin Chic wine glasses. The problem illustrates how failure to achieve the budgeted market penetration can have negative effects on operating income.


SOLUTION EXHIBIT 14-24 Columnar Presentation of Sales-Volume, Sales-Quantity and Sales-Mix Variances for Jinwa Corporation

Panel A: Plain

Panel B: Chic

Panel C: All Glasses

Flexible Budget: Static Budget: Actual Units Actual Units Budgeted Units of All Glasses Sold of All Glasses Sold of All Glasses Sold Actual Sales Mix Budgeted Sales Mix Budgeted Sales Mix Budgeted Budgeted Budgeted Contribution Contribution Contribution Margin per Unit Margin per Unit Margin per Unit (1,600 0.6) $4 (1,600 0.75) $4 (2,000 0.75) $4 960 $4 1,200 $4 1,500 $4 $3,840 $4,800 $6,000 $960 U $1,200 U Sales-mix variance Sales-quantity variance $2,160 U Sales-volume variance (1,600 0.4) $10 (1,600 0.25) $10 (2,000 0.25) 640 $10 400 $10 500 $10 $6,400 $4,000 $5,000 $2,400 F $1,000 U Sales-mix variance Sales-quantity variance $1,400 F Sales-volume variance $10,240

$8,800

$10

$11,000

$1,440 F $2,200 U Total sales-mix variance Total sales-quantity variance $760 U Total sales-volume variance

F = favorable effect on operating income; U = unfavorable effect on operating income.


14-25 (60 min.) Variance analysis, multiple products. 1. Budget for 2011

Kola Limor Orlem Total

Selling Price (1) $8.00 6.00 7.50

Variable Contrib. Cost Margin Units Sales per Unit per Unit Sold Mix (2) (3) = (1) – (2) (4) (5) $5.00 $3.00 480,000 20% 3.80 2.20 720,000 30 5.50 2.00 1,200,000 50 2,400,000 100%

Contribution Margin (6) = (3) × (4) $1,440,000 1,584,000 2,400,000 $5,424,000

Variable Contrib. Cost Margin Units per Unit per Unit Sold (2) (3) = (1) – (2) (4) $5.50 $2.70 467,500 3.75 2.00 852,500 5.60 2.20 1,430,000 2,750,000

Contribution Margin (6) = (3) × (4) $1,262,250 1,705,000 3,146,000 $6,113,250

Actual for 2011


Selling Price (1) $8.20 5.75 7.80

Sales Mix (5) 17% 31 52 100%

Solution Exhibit 14-25 presents the sales-volume, sales-quantity, and sales-mix variances for each product and in total for 2011. Sales-volume = variance

Kola Limor Orlem Total Sales-quantity variance


Actual quantity of units sold

Budgeted quantity of units sold

Budgeted contribution margin per unit

= ( 467,500 – 480,000) × $3.00 = = ( 852,500 – 720,000) × $2.20 = = (1,430,000 – 1,200,000) × $2.00 =

Actual units of all products sold

Budgeted units of all products sold

$ 37,500 U 291,500 F 460,000 F $714,000 F

Budgeted sales-mix percentage

= (2,750,000 – 2,400,000) × 0.20 × $3.00 = (2,750,000 – 2,400,000) × 0.30 × $2.20 = (2,750,000 – 2,400,000) × 0.50 × $2.00

= = =


$210,000 F 231,000 F 350,000 F $791,000 F


Sales-mix = variance


= = =

Actual units of all products sold

Actual Budgeted sales-mix – sales-mix percentage percentage

2,750,000 × (0.17 – 0.20) × $3.00 2,750,000 × (0.31 – 0.30) × $2.20 2,750,000 × (0.52 – 0.50) × $2.00


= = =

$247,500 U 60,500 F 110,000 F $ 77,000 U

2. The breakdown of the favorable sales-volume variance of $714,000 shows that the biggest contributor is the 350,000 unit increase in sales resulting in a favorable sales-quantity variance of $791,000. There is a partially offsetting unfavorable sales-mix variance of $77,000 in contribution margin. SOLUTION EXHIBIT 14-25 Sales-Mix and Sales-Quantity Variance Analysis of Soda King for 2011 Flexible Budget: Actual Units of All Products Sold Actual Sales Mix Budgeted Contribution Margin Per Unit Kola Limor Orlem

2,750,000 2,750,000 2,750,000

0.17 0.31 0.52

$3.00 = $1,402,500 $2.20 = 1,875,500 $2.00 = 2,860,000 $6,138,000

Static Budget: Budgeted Units of All Products Sold Budgeted Sales Mix Budgeted Contribution Margin Per Unit

Actual Units of All Products Sold Budgeted Sales Mix Budgeted Contribution Margin Per Unit 2,750,000 2,750,000 2,750,000

0.2 0.3 0.5

$3.00 = $2.20 = $2.00 =

$ 77,000 U Sales-mix variance

$1,650,000 1,815,000 2,750,000 $6,215,000

2,400,000 2,400,000 2,400,000

0.2 0.3 0.5

$3.00 = $1,440,000 $2.20 = 1,584,000 $2.00 = 2,400,000 $5,424,000

$ 791,000 F Sales-quantity variance


F = favorable effect on operating income; U= unfavorable effect on operating income


14-26 (20 min.) Market-share and market-size variances (continuation of 14-25).

Western region Soda King Market share

Actual 27.5 million 2.75 million 10%

Budgeted 20 million 2.4 million 12%

Average budgeted contribution margin per unit = $2.26 ($5,424,000 ÷ 2,400,000) Solution Exhibit 14-26 presents the sales-quantity variance, market-size variance, and marketshare variance for 2011. Market share = Actual market size in units variance

Actual Budgeted market – market share share

Budgeted contribution margin per composite unit for budgeted mix

= 27,500,000 × (0.10 – 0.12) × $2.26 = 27,500,000 × .02 × $2.267 = $1,243,000 U

Actual Budgeted Market-size = market size – market size variance in units in units

Budgeted market share


= (27,500,000 – 20,000,000) × 0.12 × $2.26 = 7,500,000 × 0.12 × $2.26 = 2,034,000 F

The market share variance is unfavorable because the actual 10% market share was lower than the budgeted 12% market share. The market size variance is favorable because the market size increased 37.5% [(27,500,000 – 20,000,000) ÷ 20,000,000]. Despite the unfavorable market-share variance, the increase in market size was enough to result in a favorable sales-quantity variance. Sales-Quantity Variance $791,000 F

Market-share variance $1,243,000 U

Market-size variance $2,034,000 F


SOLUTION EXHIBIT 14-26 Market-Share and Market-Size Variance Analysis of Soda King for 2011 Actual Market Size Budgeted Market Share Budgeted Average Contribution Margin Per Unit

Static Budget: Budgeted Market Size Budgeted Market Share Budgeted Average Contribution Margin Per Unit

27,500,000 0.12c $2.26 b $7,458,000

20,000,000 0.12c $2.26b $5,424,000

Actual Market Size Actual Market Share Budgeted Average Contribution Margin Per Unit 27,500,000 0.10a $2.26b $6,215,000

$1,243,000 U

$2,034,000 F

Market-share variance

Market-size variance $791,000 F

Sales-quantity variance

F = favorable effect on operating income; U = unfavorable effect on operating income a Actual market share: 2,750,000 units ÷ 27,500,000 units = 0.10, or 10% b Budgeted average contribution margin per unit $5,424,000 ÷ 2,400,000 units = $2.26 per unit c Budgeted market share: 2,400,000 units ÷ 20,000,000 units = 0.12, or 12%


14-27 (40 min.) Allocation of corporate costs to divisions. 1. a.

b.

c.

d.

The purposes for allocating central corporate costs to each division include the following (students may pick and discuss any two): To provide information for economic decisions. Allocations can signal to division managers that decisions to expand (contract) activities will likely require increases (decreases) in corporate costs that should be considered in the initial decision about expansion (contraction). When top management is allocating resources to divisions, analysis of relative division profitability should consider differential use of corporate services by divisions. Some allocation schemes can encourage the use of central services that would otherwise be underutilized. A common rationale related to this purpose is ―to remind profit center managers that central corporate costs exist and that division earnings must be adequate to cover some share of those costs.‖ Motivation. Allocations create incentives for division managers to control costs; for example, by reducing the number of employees at a division, a manager will save direct labor costs as well as central personnel and payroll costs allocated on the basis of number of employees. Allocation also creates incentives for division managers to monitor the effectiveness and efficiency with which central corporate costs are spent. Cost justification or reimbursement. Some lines of business of Richfield Oil may be regulated with cost data used in determining ―fair prices‖; allocations of central corporate costs will result in higher prices being set by a regulator. Income measurement for external parties. Richfield Oil may include allocations of central corporate costs in its external line-of-business reporting.

2.

Revenues Percentage of revenues $8,000; $16,000; $4,800; $3,200 $32,000

(Dollar amounts in millions) Revenues Operating costs Operating income Corp. costs allocated on revenues (% of revs $3,228) Division operating income

Oil & Gas Upstream $8,000

Oil & Gas Downstream $16,000

25%

50%

Oil & Gas Upstream $8,000 3,000 5,000

Oil & Gas Downstream $16,000 15,000 1,000

807 $4,193

,614 (614)

$

Chemical Products $4,800

15%

Copper Mining $3,200

Total $32,0

10%

100%

Chemical Products $4,800 3,800 1,000

Copper Mining $3,200 3,500 (300)

484 $ 516

323 $ (623)


Total $32,0 25,3 6,7

3,2 $ 3,4

3.

First, calculate the share of each allocation base for each of the four corporate cost pools:

Identifiable assets (1)Percentage of total identifiable assets $14,000; $6,000; $3,000; $2,000 $25,000

Oil & Gas Upstream $14,000 56%

Division revenues (2) Percentage of total division revenues $8,000; $16,000; $4,800; $3,200 $32,000

$8,000

Positive operating income (3) Percentage of total positive operating income $5,000; $1,000; $1,000; 0 $7,000

$5,000

Number of employees (4) Percentage of total employees 9,000; 12,000; 6,000; 3,000 30,000

Oil & Gas Downstream $6,000 24% $16,000

25%

50% $1,000

71.43%

14.29%

9,000

12,000

30%

40%

Chemical Products $3,000

Copper Mining $2,000

12%

8%

$4,800

$3,200

15%

10%

$1,000

NONE

Total $25,000 100% $32,000 100% $7,000

14.29%

0%

100%

6,000

3,000

30,000

20%

10%

100%

Using these allocation percentages and the allocation bases suggested by Rhodes, we can allocate the $3,228 M of corporate costs as shown below. Note that the costs in Cost Pool 2 total $800 M ($150 + $110 + $200 + $140 + $200).

(Dollar amounts in millions) Revenues Operating Costs Operating Income Cost Pool 1 Allocation ((1) $2,000) Cost Pool 2 Allocation ((2) $800) Cost Pool 3 Allocation ((3) $203) Cost Pool 4 Allocation ((4) Division Income

$225)

Oil & Gas Upstream $8,000.00 3,000.00 5,000.00 1,120.00 200.00 145.00

Oil & Gas Downstream $16,000.00 15,000.00 1,000.00 480.00 400.00 29.00

67.50 $3,467.50

$

90.00 1.00

Chemical Products $4,800.00 3,800.00 1,000.00 240.00 120.00 29.00 45.00 $ 566.00

Copper Mining $3,200.00 3,500.00 (300.00) 160.00 80.00 0.00 22.50 $ (562.50)

Total $32,000 25,300 6,700 2,000 800 203 225 $ 3,472

4. The table below compares the reported income of each division under the original revenue-based allocation scheme and the new 4-pool-based allocation scheme. Oil & Gas Upstream seems 17% less profitable than before ($3,467.5 $4,193 = 83%), and may resist the new allocation, but each of the other divisions seem more profitable (or less loss-making) than before and they will probably welcome it. In this setting, corporate costs are relatively large (about 13% of total operating costs), and division incomes are sensitive to the corporate cost allocation method. (Dollar amounts in millions) Operating Income (before corp. cost allocation) Division income under revenue-based allocation of corporate costs Division income under 4-cost-pool allocation of corporate costs

Oil & Gas Upstream

Oil & Gas Downstream

$5,000.00

$1,000.00

Chemical Products

Copper Mining

Total

$1,000.00 $(300.00)

$6,700

$4,193.00

$ (614.00)

$ 516.00 $(623.00)

$3,472

$3,467.50

$

$ 566.00 $(562.50)

$3,472

1.00

Strengths of Rhodes’ proposal relative to existing single-cost pool method:


a.

Better able to capture cause-and-effect relationships. Interest on debt is more likely caused by the financing of assets than by revenues. Personnel and payroll costs are more likely caused by the number of employees than by revenues.

b.

Relatively simple. No extra information need be collected beyond that already available. (Some students will list the extra costs of Rhodes' proposal as a weakness. However, for a company with $30 billion in revenues, those extra costs are minimal.)

Weaknesses of Rhodes’ proposal relative to existing single-cost pool method: a.

May promote dysfunctional decision making. May encourage division managers to lease or rent assets rather than to purchase assets, even where it is economical for Richfield Oil to purchase them. This off-balance sheet financing will reduce the ―identifiable assets‖ of the division and thus will reduce the interest on debt costs allocated to the division. (Richfield Oil could counteract this problem by incorporating leased and rented assets in the "identifiable assets" base.)

Note: Some students criticized Rhodes’ proposal, even though agreeing that it is preferable to the existing single-cost pool method. These criticisms include: a.

The proposal does not adequately capture cause-and-effect relationships for the legal and research and development cost pools. For these cost pools, specific identification of individual projects with an individual division can better capture cause-and-effect relationships.

b.

The proposal may give rise to disputes over the definition and valuation of ―identifiable assets.‖

c.

The use of actual rather than budgeted amounts in the allocation bases creates interdependencies between divisions. Moreover, use of actual amounts means that division managers do not know cost allocation consequences of their decisions until the end of each reporting period.

d.

A separate allocation of fixed and variable costs would result in more refined cost allocations.

e.

It is questionable that 100% of central corporate costs should be allocated. Many students argue that public affairs should not be allocated to any division, based on the notion that division managers may not control many of the individual expenditures in this cost pool.


14-28 Cost allocation to divisions. 1. Segment margin Allocated headquarter costs ($5,100,000 ÷ 3) Operating income

Bread $6,400,000

Cake $1,300,000

Doughnuts $6,150,000

Total $13,850,000

1,700,000 $4,700,000

1,700,000 $ (400,000)

1,700,000 $4,450,000

5,100,000 $ 8,750,000

2. Segment margin Allocated headquarter costs, Human resources1 (50%; 12.5%; 37.5% × $1,900,000) Accounting department2 (53.9%; 11.6%; 34.5% × $1,400,000) Rent and depreciation3 (50%; 20%; 30% × $1,200,000) 1 $600,000 ) Other ( 3 Total Operating income

Bread $6,400,000

Cake $1,300,000

Doughnuts $6,150,000

Total $13,850,000

950,000

237,500

712,500

1,900,000

754,600

162,400

483,000

1,400,000

600,000

240,000

360,000

1,200,000

200,000

200,000

200,000

600,000

2,504,600 $3,895,400

839,900 $ 460,100

1,755,500 $4,394,500

5,100,000 $ 8,750,000

1

HR costs: 400 ÷ 800 = 50%; 100 ÷ 800 = 12.5%; 300 ÷ 800 = 37.5% Accounting: $20,900,000 ÷ $38,800,000 = 53.9%; $4,500,000 ÷ $38,800,000 = 11.6%; $13,400,000 ÷ $38,800,000 = 34.5% 3 Rent and depreciation: 10,000 ÷ 20,000 = 50%; 4,000 ÷ 20,000 = 20%; 6,000 ÷ 20,000 = 30% 2

A cause-and-effect relationship may exist between Human Resources costs and the number of employees at each division. Rent and depreciation costs may be related to square feet, except that very expensive machines may require little square footage, which is inconsistent with this choice of allocation base. The Accounting Department costs are probably related to the revenues earned by each division – higher revenues mean more transactions and more accounting. Other overhead costs are allocated arbitrarily. 3. The manager suggesting the new allocation bases probably works in the Cake Division. Under the old scheme, the Cake Division shows an operating loss after allocating headquarter costs because it is smaller, yet was charged an equal amount (a third) of headquarter costs. The new allocation scheme shows an operating profit in the Cake Division, even after allocating headquarter costs. The ABC method is a better way to allocate headquarter costs because it uses cost allocation bases that, by and large, represent cause-and-effect relationships between various categories of headquarter costs and the demands that different divisions place on these costs.


14-29 Customer-profitability. 1. 01

02

Customer 03 04

05

06

Customer-level costs Customer orders ($40 × 2; 7; 1; 5; 20; 3) $ 80 Customer fittings ($25 × 1; 2; 0; 0; 4; 1) 25 Rush order costs ($100 × 0; 0; 1; 1; 3; 0) 0 Returns for repair ($30 × 0; 1; 0; 1; 5; 1) 0 Total customer-level costs $105

$ 280 50 0 30 $ 360

$ 40 0 100 0 $140

$ 200 0 100 30 $ 330

$ 800 100 300 150 $1,350

$120 25 0 30 $175

Revenue Cost of product Gross profit Customer-level costs Customer-level operating income

$4,200 2,940 1,260 360 $ 900

$300 210 90 140 $(50)

$2,500 1,750 750 330 $ 420

$4,900 3,430 1,470 1,350 $ 120

$700 490 210 175 $ 35

$600 420 180 105 $ 75

The table indicates there are profitable and unprofitable customers. The ranking of customers from most to least profitable is: Customer-Level Cumulative Cumulative CustomerOperating CustomerCustomer-Level Level Income Level Operating Income Operating Customer Divided by Operating as a % of Total Customer Income Revenue Revenue Income Customer Income Number (1) (2) (3) = (1) ÷ (2) (4) (5) = (4) ÷ $1,500 02 04 05 01 06 03

$ 900 420 120 75 35 (50) $1,500

$ 4,200 2,500 4,900 600 700 300 $13,200

21.4% 16.8% 2.4% 12.5% 5% -16.7%

$ 900 $1,320 $1,440 $1,515 $1,550 $1,500

60.0% 88.0% 96.0% 101.0% 103.3% 100.0%

2. Customer 03 is unprofitable and of the rest, customer 06 has the lowest operating income. Customer 05 has a very low operating income to revenue percentage. Customer 3 is unprofitable because it has very low revenues and requires a rush order. Customer 5 has a low operating income percentage because it places many orders, several rush orders, and requires a large number of customer return visits for repairs in the 30-day period after the sale. Ring Delights could make these customers more profitable by charging extra for rush orders, charging a small fee for repairs, increasing the selling price, or requiring a minimum total revenue for free post-sales service. Whatever decision it takes, Ring Delights must also consider the effect the decision might have on sales. 14-29 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

14-30 (40 min.) Customer profitability, distribution. 1. a

Revenues at list prices b Discount Revenues (at actual prices) c Cost of goods sold Gross margin Customer-level operating costs d Order taking e Customer visits f Delivery vehicles g Product handling h Expedited runs Total Customer-level operating income a $14.40 2,080; 8,750; 60,800; 31,800; 3,900 b ($14.40 – $14.40) 2,080; ($14.40 – $14.16) ($14.40 – $12.96) 3,900 c $12 2,080; 8,750; 60,800, 31,800; 3,900 d $100 15; 25; 30; 25; 30 e $80 2; 3; 6; 2; 3 f $2 (10 14); (30 4); (60 3); (40 8); (20 g $0.50 2,080; 8,750; 60,800; 31,800; 3,900 h $300 0; 0; 0; 0; 1

P $29,952 0

Customer Q R $126,000 $875,520 2,100 72,960

S $457,920 15,264

T $56,160 5,616

29,952 24,960 4,992 1,500 160 280 1,040 0 2,980 $ 2,012

123,900 105,000 18,900 2,500 240 240 4,375 0 7,355 $ 11,545

442,656 381,600 61,056 2,500 160 640 15,900 0 19,200 $ 41,856

50,544 46,800 3,744 3,000 240 1,600 1,950 300 7,090 $ (3,346)

8,750; ($14.40 – $13.20)

802,560 729,600 72,960 3,000 480 360 30,400 0 34,240 $ 38,720

60,800; ($14.40 – $13.92)

31,800;

40)

Customer S is the most profitable customer, despite having only 52% (31,800 60,800) of the unit volume of Customer R. A major explanation is that Customer R receives a $1.20 discount per case while Customer S receives only a $0.48 discount per case. Customer T is unprofitable, while the smaller customer P is profitable. Customer T receives a $1.44 discount per case, makes more frequent orders, requires more customer visits, and requires more delivery miles than Customer P. 2. Separate reporting of both the list selling price and the actual selling price enables Spring Distribution to examine which customers receive different discounts and how salespeople may differ in the discounts they grant. There is a size pattern in the discounts across the five customers, except for Customer T, larger volume customers get larger discounts: Sales Volume R (60,800 cases) S (31,800 cases) Q (8,750 cases) T (3,900 cases) P (2,080 cases)

Discount per case $1.20 $0.48 $0.24 $1.44 $0.00

The reasons for the $1.44 discount for T should be explored.


3. Dropping customers should be the last resort taken by Spring Distribution. Factors to consider include the following: a. What is the expected future profitability of each customer? Are the currently unprofitable (T) or low-profit (P) customers likely to be highly profitable in the future? b. Are there externalities from having some customers, even if they are unprofitable in the short run? For example, some customers have a marquee-value that is ―in effect‖ advertising that benefits the business. c. What costs are avoidable if one or more customers are dropped? d. Can the relationship with the ―problem‖ customers be restructured so that there is a ―win-win‖ situation? For example, could Customer T get by with fewer deliveries per month?


14-31 Customer profitability in a manufacturing firm. 1. Calculation of customer profitability by customer: Customer A

B

C

D

E

Revenues at list price $100 × 6,000; 2,500; 1,300; 4,200; 7,800 Price discount 10% × $600,000; 0; 10% × $130,000; 0; 10% × $390,000 Revenues (actual price) Cost of goods sold $80 × 6,000; 2,500, 1,300; 4,200; 7,800 Gross margin Customer-level costs: Order taking $390 × 10; 12; 52; 18; 12 Product handling $10 × 600; 250; 120; 420; 780 Warehousing $55 × 14; 18; 0; 12; 140 Rush order processing $540 × 0; 3; 0; 0; 6 Exchange and repair $45 × 0; 25; 4; 25; 80

$600,000

$250,000

$130,000

$420,000

$780,000

60,000 540,000

0 250,000

13,000 117,000

0 420,000

39,000 741,000

480,000 60,000

200,000 50,000

104,000 13,000

336,000 84,000

624,000 117,000

3,900

4,680

20,280

7,020

6,000

2,500

1,200

4,200

770

Total customer-level costs Customer-level operating income

990

660

7,700

0

3,240

1,125

3,600

13,005

27,020

$ 70,995

$ 89,980

1,620

0

0

1,125

180

10,915

$ 49,330

$ 39,085

21,660 $ (8,660)

Customer ranking

Customer-Level Operating Customer Income Code (1)

Customer Revenue (2)

Customer-Level Operating Cumulative Income Customer-Level Divided by Revenue Operating Income (3) = (1) ÷ (2) (4)

Cumulative Customer-Level Operating Income as a % of Total Customer-Level Operating Income (5) = (4) ÷ $240,730

E

$ 89,980

$ 741,000

12.1%

$ 89,980

37.4%

D

70,995

420,000

16.9%

$160,975

66.9%

A

49,330

540,000

9.1%

$210,305

87.4%

B

39,085

250,000

15.6%

$249,390

103.6%

C

(8,660)

117,000

-7.4%

$240,730

100.0%

$240,730

$2,068,000

Total

7,800

0

0

10,670

4680

2. Customer C is Bizzan’s only unprofitable customer. All other customers are profitable in line with revenue, except customer A which has more revenue than D but less operating income. If Customer C were not being given price discounts, C would be profitable. The salesperson is giving discounts on orders, even though the size of the order is small. It is


costing Bizzan money to process many small orders as opposed to a few large orders. To turn Customer C into a profitable customer, Bizzan needs to encourage Customer C to place fewer, larger orders and offer a price discount only if Customer C changes behavior, rather than as a reward for repeat business. Customer E has many rush orders in proportion to total number of orders. Bizzan should work with Customer E to find a production schedule that would meet its needs without having to rush the order. Customer E has high warehousing needs that are costly to Bizzan. Bizzan should work with Customer E to align its production schedule to Customer E’s needs. The exchange and repair rate for customers with rush orders is higher than for other customers. Bizzan should explore whether rushing an order reduces attention to quality. Either reducing the number of rush orders (which would also save Bizzan money) or working toward increasing the quality of rush orders would help to reduce these costs. The three most profitable customers (E, D, and A) generate 87% of the customer-level operating income. These customers are valued customers and should receive the highest level of customer service.


14-32 (60 min.) Variance analysis, sales-mix and sales-quantity variances. 1.

Actual Contribution Margins Actual Actual Actual Variable Contribution Selling Cost per Margin per Product Price Unit Unit Palm Pro $365 $175 $190 Palm CE 288 94 194 PalmKid 110 75 35

Actual Sales Actual Actual Volume in Contribution Contribution Units Dollars Percent 10,120 $1,922,800 19% 32,200 6,246,800 63% 49,680 1,738,800 18% 92,000 $9,908,400 100% The actual average contribution margin per unit is $107.70 ($9,908,400 92,000 units). Budgeted Contribution Margins Budgeted Budgeted Variable Selling Cost per Product Price Unit Palm Pro $374 $185 Palm CE 272 96 Palm Kid 144 66

Budgeted Sales Budgeted Budgeted Volume in Contribution Contribution Units Dollars Percent 13,580 $ 2,566,620 20% 35,890 6,316,640 50% 47,530 3,707,340 30% 97,000 $12,590,600 100% The budgeted average contribution margin per unit is $129.80 ($12,590,600 97,000 units). 2.

Budgeted Contribution Margin per Unit $189 176 78

Actual Sales Mix

Product Palm Pro Palm CE Palm Kid

Actual Sales Volume in Units 10,120 32,200 49,680 92,000

Actual Sales Mix 11% (10,120 ÷ 92,000) 35% (32,200 ÷ 92,000) 54% (49,680 ÷ 92,000) 100%

Budgeted Sales Mix

Product Palm Pro Palm CE Palm Kid

Budgeted Sales Volume Budgeted in Units Sales Mix 13,580 14% (13,580 ÷ 97,000) 35,890 37% (35,890 ÷ 97,000) 47,530 49% (47,530 ÷ 97,000) 97,000 100%


3. Sales-volume variance:

Actual = quantity of units sold

Budgeted quantity of units sold

PalmPro (10,120 PalmCE (32,200 PalmKid (49,680 Total sales-volume variance

13,580) 35,890) 47,530)


× × ×

$189 $176 $ 78

= = =

$ 653,940 U 649,440 U 167,700 F $1,135,680 U

Sales-mix variance:

=

Actual units Actual of all × sales mix products sold percentage

PalmPro = 92,000 PalmCE = 92,000 PalmKid = 92,000 Total sales-mix variance

× × ×

Budgeted Budgeted sales mix × contrib. margin per unit percentage

(0.11 (0.35 (0.54

0.14) 0.37) 0.49)

× × ×

$189 = $176 = $ 78 =

$521,640 U 323,840 U 358,800 F $486,680 U

Sales-quantity variance:

Actual units of all = products sold PalmPro = (92,000 PalmCE = (92,000 PalmKid = (92,000 Total sales-quantity variance

Budgeted Budgeted units Budgeted of all × sales mix × contribution margin percentage per unit products sold

97,000) 97,000) 97,000)

× × ×

0.14 0.37 0.49

× × ×

$189 = $176 = $ 78 =

$132,300 U 325,600 U 191,100 U $ 649,000 U

Solution Exhibit 14-32 presents the sales-volume variance, the sales-mix variance, and the salesquantity variance for Palm Pro, Palm CE, and PalmKid and in total for the third quarter 2012.


SOLUTION EXHIBIT 14-32 Sales-Mix and Sales-Quantity Variance Analysis of Chicago Infonautics for the Third Quarter 2012. Flexible Budget: Actual Units of All Products Sold Actual Sales Mix Budgeted Contribution Margin Per Unit

Static Budget: Budgeted Units of All Products Sold Budgeted Sales Mix Budgeted Contribution Margin Per Unit

Actual Units of All Products Sold Budgeted Sales Mix Budgeted Contribution Margin Per Unit

Palm Pro 92,000

0.11

$189 =$ 1,912,680

92,000

0.14

$189 =$ 2,434,320

97,000

0.14

$189 =$ 2,566,620

PalmCE

92,000

0.35

$176 = 5,667,200

92,000

0.37

$176 = 5,991,040

97,000

0.37

$176 = 6,316,640

PalmKid 92,000

0.54

$ 78 = 3,875,040

92,000

0.49

$ 78 = 3,516,240

97,000

0.49

$ 78 = 3,707,340

$11,454,920

$11,941,600

$12,590,600

$486,680 U

$649,000 U

Sales-mix variance

Sales-quantity variance $1,135,680 U

Sales-volume variance

F = favorable effect on operating income; U= unfavorable effect on operating income

4.

The following factors help explain the difference between actual and budgeted amounts: The difference in actual versus budgeted contribution margins was $2,682,200 unfavorable ($9,908,400 $12,590,600). The contribution margins from PalmCE, PalmPro and the PalmKid were lower than expected. In percentage terms, the PalmCE accounted for 63% of actual contribution margin versus a planned 50% contribution margin. However, the PalmPro accounted for 19% versus planned 20% and the PalmKid accounted for only 18% versus a planned 30%. In unit terms (rather than in contribution terms), the PalmKid accounted for 54% of the sales mix, a little more than the planned 49%. However, the PalmPro accounted for only 11% versus a budgeted 14% and the PalmCE accounted for 35% versus a planned 37%. Variance analysis for the PalmPro and PalmCE shows an unfavorable sales-mix variance and an unfavorable sales-quantity variance producing an unfavorable salesvolume variance. The PalmKid gained sales-mix share at 54%—as a result, the sales-mix variance is positive. Overall, there was an unfavorable total sales-volume variance. However, the large drop in PalmKid’s contribution margin per unit combined with a decrease in the actual number of PalmPro and PalmCE units sold as well as a drop in the actual contribution margin per unit below budget, led to the total contribution margin being much lower than budgeted.

Other factors could be discussed here—for example, it seems that the PalmKid did not achieve much success with a three digit price point—selling price was budgeted at $144 but dropped to $110. At the same time, variable costs increased. This could have been due to a marketing push that did not succeed. 14-36 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

14-33 (20 min.) Market-share and market-size variances (continuation of 14-32). 1. Actual Budgeted 400,000 388,000 92,000 97,000 23% 25%

Worldwide Chicago Info. Market share

Average contribution margin per unit: Actual = $107.70 ($9,908,400 92,000) Budgeted = $129.80 ($12,590,600 97,000)


=

Actual market size in units

Actual market share



= 400,000 (0.23 – 0.25) $129.80 = 400,000 (–0.02) $129.80 = $1,038,400 U Market-size variance

=


Budgeted market size in units

= (400,000 – 388,000) 0.25 = 12,000 0.25 $129.80 = $389,400 F



$129.80


Solution Exhibit 14-33 presents the market-share variance, the market-size variance, and the sales-quantity variance for the third quarter 2012. SOLUTION EXHIBIT 14-33 Market-Share and Market-Size Variance Analysis of Chicago Infonautics for the Third Quarter 2012.

Actual Market Size Budgeted Market Share Budgeted Average Contribution Margin Per Unit

Static Budget: Budgeted Market Size Budgeted Market Share Budgeted Average Contribution Margin Per Unit

400,000 0.25c $129.80 b $12,980,000

388,000 0.25c $129.80b $12,590,600

Actual Market Size Actual Market Share Budgeted Average Contribution Margin Per Unit 400,000 0.23a $129.80b $11,941,600

$1,038,400 U

$389,400 F


Market-size variance $649,000 U

Sales-quantity variance

F = favorable effect on operating income; U = unfavorable effect on operating income a Actual market share: 92,000 units ÷ 400,000 units = 0.23, or 23% b Budgeted average contribution margin per unit $12,590,600 ÷ 97,000 units = $129.80 per unit c Budgeted market share: 97,000 units ÷ 388,000 units = 0.25, or 25%

2. The actual market size of 400,000 units exceeded the projected size of 388,000 units, leading to a favorable market-size variance. However, Chicago Infonautics’ share of the market declined from 25% to 23%, and the substantial unfavorable market-share variance created by this drop led to an unfavorable sales-quantity variance overall: Sales-Quantity Variance $649,000 U

Market-Share Variance $1,038,400 U

Market Size Variance $389,400 F


3. The required actual market size is the budgeted market size, i.e., 388,000 units. This can easily be seen by setting up the following equation:

Actual Budgeted market size market size in units in units

Market-size variance



= (M – 388,000) × 0.25 × $129.80 When M = 400,000, the market-size variance is $0.

Actual Market-Share Calculation Again, the answer is the budgeted market share, 25%. By definition, this will hold irrespective of the actual market size. This can be seen by setting up the appropriate equation: Market-share variance

=

= When M =


Actual market share



Actual market size × (M – 25%) × $129.80 25%, the market-share variance is $0.


14-34 (40 min.) Variance analysis, multiple products. 1, 2, and 3. Solution Exhibit 14-34 presents the sales-volume, sales-quantity, and sales-mix variances for each flavor of gelato and in total for The Split Banana, Inc., in August 2011. The sales-volume variances can also be computed as: (Actual pints sold – Budgeted pints sold) × Budgeted contribution margin per unit The sales-volume variances are Mint chocolate chip = (30,800 – 25,000) Vanilla = (27,500 – 35,000) Rum Raisin = ( 8,800 – 5,000) Peach = (14,300 – 15,000) Coffee = (28,600 – 20,000) All cookies

$4.20 $5.80 $4.00 $3.60 $5.10

= = = = =

$24,360 F 43,500 U 15,200 F 2,520 U 43,860 F $37,400 F

The sales-quantity variance can be computed as:

Actual pints of all flavors sold

Budgeted pints Budgeted of all × sales mix percentage flavors sold

The sales-quantity variances are Mint chocolate chip = (110,000 – 100,000) Vanilla = (110,000 – 100,000) Rum Raisin = (110,000 – 100,000) Peach = (110,000 – 100,000) Coffee = (110,000 – 100,000) All flavors

0.25 0.35 0.05 0.15 0.20

$4.20 $5.80 $4.00 $3.60 $5.10

The sales-mix variances can be computed as: Actual Budgeted Actual pints of all sales-mix × = sales-mix flavors sold percentage percentage The sales-mix variances are: Mint chocolate chip = (0.28 – 0.25) Vanilla = (0.25 – 0.35) Rum raisin = (0.08 – 0.05) Peach = (0.13 – 0.15) Coffee = (0.26 – 0.20) All flavors

110,000 110,000 110,000 110,000 110,000


$4.20 $5.80 $4.00 $3.60 $5.10

= = = = =

$10,500 F 20,300 F 2,000 F 5,400 F 10,200 F $48,400 F


= = = = =

$13,860 F 63,800 U 13,200 F 7,920 U 33,660 F $11,000 U


A summary of the variances is: Sales-Volume Variance Mint chocolate chip $24,360 F Vanilla 43,500 U Rum Raisin 15,200 F Peach 2,520 U Coffee 43,860 F All flavors $37,400 F

Sales-Mix Variance Mint chocolate chip Vanilla63,800

$13,860 F U

Rum raisin Peach Coffee All flavors

13,200 F 7,920 U 33,660 F $11,000 U

Sales-Quantity Variance Mint chocolate chip $10,500 F Vanilla 20,300 F Rum raisin 2,000 F Peach 5,400 F Coffee 10,200 F All flavors $48,400 F

4. The Split Banana shows a favorable sales-quantity variance because it sold more pints in total than was budgeted. Although The Split Banana sold less of the high-contribution margin vanilla gelato relative to the budgeted mix, and as a result, showed an unfavorable sales-mix variance, The Split Banana showed a favorable sales-volume variance overall.


SOLUTION EXHIBIT 14-34 Columnar Presentation of Sales-Volume, Sales-Quantity, and Sales-Mix Variances for The Split Banana

Panel A: Mint choc. chip

Flexible Budget: Actual Pints of All Flavors Sold × Actual Sales Mix × Budgeted Contribution Margin per Pint (1)

Actual Pints of All Flavors Sold × Budgeted Sales Mix × Budgeted Contribution Margin per Pint (2)

Static Budget: Budgeted Pints of All Flavors Sold × Budgeted Sales Mix × Budgeted Contribution Margin per Pint (3)

(110,000 × 0.28a) × $4.20 30,800 × $4.20 $129,360

(110,000 × 0.25b) × $4.20 27,500 × $4.20 $115,500

(100,000 × 0.25b) × $4.20 25,000 × $4.20 $105,000



$24,360 F Sales-volume variance Panel B: Vanilla

(110,000 × 0.25c) × $5.80 27,500 × $5.80 $159,500

(110,000 × 0.35d) × $5.80 38,500 × $5.80 $223,300

$63,800 U Sales-mix variance

(100,000 × 0.35d) × $5.80 35,000 × $5.80 $203,000


$43,500 U Sales-volume variance Panel C: Rum Raisin

(110,000 × 0.08e) × $4.00 8,800 × $4.00 $35,200

(110,000 × 0.05f) × $4.00 5,500 × $4.00 $22,000


(100,000 × 0.05f) × $4.00 5,000 × $4.00 $20,000


$15,200 F Sales-volume variance F = favorable effect on operating income; U = unfavorable effect on operating income. Actual Sales Mix: aMint choc. chip cVanilla eRum raisin

= 30,800 ÷ 110,000 = 28% = 27,500 ÷ 110,000 = 25% = 8,800 ÷ 110,000 = 8%

Budgeted Sales Mix: bMint choc. chip dVanilla f Rum raisin

= = =

25,000 ÷ 100,000 = 25% 35,000 ÷ 100,000 = 35% 5,000 ÷ 100,000 = 5%


SOLUTION EXHIBIT 14-34 (Cont’d.) Columnar Presentation of Sales-Volume, Sales-Quantity, and Sales-Mix Variances for The Split Banana

Panel D: Peach

Flexible Budget: Actual Pints of All Flavors Sold × Actual Sales Mix × Budgeted Contribution Margin per Pint (1)

Actual Pounds of All Cookies Sold × Budgeted Sales Mix × Budgeted Contribution Margin per Pound (2)

Static Budget: Budgeted Pounds of All Cookies Sold × Budgeted Sales Mix × Budgeted Contribution Margin per Pound (3)

(110,000 × 0.13g) × $3.60 14,300 × $3.60 $51,480

(110,000 × 0.15h) × $3.60 16,500 × $3.60 $59,400

(100,000 × 0.15h) × $3.60 15,000 × $3.60 $54,000

$7,920 U Sales-mix variance


$2,520 U Sales-volume variance Panel E: Coffee

(110,000 × 0.26j) × $5.10 28,600 × $5.10 $145,860

(110,000 × 0.20k) × $5.10 22,000 × $5.10 $112,200

(100,000 × 0.20k) × $5.10 20,000 × $5.10 $102,000




Panel F: All Flavors

$521,400l

$532,400m

$11,000 U Total sales-mix variance

$484,000n

$48,400 F Total sales-quantity variance

$37,400 F Total sales-volume variance F = favorable effect on operating income; U = unfavorable effect on operating income. Actual Sales Mix: gPeach = 14,300 ÷ 110,000 = 13% jCoffee = 28,600 ÷ 110,000 = 26% l$129,360 + $159,500 + $35,200 + $51,480 + $145,860 = $521,400

Budgeted Sales Mix: hPeach = 15,000 ÷ 100,000 = 15% kCoffee = 20,000 ÷ 100,000 = 20% m$115,500 + $223,300 + $22,000 + $59,400 + $112,200 = $532,400 n$105,000 + $203,000 + $20,000 + $54,000 + $102,000 = $484,000


14-35 (35 min.) Direct materials efficiency, mix, and yield variances (Chapter Appendix). 1.

Almonds ($1 × 180 cups) Cashews ($2 × 300 cups) Pistachios ($3 × 90 cups) Seasoning ($6 × 30 cups) Budgeted cost per batch Number of batches Budgeted Cost

$

180 600 270 180 $ 1,230 × 25 $30,750

2. Solution Exhibit 14-35A presents the total price variance ($0), the total efficiency variance ($610 U), and the total flexible-budget variance ($610 U). Total direct materials efficiency variance can also be computed as: Direct materials efficiency variance = for each input

Actual quantity of input

Budgeted quantity of input allowed for actual output

Almonds = (5,280 – 4,500) × $1 Cashews = (7,520 – 7,500) × $2 Pistachios = (2,720 – 2,250) × $3 Seasoning = ( 480 – 750) × $6 Total direct materials efficiency variance

Budgeted × price of input

= $ 780 U = 40 U = 1,410 U = 1,620 F $ 610 U

SOLUTION EXHIBIT 14-35A Columnar Presentation of Direct Materials Price and Efficiency Variances for Nature’s Best Company.

Almonds Cashews Pistachios Seasonings

Actual Costs Incurred (Actual Input Quantity × Actual Price) (1) 5,280 × $1 = $ 5,280 7,520 × $2 = 15,040 2,720 × $3 = 8,160 480 × $6 = 2,880 $31,360

Actual Input Quantity × Budgeted Price (2) 5,280 × $1 = $ 5,280 7,520 × $2 = 15,040 2,720 × $3 = 8,160 480 × $6 = 2,880 $31,360 $0 Total price variance

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (3) 4,500 × $1 = $ 4,500 7,500 × $2 = 15,000 2,250 × $3 = 6,750 750 × $6 = 4,500 $30,750 $610 U

Total efficiency variance $610 U

Total flexible-budget variance F = favorable effect on operating income; U = unfavorable effect on operating income


3. The total direct materials price variance equals zero because for all four inputs, actual price per cup equals the budgeted price per cup. 4.

Solution Exhibit 14-35B presents the total direct materials yield and mix variances.

The total direct materials yield variance can also be computed as the sum of the direct materials yield variances for each input: Direct materials = yield variance for each input

Actual total quantity of all direct materials inputs used

Budgeted Budgeted total quantity direct materials of all direct materials inputs × input mix allowed for actual output percentage

Almonds = (16,000 – 15,000) × 0.30a × $1 = 1,000 × 0.30 × $1 Cashew s = (16,000 – 15,000) × 0.50b × $2 = 1,000 × 0.50 × $2 Pistachios = (16,000 – 15,000) × 0.15c × $3 = 1,000 × 0.15 × $3 Seasoning = (16,000 – 15,000) × 0.05d × $6 = 1,000 × 0.05 × $6 Total direct materials yield variance a

180

600; b 300

600; c 90

600; d30

Budgeted price of × direct materials inputs

= $ 300 U = 1,000 U = 450 U = 300 U $2,050 U

600

The total direct materials mix variance can also be computed as the sum of the direct materials mix variances for each input: Direct Actual materials direct materials = mix variance input mix for each input percentage

Actual total Budgeted Budgeted quantity of all price of direct materials × × direct materials direct materials input mix inputs used inputs percentage

Almonds = (0.33 – 0.30) × 16,000 × $1 = 0.03 × 16,000 × $1 = Cashews = (0.47 – 0.50) × 16,000 × $2 = –0.03 × 16,000 × $2 = Pistachios = (0.17 – 0.15) × 16,000 × $3 = 0.02 × 16,000 × $3 = Seasoning = (0.03 – 0.05) × 16,000 × $6 = –0.02 × 16,000 × $6 = Total direct materials mix variance

$ 480 U 960 F 960 U 1,920 F $1,440 F


SOLUTION EXHIBIT 14-35B Columnar Presentation of Direct Materials Yield and Mix Variances for Nature’s Best Company. Actual Total Quantity of All Inputs Used × Actual Input Mix × Budgeted Price (1) Almonds Cashews Pistachios Seasoning

16,000 × 0.33 × $1 16,000 × 0.47 × $2 16,000 × 0.17 × $3 16,000 × 0.03 × $6

= = = =

$ 5,280 15,040 8,160 2,880 $31,360

Actual Total Quantity of All Inputs Used × Budgeted Input Mix × Budgeted Price (2) 16,000 × 0.30 × $1 16,000 × 0.50 × $2 16,000 × 0.15 × $3 16,000 × 0.05 × $6

= = = =

Flexible Budget: Budgeted Total Quantity of All Inputs Allowed for Actual Output × Budgeted Input Mix × Budgeted Price (3) 15,000 × 0.30 × $1 15,000 × 0.50 × $2 15,000 × 0.15 × $3 15,000 × 0.05 × $6

$ 4,800 16,000 7,200 4,800 $32,800

$1,440 F Total mix variance

= $ 4,500 = 15,000 = 6,750 = 4,500 $30,750

$2,050 U Total yield variance $610 U

Total efficiency variance

F = favorable effect on operating income; U = unfavorable effect on operating income.

The direct materials mix variance of $1,440 F indicates that the actual product mix uses relatively more of less expensive ingredients than planned. In this case, the actual mix contains slightly more almonds and pistachios, while using fewer cashews and substantially less seasoning. The direct materials yield variance of $2,050 U occurs because the amount of total inputs needed (16,000 cups) exceeded the budgeted amount (15,000 cups) expected to produce 2,500 tins. The direct materials yield variance is significant enough to be investigated. The mix variance may be within expectations, but should be monitored since it is favorable largely due to the use of less seasoning, which is considered an important element of the product’s appeal to customers.


14-36 (35 min.) Direct labor variances: price, efficiency, mix and yield. 1. George ($30 × 6 hrs.) Earl ($20 × 4 hrs.) Cost per guitar Number of guitars Total budgeted cost

$ $ $

180 80 260 × 25 units 6,500

2. Solution Exhibit 14-36A presents the total price variance ($0), the total efficiency variance ($10 U), and the total flexible-budget variance ($10U). Total direct labor price variance can also be computed as: Direct labor price variance = for each input

Actual price of input

Budgeted Actual price of × quantity of input input

George = ($30 – $30) × 145 = $0 Earl = ($20 – $20) × 108 = 0 Total direct labor price variance $0 Total direct labor efficiency variance can also be computed as: Direct labor efficiency variance = for each input

Actual quantity of input

Budgeted quantity of input × Budgeted price of input allowed for actual output

George = (145 – 150) × $30.00 = $150 F Earl = (108 – 100) × $20.00 = 160 U Total direct labor efficiency variance $ 10 U


SOLUTION EXHIBIT 14-36A Columnar Presentation of Direct Labor Price and Efficiency Variances for Trevor Joseph Guitars Actual Costs Incurred (Actual Input Quantity × Actual Price) (1) 145 $30 = $4,350 108 $20 = 2,160 $6,510

George Earl

Actual Input Quantity × Budgeted Price (2) 145 $30 = $4,350 108 $20 = 2,160 $6,510 $0 Total price variance

Flexible Budget (Budgeted Input Quantity Allowed for Actual Output × Budgeted Price) (3) 150 $30 = $4,500 100 $20 = 2,000 $6,500

$10 U Total efficiency variance

$10 U Total flexible-budget variance F = favorable effect on operating income; U = unfavorable effect on operating income

3.

George Earl Total

Actual Quantity of Input 145 hours 108 hours 253 hours

Actual Mix 57.3% 42.7% 100.0%

Budgeted Quantity of Input for Actual Output 6 hours × 25 units = 150 hours 4 hours × 25 units = 100 hours 250 hours

Budgeted Mix 60% 40% 100%

4. Solution Exhibit 14-36B presents the total direct labor yield and mix variances for Trevor Joseph Guitars. The total direct labor yield variance can also be computed as the sum of the direct labor yield variances for each input:

Actual total Budgeted total quantity Direct labor quantity of all of all direct labor yield variance = – direct labor inputs allowed for for each input inputs used actual output

Budgeted direct labor input mix percentage

Budgeted price of direct labor inputs

George = (253 – 250) × 0.60 × $30 = 3 × 0.60 × $30 = $54 U Earl = (253 – 250) × 0.40 × $20 = 3 × 0.40 × $20 = 24 U Total direct labor yield variance $78 U


The total direct labor mix variance can also be computed as the sum of the direct labor mix variances for each input:

Direct labor Actual direct Budgeted direct mix variance = labor input – labor input for each input mix percentage mix percentage

Actual total quantity of all direct labor inputs used

Budgeted price of direct labor inputs

George = (0.573 – 0.60) × 253 × $30 = 0.027 × 253 × $30 = $205 F Earl = (0.427 – 0.40) × 253 × $20 = – 0.027 × 253 × $20= 137 U Total direct labor mix variance $ 68 F The sum of the direct labor mix variance and the direct labor yield variance equals the direct labor efficiency variance. The favorable mix variance arises from using more of the cheaper labor (and less of the costlier labor) than the budgeted mix. The yield variance indicates that the guitars required more total inputs (253 hours) than expected (250 hours) for the production of 25 guitars. Both variances are relatively small and probably within tolerable limits. It is likely that Earl, who is less experienced, worked more slowly than George, which caused the unfavorable yield variance. Trevor Joseph should be careful that using more of the cheaper labor does not reduce the quality of the guitar or how customers perceive it. SOLUTION EXHIBIT 14-36B Columnar Presentation of Direct Labor Yield and Mix Variances for Trevor Joseph Guitars

Actual Total Quantity of All Inputs Used × Actual Input Mix × Budgeted Price (1) George Earl

253 × 0.573 × $30 = 253 × 0.427 × $20 =

$4,349 2,161 $6,510

Actual Total Quantity of All Inputs Used × Budgeted Input Mix × Budgeted Price (2) 253 × 0.60 × $30 = 253 × 0.40 × $20 =

Flexible Budget: Budgeted Total Quantity of All Inputs Allowed for Actual Output × Budgeted Input Mix × Budgeted Price (3)

$4,554 2,024 $6,578

68 F Total mix variance

250 × 0.60 × $30 = 250 × 0.40 × $20 =

$78 U Total yield variance

$10 U Total efficiency variance F = favorable effect on operating income; U = unfavorable effect on operating income.


$4,500 2,000 $6,500

14-37 (30 min.) Purposes of cost allocation 1. Financial reporting is guided by GAAP when determining the cost of a product such as SR460. Therefore, only inventoriable costs, such as direct materials, direct labor, and manufacturing overhead, are included in the cost of SR460 that are given to the financial reporting department. In contrast, managers at Mize will include any relevant costs when making internal decisions, such as pricing for the new catalog. Typically, pricing decisions are based on full costing, or all of the costs related to the product. 2. For the four different purposes considered in the question, the cost of one unit of SR460 would be determined as follows:

a. Direct materials Direct manufacturing labor Variable manufacturing overhead Allocated fixed manufacturing overhead

b.

c.

d.

$28.50

$28.50

$28.50

$28.50

16.35

16.35

16.35

16.35

8.76

8.76

8.76

8.76

32.84

32.84

Research and development costs specific to SR460

6.20

Marketing costs

5.95

Sales commissions

11.40

Allocated administrative costs of production department

5.38

Allocated administrative costs of corporate headquarters

18.60

Customer service costs

3.05

Distribution costs

8.80

Total

32.84

5.38

$145.83

$86.45

$53.61

$91.83


14-38 (30 min.) Customer-cost hierarchy, customer profitability. 1.

Total (all customers) (1) = (2) + (5) Gross Revenues $250,305 (less) Discounts ___6,765 Net Revenues 243,540 Customer-level costs 163,885 Customer-level operating income 79,655 Distribution-channel (Overhead) costsa 55,315 Distribution-channel-level oper. income 24,340 Corporate-sustaining costsa 29,785 Operating income $ (5,445) a

Architecture Firms Total Architecture AA (2) = (3) + (4) (3) $105,700 $58,500 ___5,850 5,850 99,850 52,650 66,050 36,750 33,800 $15,900 21,275 $ 12,525

BB (4) $47,200 _____0 47,200 29,300 $17,900

Commercial Clients Total DD Commercial CC (7) (5) = (6)+(7)+(8) (6) $144,605 $89,345 $36,960 915 _____0 _____0 143,690 89,345 36,960 97,835 54,645 28,930 45,855 $34,700 $ 8,030 34,040 $ 11,815

Architecture: 25% × $85,100 = $21,275; Commercial: 40% × $85,100 = $34,040; Corporate-sustaining: 35% × $85,100 = $29,785;

2.

Customer Code CC BB AA DD EE

Customer-Level Operating Income (1) $34,700 17,900 15,900 8,030 3,125

Customer Revenue (2) $ 89,345 47,200 52,650 36,960 17,385

$79,655

$243,540

Customer-Level Operating Income as a % of Revenue (3) = (1) (2) 38.84% 37.92% 30.20% 21.72% 17.98%

Cumulative Customer-Level Operating Income (4) $34,700 52,600 68,500 76,530 79,655

Cumulative Customer-Level Operating Income as a % of Total Customer-Level Operating Income (5) = (4) $79,655 43.6% 66.0% 86.0% 96.1% 100.0%


EE (8) $18,300 915 17,385 14,260 $ 3,125

3. Designs by Denise reported a net operating loss for the quarter. All of Denise’s customers are profitable, but the presence of substantial corporate-sustaining costs led to the overall negative level of income. Offering a discount to Attractive Abodes in order to gain their business was a good move because even with the discount the customer contributed significant customer-level operating income, without affecting overall profit margins. Similarly, despite the discount offered to Elegant Extras for advance cash payment, Elegant Extras still provided a positive contribution to overall income. However, Elegant Extras was the least profitable customer, on the basis of profit margins. It is possible that Denise gave the discount at a time when she needed liquidity, thereby trading off some income for immediate cash. Going forward, it is important to ensure that customers do not come to expect the same deal for every transaction.


14-39 (40 min.) Customer profitability and ethics. 1. Order taking Product handling Delivery Expedited delivery Restocking Visits to customers Sales commissions

– – – – – – –

Customer batch-level Customer output-unit-level Customer batch-level Customer batch-level Customer batch-level Customer sustaining-level Customer batch-level

2. Customer-level operating income based on expected cost of orders: Customers SR Revenues $50 × 250; 550; 320; 130; 450; 1,200 Less: Returns $50 ×20; 35; 0; 0; 40; 60 Net Revenues $50 ×230; 515; 320; 130; 410; 1140 Cost of goods sold $35 × 230; 515; 320; 130; 410; 1,140 Gross margin Customer-level operating costs: Order taking $30 ×6; 15; 8; 7; 20; 30 Product handling $2 × 250; 550; 320; 130; 450; 1,200 Delivery $0.50 × 420; 620; 470; 280; 806; 900 Expedited delivery $325 × 0; 6; 0; 0; 2; 5 Restocking $100 ×2; 1; 0; 0; 2; 6 Visits to customers Sales commissions $25× 6; 15; 8; 7; 20; 30 Total customer-level operating costs Customer-level operating income

SRU

NS

SB

WS

$22,500

$60,000

0

2,000

3,000

$12,500

$27,500

1,000

1,750

11,500

25,750

16,000

6,500

20,500

57,000

8,050 3,450

18,025 7,725

11,200 4,800

4,550 1,950

14,350 6,150

39,900 17,100

180

450

500 210 0

1,100 310 1,950

$16,000

SM

0

$6,500

240

210

600

640

260

900

235

140

403

0

0

650

900 2,400 450 1,625

200

100

0

0

200

600

150

150

150

150

150

150

200 1,465 $ 3,335

175 935 $1,015

500 3,403 $ 2,747

750 6,875 $10,225

150 1,390 $ 2,060

375 4,435 $ 3,290


3. Customer level operating income based on actual order costs: Customer SR Revenues $50 × 250; 550; 320; 130; 450; 1,200 Less: Returns $50 ×20; 35; 0; 0; 40; 60 Net Revenues $50 ×230; 515; 320; 130; 410; 1,140 Cost of good sold $35 × 230; 515; 320; 130; 410; 1,140 Gross margin Customer-level operating costs: Order taking $14 × 6; $30 × 15; $14 × 8; $14 × 7; $14 × 20; $14 × 30 Product handling $2 × 250; 550; 320; 130; 450; 1,200 Delivery $0.50 × 420; 620; 470; 280; 806; 900 Expedited delivery $325 × 0; 6; 0; 0; 2; 5 Restocking $100 ×2; 1; 0; 0; 2; 6 Visits to customers Sales commissions $25× 6; 15; 8; 7; 20; 30 Total customer-level operating costs Customer-level operating income

SRU

NS

SB

$22,500

$60,000

$27,500

1,000

1,750

0

0

2,000

3,000

11,500

25,750

16,000

6,500

20,500

57,000

8,050 3,450

18,025 7,725

11,200 4,800

4,550 1,950

14,350 6,150

39,900 17,100

500 210 0

450 1,100 310 1,950

$6,500

WS

$12,500

84

$16,000

SM

112

98

280

640

260

900

235

140

403

0

0

650

420 2,400 450 1,625

200

100

0

0

200

600

150

150

150

150

150

150

500 3,083 $ 3,067

750 6,395 $ 10,705

150 1,294 $ 2,156

375 4,435 $ 3,290

200 1,337 $ 3,463

175 823 $1,127

Comparing the answers in requirements 2 and 3, it appears that operating income is higher than expected, so the management of Snark Corporation would be very pleased with the performance of the salespeople for reducing order costs. Except for SRU, all of the customers are more profitable than originally reported.


4. Customer-level operating income based on actual orders and adjusted commissions Customer

SR Revenues $50 × 250; 550; 320; 130; 450; 1,200 Less: Returns $50 ×20; 35; 0; 0; 40; 60 Net Revenues $50 ×230; 515; 320; 130; 410; 1140 Cost of good sold $35 × 230; 515; 320; 130; 410; 1,140 Gross margin Customer-level operating costs: Order taking $30 ×3; 15; 3; 4; 5; 15 Product handling $2 × 250; 550; 320; 130; 450; 1,200 Delivery $0.50 × 420; 620; 470; 280; 806; 900 Expedited delivery $325 × 0; 6; 0; 0; 2; 5 Restocking $100 ×2; 1; 0; 0; 2; 6 Visits to customers Sales commissions $25× 3; 15; 3; 4; 5; 15 Total customer-level operating costs Customer-level operating income

SRU

$12,500

$27,500

1,000

NS

SB

SM

WS

$22,500

$60,000

$16,000

$6,500

1,750

0

0

2,000

3,000

11,500

25,750

16,000

6,500

20,500

57,000

8,050 3,450

18,025 7,725

11,200 4,800

4,550 1,950

14,350 6,150

39,900 17,100

90

450

450

500 210 0

1,100 310 1,950

90

120

150

640

260

900

235

140

403

0

0

650

2,400 450 1,625

200

100

0

0

200

600

150

150

150

150

150

150

75 1,225 $ 2,225

375 4,435 $ 3,290

75 1,190 $ 3,610

125 2,578 $ 3,572

375 6,050 $11,050

100 770 $1,180

5. The behavior of the salespeople is costing Snark Corporation $1,119 in profit (the difference between the incomes in requirements 3 and 4.) Although management thinks the salespeople are saving money based on the budgeted order costs, in reality they are costing the firm money by increasing the costs of orders ($2,580 in requirement 2 versus $1,350 in requirement 4) and at the same time increasing their sales commissions ($2,150 in requirement 3 versus $1,125 in requirement 4). This is not ethical. Snark Corporation needs to change the structure of the sales commission, possibly linking commissions to the overall units sold rather than on number of orders.


CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES 15-1 The single-rate (cost-allocation) method makes no distinction between fixed costs and variable costs in the cost pool. It allocates costs in each cost pool to cost objects using the same rate per unit of the single allocation base. The dual-rate (cost-allocation) method classifies costs in each cost pool into two pools—a variable-cost pool and a fixed-cost pool—with each pool using a different cost-allocation base. 15-2 The dual-rate method provides information to division managers about cost behavior. Knowing how fixed costs and variable costs behave differently is useful in decision making. 15-3 Budgeted cost rates motivate the manager of the support department to improve efficiency because the support department bears the risk of any unfavorable cost variances. 15-4 Examples of bases used to allocate support department cost pools to operating departments include the number of employees, square feet of space, number of direct labor hours, and machine-hours. 15-5 The use of budgeted indirect cost allocation rates rather than actual indirect rates has several attractive features to the manager of a user department: a. the user knows the costs in advance and can factor them into ongoing operating choices, b. the cost allocated to a particular user department does not depend on the amount of resources used by other user departments, and c. inefficiencies at the department providing the service do not affect the costs allocated to the user department. 15-6 Disagree. Allocating costs on ―the basis of estimated long-run use by user department managers‖ means department managers can lower their cost allocations by deliberately underestimating their long-run use (assuming all other managers do not similarly underestimate their usage). 15-7 The three methods differ in how they recognize reciprocal services among support departments: a. The direct (allocation) method ignores any services rendered by one support department to another; it allocates each support department’s costs directly to the operating departments. b. The step-down (allocation) method allocates support-department costs to other support departments and to operating departments in a sequential manner that partially recognizes the mutual services provided among all support departments. c. The reciprocal (allocation) method allocates support-department costs to operating departments by fully recognizing the mutual services provided among all support departments.


15-8 The reciprocal method is theoretically the most defensible method because it fully recognizes the mutual services provided among all departments, irrespective of whether those departments are operating or support departments. 15-9 The stand-alone cost-allocation method uses information pertaining to each user of a cost object as a separate entity to determine the cost-allocation weights. The incremental cost-allocation method ranks the individual users of a cost object in the order of users most responsible for the common costs and then uses this ranking to allocate costs among those users. The first-ranked user of the cost object is the primary user and is allocated costs up to the costs of the primary user as a stand-alone user. The second-ranked user is the first incremental user and is allocated the additional cost that arises from two users instead of only the primary user. The third-ranked user is the second incremental user and is allocated the additional cost that arises from three users instead of two users, and so on. The Shapley Value method calculates an average cost based on the costs allocated to each user as first the primary user, the second-ranked user, the third-ranked user, and so on. 15-10 All contracts with U.S. government agencies must comply with cost accounting standards issued by the Cost Accounting Standards Board (CASB). 15-11 Areas of dispute between contracting parties can be reduced by making the ―rules of the game‖ explicit and in writing at the time the contract is signed. 15-12 Companies increasingly are selling packages of products or services for a single price. Revenue allocation is required when managers in charge of developing or marketing individual products in a bundle are evaluated using product-specific revenues. 15-13 The stand-alone revenue-allocation method uses product-specific information on the products in the bundle as weights for allocating the bundled revenues to the individual products. The incremental revenue allocation method ranks individual products in a bundle according to criteria determined by management—such as the product in the bundle with the most sales—and then uses this ranking to allocate bundled revenues to the individual products. The first-ranked product is the primary product in the bundle. The second-ranked product is the first incremental product, the third-ranked product is the second incremental product, and so on. 15-14 Managers typically will argue that their individual product is the prime reason why consumers buy a bundle of products. Evidence on this argument could come from the sales of the products when sold as individual products. Other pieces of evidence include surveys of users of each product and surveys of people who purchase the bundle of products. 15-15 A dispute over allocation of revenues of a bundled product could be resolved by (a) having an agreement that outlines the preferred method in the case of a dispute, or (b) having a third party (such as the company president or an independent arbitrator) make a decision.


15-16 (20 min.) Single-rate versus dual-rate methods, support department. Bases available (kilowatt hours): Rockford Practical capacity 10,000 Expected monthly usage 8,000 1a.

Rockford 10,000 $3,000

Peoria Hammond Kankakee Total 20,000 12,000 8,000 50,000 $6,000 $3,600 $2,400 $15,000

Single-rate method based on expected monthly usage: Total costs in pool = $6,000 + $9,000 = $15,000 Expected usage = 30,000 kilowatt hours Allocation rate = $15,000 ÷ 30,000 = $0.50 per hour of expected usage

Expected monthly usage in hours Costs allocated at $0.50 per hour 2.

Total 50,000 30,000

Single-rate method based on practical capacity: Total costs in pool = $6,000 + $9,000 = $15,000 Practical capacity = 50,000 kilowatt hours Allocation rate = $15,000 ÷ 50,000 = $0.30 per hour of capacity

Practical capacity in hours Costs allocated at $0.30 per hour 1b.

Peoria Hammond Kankakee 20,000 12,000 8,000 9,000 7,000 6,000

Variable-Cost Pool: Total costs in pool Expected usage Allocation rate Fixed-Cost Pool: Total costs in pool Practical capacity Allocation rate

Rockford Peoria Hammond Kankakee Total 8,000 9,000 7,000 6,000 30,000 $4,000 $4,500 $3,500 $3,000 $15,000 = = =

$6,000 30,000 kilowatt hours $6,000 ÷ 30,000 = $0.20 per hour of expected usage

= = =

$9,000 50,000 kilowatt hours $9,000 ÷ 50,000 = $0.18 per hour of capacity

Rockford Variable-cost pool $0.20 × 8,000; 9,000; 7,000, 6,000 Fixed-cost pool $0.18 × 10,000; 20,000; 12,000, 8,000 Total

Peoria

Hammond

Kankakee

Total

$1,600

$1,800

$1,400

$1,200 $ 6,000

1,800 $3,400

3,600 $5,400

2,160 $3,560

1,440 9,000 $2,640 $15,000

The dual-rate method permits a more refined allocation of the power department costs; it permits the use of different allocation bases for different cost pools. The fixed costs result from decisions most likely associated with the scale of the facility, or the practical capacity level. The variable costs result from decisions most likely associated with monthly usage.


15-17 (20–25 min.) Single-rate method, budgeted versus actual costs and quantities. 1. a. Budgeted rate =

Budgeted indirect costs = $115,000/50 trips = $2,300 per round-trip Budgeted trips

Indirect costs allocated to Dark C. Division

= $2,300 per round-trip = $69,000

30 budgeted round trips

Indirect costs allocated to Milk C. Division

= $2,300 per round-trip = $46,000

20 budgeted round trips


= $2,300 per round-trip = $69,000

30 actual round trips


= $2,300 per round-trip = $34,500


b. Budgeted rate = $2,300 per round-trip

c. Actual rate =

Actual indirect costs = $96,750/ 45 trips = $2,150 per round-trip Actual trips


= $2,150 per round-trip = $64,500



= $2,150 per round-trip = $32,250


2. When budgeted rates/budgeted quantities are used, the Dark Chocolate and Milk Chocolate Divisions know at the start of 2012 that they will be charged a total of $69,000 and $46,000 respectively for transportation. In effect, the fleet resource becomes a fixed cost for each division. Then, each may be motivated to over-use the trucking fleet, knowing that their 2012 transportation costs will not change. When budgeted rates/actual quantities are used, the Dark Chocolate and Milk Chocolate Divisions know at the start of 2012 that they will be charged a rate of $2,300 per round trip, i.e., they know the price per unit of this resource. This enables them to make operating decisions knowing the rate they will have to pay for transportation. Each can still control its total transportation costs by minimizing the number of round trips it uses. Assuming that the budgeted rate was based on honest estimates of their annual usage, this method will also provide an estimate of the excess trucking capacity (the portion of fleet costs not charged to either division). In contrast, when actual costs/actual quantities are used, the two divisions must wait until yearend to know their transportation charges. The use of actual costs/actual quantities makes the costs allocated to one division a function of the actual demand of other users. In 2012, the actual usage was 45 trips, which is 5 trips below the 50 trips budgeted. The Dark Chocolate Division used all the 30 trips it had budgeted. The Milk Chocolate Division used only 15 of the 20 trips budgeted. When costs are allocated based on actual costs and actual quantities, the same fixed costs are spread over fewer


trips resulting in a higher rate than if the Milk Chocolate Division had used its budgeted 20 trips. As a result, the Dark Chocolate Division bears a proportionately higher share of the fixed costs. Using actual costs/actual rates also means that any efficiencies or inefficiencies of the trucking fleet get passed along to the user divisions. In general, this will have the effect of making the truck fleet less careful about its costs, although in 2012, it appears to have managed its costs well, leading to a lower actual cost per roundtrip relative to the budgeted cost per round trip. For the reasons stated above, of the three single-rate methods suggested in this problem, the budgeted rate and actual quantity may be the best one to use. (The management of Chocolat would have to ensure that the managers of the Dark Chocolate and Milk Chocolate divisions do not systematically overestimate their budgeted use of the fleet division in an effort to drive down the budgeted rate). 15-18 (20 min.) Dual-rate method, budgeted versus actual costs, and practical capacity versus actual quantities (continuation of 15-17). 1. Charges with dual rate method. Variable indirect cost rate

=

$1,350 per trip

Fixed indirect cost rate

= =

$47,500 budgeted costs/ 50 round trips budgeted $950 per trip

Dark Chocolate Division Variable indirect costs, $1,350 × 30 Fixed indirect costs, $950 × 30 Milk Chocolate Division Variable indirect costs, $1,350 × 15 Fixed indirect costs, $950 × 20

$40,500 28,500 $69,000 $20,250 19,000 $39,250

2. The dual rate changes how the fixed indirect cost component is treated. By using budgeted trips made, the Dark Chocolate Division is unaffected by changes from its own budgeted usage or that of other divisions. When budgeted rates and actual trips are used for allocation (see requirement 1.b. of problem 15-17), the Dark Chocolate Division is assigned the same $28,500 for fixed costs as under the dual-rate method because it made the same number of trips as budgeted. However, note that the Milk Chocolate Division is allocated $19,000 in fixed trucking costs under the dual-rate system, compared to $950 15 actual trips = $14,250 when actual trips are used for allocation. As such, the Dark Chocolate Division is not made to appear disproportionately more expensive than the Milk Chocolate Division simply because the latter did not make the number of trips it budgeted at the start of the year.


15-19 (30 min.) Support department cost allocation; direct and step-down methods. 1. a.

AS IS GOVT $600,000 $2,400,000

Direct method costs Alloc. of AS costs (40/75, 35/75) Alloc. of IS costs (30/90, 60/90)

(600,000)

$ b.

Step-down (AS first) costs Alloc. of AS costs (0.25, 0.40, 0.35) Alloc. of IS costs (30/90, 60/90)

0 $ $600,000 (600,000)

$ c.

Step-down (IS first) costs Alloc. of IS costs (0.10, 0.30, 0.60) Alloc. of AS costs (40/75, 35/75)

0 $ $600,000 240,000

$

(840,000) 0 $

2.

CORP

$ 320,000 (2,400,000) 0 $2,400,000 150,000

800,000 $1,120,000

$ 240,000

(2,550,000) 0

$ 280,000 1,600,000 $1,880,000

$ 210,000

850,000 $1,090,000

1,700,000 $1,910,000

$2,400,000 (2,400,000)$ 720,000

0

$1,168,000

$1,440,000

448,000 $1,832,000

GOVT CORP $1,120,000 $1,880,000 1,090,000 1,910,000 1,168,000 1,832,000

Direct method Step-down (AS first) Step-down (IS first)

The direct method ignores any services to other support departments. The step-down method partially recognizes services to other support departments. The information systems support group (with total budget of $2,400,000) provides 10% of its services to the AS group. The AS support group (with total budget of $600,000) provides 25% of its services to the information systems support group. When the AS group is allocated first, a total of $2,550,000 is then assigned out from the IS group. Given CORP’s disproportionate (2:1) usage of the services of IS, this method then results in the highest overall allocation of costs to CORP. By contrast, GOVT’s usage of the AS group exceeds that of CORP (by a ratio of 8:7), and so GOVT is assigned relatively more in support costs when AS costs are assigned second, after they have already been incremented by the AS share of IS costs as well.


392,000

3.

Three criteria that could determine the sequence in the step-down method are: a. Allocate support departments on a ranking of the percentage of their total services provided to other support departments. 1. Administrative Services 25% 2. Information Systems 10% b. Allocate support departments on a ranking of the total dollar amount in the support departments. 1. Information Systems $2,400,000 2. Administrative Services $ 600,000 c. Allocate support departments on a ranking of the dollar amounts of service provided to other support departments 1. Information Systems (0.10 $2,400,000) = 2. Administrative Services (0.25 $600,000) =

$240,000 $150,000

The approach in (a) above typically better approximates the theoretically preferred reciprocal method. It results in a higher percentage of support-department costs provided to other support departments being incorporated into the step-down process than does (b) or (c), above. 15-20 (50 min.) Support-department cost allocation, reciprocal method (continuation of 15-19). 1a.

Costs Alloc. of AS costs (0.25, 0.40, 0.35) Alloc. of IS costs (0.10, 0.30, 0.60)

Support Departments AS IS $600,000 $2,400,000

Operating Departments Govt. Corp.

(861,538)

215,385

$ 344,615

$ 301,538

261,538 $ 0

(2,615,385) $ 0

784,616 $1,129,231

1,569,231 $1,870,769

Reciprocal Method Computation AS = $600,000 + 0.10 IS IS = $2,400,000 + 0.25AS IS = $2,400,000 + 0.25 ($600,000 + 0.10 IS) = $2,400,000 + $150,000 + 0.025 IS 0.975IS = $2,550,000 IS = $2,550,000 ÷ 0.975 = $2,615,385 AS = $600,000 + 0.10 ($2,615,385) = $600,000 + $261,538 = $861,538


1b. Support Departments AS IS $600,000 $2,400,000

Costs 1st Allocation of AS (0.25, 0.40, 0.35) 1st Allocation of IS (0.10, 0.30, 0.60) nd 2 Allocation of AS (0.25, 0.40, 0.35) nd 2 Allocation of IS (0.10, 0.30, 0.60) 3rd Allocation of AS (0.25, 0.40, 0.35) 3rd Allocation of IS (0.10, 0.30, 0.60) th 4 Allocation of AS (0.25, 0.40, 0.35) 4th Allocation of IS (0.10, 0.30, 0.60) 5th Allocation of AS (0.25, 0.40, 0.35) th 5 Allocation of IS (0.10, 0.30, 0.60) Total allocation

(600,000) 255,000

150,000 2,550,000

$ 240,000

$ 210,000

(2,550,000)

765,000

1,530,000

63,750

102,000

89,250

(63,750)

19,125

38,250

1,594

2,550

2,231

(255,000) 6,375 (6,375) 160

(1,594)

478

956

40

64

56

4

(40)

12

24

(4)

1

2

1

(160)

$

Operating Departments Govt. Corp.

0 0

(1) 0

$

0 $1,129,231

1 $1,870,769

2. a. b. c. d.

Direct Step-Down (AS first) Step-Down (IS first) Reciprocal

Govt. Consulting $1,120,000 1,090,000 1,168,000 1,129,231

Corp. Consulting $1,880,000 1,910,000 1,832,080 1,870,769

The four methods differ in the level of support department cost allocation across support departments. The level of reciprocal service by support departments is material. Administrative Services supplies 25% of its services to Information Systems. Information Systems supplies 10% of its services to Administrative Services. The Information Department has a budget of $2,400,000 that is 400% higher than Administrative Services. The reciprocal method recognizes all the interactions and is thus the most accurate. This is especially clear from looking at the repeated iterations calculations.


15-21 (40 min.) Direct and step-down allocation. 1.

Costs Incurred Alloc. of HR costs (42/70, 28/70) Alloc. of Info. Syst. costs (1,920/3,520, 1,600/3,520)

2.

Support Departments HR Info. Systems $72,700 $234,400 (72,700) ______ $ 0

$

(234,400) 0

Operating Departments Corporate Consumer $ 998,270 $489,860 43,620

29,080

127,855 $1,169,745

106,545 $625,485

Total $1,795,230

________ $1,795,230

Rank on percentage of services rendered to other support departments.

Step 1: HR provides 23.077% of its services to information systems: 21 21 = = 23.077% 91 42 28 21 This 23.077% of $72,700 HR department costs is $16,777.

Step 2: Information systems provides 8.333% of its services to HR:

1,920

320 1,600

320

=

320 = 8.333% 3,840

This 8.333% of $234,400 information systems department costs is $19,533.

Costs Incurred Alloc. of HR costs (21/91, 42/91, 28/91)

Support Departments HR Info. Systems $72,700 $234,400 (72,700) $ 0

Alloc. of Info. Syst. costs (1,920/3,520, 1,600/3,520) $

Operating Departments Corporate Consumer $ 998,270 $489,860

16,777 251,177

33,554

22,369

(251,177) 0

137,006 $1,168,830

114,171 $626,400

Total $1,795,230

$1,795,230

3. An alternative ranking is based on the dollar amount of services rendered to other support departments. Using numbers from requirement 2, this approach would use the following sequence: Step 1: Allocate Information Systems first ($19 533 provided to HR). Step 2: Allocate HR second ($16 777 provided to Information Systems).


15-22 (30 min.) Reciprocal cost allocation (continuation of 15-21). 1. The reciprocal allocation method explicitly includes the mutual services provided among all support departments. Interdepartmental relationships are fully incorporated into the support department cost allocations. 2.

HR = $72,700 + .08333 IS IS = $234,400 + .23077 HR HR = $72,700 + [.08333($234,400 + .23077 HR)] = $72,700 + [$19,532.55 + 0.01923 HR] 0.98077 HR = $92,232.55 HR = $92,232.55 0.98077 = $94,041 IS = $234,400 + (0.23077 $94,041) = $256,102

Costs Incurred Alloc. of HR costs (21/91, 42/91, 28/91)

Support Depts. HR Info. Systems $72,700 $234,400 (94,041)

Alloc. of Info. Syst. costs (320/3,840, 1,920/3,840, 1,600/3,840) $

21,341 0

$

Operating Depts. Corporate Consumer $ 998,270 $489,860

21,702

43,404

28,935

(256,102) 0

128,051 $1,169,725

106,710 $625,505

Total $1,795,230

_________ $1,795,230

Solution Exhibit 15-22 presents the reciprocal method using repeated iterations.


SOLUTION EXHIBIT 15-22 Reciprocal Method of Allocating Support Department Costs for September 2012 at E-books Using Repeated Iterations Support Departments Human Information Resources Systems Budgeted manufacturing overhead costs before any interdepartmental cost allocation 1st Allocation of HR (21/91, 42/91, 28/91)a 1st Allocation of Information Systems (320/3,840, 1,920/3,840, 1,600/3,840)b

$234,400

$998,270

$489,860

(72,700)

16,777 251,177

33,554

22,369

(251,177)

(20,931)

2nd Allocation of Information Systems (320/3,840, 1,920/3,840, 1,600/3,840)b 3rd Allocation of HR (21/91, 42/91, 28/91)a 3rd Allocation of Information Systems (320/3,840, 1,920/3,840, 1,600/3,840)b 4th Allocation of HR (21/91, 42/91, 28/91)a 4th Allocation of Information Systems: (320/3,840, 1,920/3,840, 1,600/3,840)b Total budgeted manufacturing overhead of operating departments

$72,700

20,931

2nd Allocation of HR (21/91, 42/91, 28/91)a

Operating Departments Corporate Consumer Sales Sales

$

4,830

402

(4,830)

(402)

93

185

104,657

9,661

6,440

2,415

2,013

124

(93)

(8)

2

4

2

0

(2)

1

1

$

0

$1,795,230

125,589

8

0

Total

46

$1,169,725

$625,505

39

_________

$1,795,230

Total accounts allocated and reallocated (the numbers in parentheses in first two columns) HR $72,700 + $20,931 + $402 + $8 = $ 94,041 Information Systems $251,177 + $4,830 + $93 + $2 = $256,102 a

Base is (21 + 42 + 28) or 91 employees Base is (320 + 1,920 + 1,600) or 3,840 minutes

b

3. The reciprocal method is more accurate than the direct and step-down methods when there are reciprocal relationships among support departments. A summary of the alternatives is: Direct method Step-down method (HR first) Reciprocal method

Corporate Sales $1,169,745 1,168,830 1,169,725

Consumer Sales $625,485 626,400 625,505

The reciprocal method is the preferred method, although for September 2012 the numbers do not appear materially different across the alternatives.


15-23 1.

(20 25 min.) Allocation of common costs. Three methods of allocating the $55 are: Ben $52 15 60 55

Stand-alone Incremental (Gary primary) Incremental (Ben primary) Shapley value

Gary $13 50 5 10

a. Stand-alone cost allocation method. Ben:

$60 $60 + $15

$65

=

4 5

$65 = $52

Gary:

$15 $60 + $15

$65

=

1 5

$65 = $13

b. Incremental cost allocation method. Assume Gary (the owner) is the primary user and Ben is the incremental user: User Gary Ben Total

Costs Allocated $15 50 ($65 – $15) $65

Cumulative Costs Allocated $15 $65

This method may generate some dispute over the ranking. Notice that Ben pays only $50 despite his prime interest in the more expensive Internet access package. Gary could make the argument that if Ben were ranked first he would have to pay $60 since he is the major Internet user. Then, Gary would only have to pay $5! Assume Ben is the primary user and Gary is the incremental user:

User Ben Gary Total

Costs Allocated $60 5 ($65 – $60) $65

Cumulative Costs Allocated $60 $65

c. Shapley value (average over costs allocated as the primary and incremental user).

User Ben Gary

Costs Allocated ($50 + $60) 2 = $55 ($15 + $5) 2 = $10


2. The Shapley value approach is recommended. It is fairer than the incremental method because it avoids considering one user as the primary user and allocating more of the common costs to that user. It also avoids disputes about who is the primary user. It allocates costs in a manner that is close to the costs allocated under the stand-alone method but takes a more comprehensive view of the common cost allocation problem by considering primary and incremental users that the stand-alone method ignores. More generally, other criteria to guide common cost allocations include the following: a. Cause and effect. It is not possible to trace individual causes (either Internet access or phone services) to individual effects (uses by Ben or Gary). The $65 total package is a bundled product. b. Benefits received. There are various ways of operationalizing the benefits received: (i) Monthly service charge for their prime interest––Internet access for Ben ($60), and phone services for Gary ($15). This measure captures the services available to each person. (ii) Actual usage by each person. This would involve keeping a record of usage by each person and then allocating the $65 on a percent usage time basis. This measure captures the services actually used by each person, but it may prove burdensome and it would be subject to honest reporting by Ben and Gary. c. Ability to pay. This criterion requires that Ben and Gary agree upon their relative ability to pay. d. Fairness or equity. This criterion is relatively nebulous. One approach would be to split the $65 equally among the two users.


15-24 (20 min.) Allocation of common costs. 1.

Alternative approaches for the allocation of the $1,600 airfare include the following: a. The stand-alone cost allocation method. This method would allocate the air fare on the basis of each client’s percentage of the total of the individual stand-alone costs. Baltimore client

$1, 200 $1, 200 $800

$1,600 =

$ 960

Chicago client

$800 $1, 200 $800

$1,600 =

640 $1,600

Advocates of this method often emphasize an equity or fairness rationale. b. The incremental cost allocation method. This requires the choice of a primary party and an incremental party. If the Baltimore client is the primary party, the allocation would be: Baltimore client Chicago client

$1,200 400 $1,600

One rationale is that Gunn was planning to make the Baltimore trip, and the Chicago stop was added subsequently. Some students have suggested allocating as much as possible to the Baltimore client since Gunn had decided not to work for them. If the Chicago client is the primary party, the allocation would be: Chicago client Baltimore client

$ 800 800 $1,600

One rationale is that the Chicago client is the one who is going to use Gunn’s services, and presumably receives more benefits from the travel expenditures. c. Gunn could calculate the Shapley value that considers each client in turn as the primary party: The Baltimore client is allocated $1,200 as the primary party and $800 as the incremental party for an average of ($1,200 + $800) ÷ 2 = $1,000. The Chicago client is allocated $800 as the primary party and $400 as the incremental party for an average of ($800 + 400) ÷ 2 = $600. The Shapley value approach would allocate $1,000 to the Baltimore client and $600 to the Chicago client. 2. Gunn should use the Shapley value method. It is fairer than the incremental method because it avoids considering one party as the primary party and allocating more of the common costs to that party. It also avoids disputes about who is the primary party. It allocates costs in a manner that is close to the costs allocated under the stand-alone method but takes a more


comprehensive view of the common cost allocation problem by considering primary and incremental users, which the stand-alone method ignores. The Shapley value (or the stand-alone cost allocation method) would be the preferred methods if Gunn was to send the travel expenses to the Baltimore and Chicago clients before deciding which engagement to accept. Other factors such as whether to charge the Chicago client more because Gunn is accepting the Chicago engagement or the Baltimore client more because Gunn is not going to work for them can be considered if Gunn sends in her travel expenses after making her decision. However, each company would not want to be considered as the primary party and so is likely to object to these arguments. 3. A simple approach is to split the $80 equally between the two clients. The limousine costs at the Sacramento end are not a function of distance traveled on the plane. An alternative approach is to add the $80 to the $1,600 and repeat requirement 1: a. Stand-alone cost allocation method. $1, 280 Baltimore client $1, 280 $880 $880 Chicago client $1, 280 $880

$1,680 = $995.56 $1,680 = $684.46

b. Incremental cost allocation method. With Baltimore client as the primary party: Baltimore client $1,280 Chicago client 400 $1,680 With Chicago client as the primary party: Chicago client $ 880 Baltimore client 800 $1,680 c. Shapley value. Baltimore client: Chicago client:

($1,280 + $800) ÷ 2 = $1,040 ($400 + $880) ÷ 2 = $ 640

As discussed in requirement 2, the Shapley value or the stand-alone cost allocation method would be the preferred approaches. Note: If any students in the class have faced this situation when visiting prospective employers, ask them how they handled it.


15-25 (20 min.) Revenue allocation, bundled products. 1a. Under the stand alone revenue-allocation method based on selling price, Monaco will be allocated 30% of all revenues, or $39 of the bundled selling price, and Innocence will be allocated 70% of all revenues, or $91 of the bundled selling price, as shown below. Stand-alone method, based on selling prices Selling price Selling price as a % of total ($48 $160; $112 $160) Allocation of $130 bundled selling price (30% $130; 70% $130)

Monaco Innocence $48 $112 30% $39

Total $160

70% $91

100% $130

1b. Under the incremental revenue-allocation method, with Monaco ranked as the primary product, Monaco will be allocated $48 (its own stand-alone selling price) and Innocence will be allocated $82 of the $130 selling price, as shown below. Incremental Method (Monaco rank 1) Selling price Allocation of $130 bundled selling price ($48; $82 = $130 – $48)

Monaco Innocence $48 $112 $48

$82

1c. Under the incremental revenue-allocation method, with Innocence ranked as the primary product, Innocence will be allocated $112 (its own stand-alone selling price) and Monaco will be allocated $18 of the $130 selling price, as shown below. Incremental Method (Innocence rank 1) Selling price Allocation of $130 bundled selling price ($18 = $130 – $112; $112)

Monaco Innocence $48 $112 $18

$112

1d. Under the Shapley value method, each product will be allocated the average of its allocations in 1b and 1c, i.e., the average of its allocations when it is the primary product and when it is the secondary product, as shown below. Shapley Value Method Allocation when Monaco = Rank 1; Innocence = Rank 2 (from 1b.) Allocation when Innocence = Rank 1; Monaco = Rank 2 (from 1c.) Average of allocated selling price ($48 + $18) 2; ($82 + $112) 2

Monaco Innocence $48

$ 82

$18

$112

$33

$ 97


2.

A summary of the allocations based on the four methods in requirement 1 is shown below.

Monaco Innocence Total for L’Amour

Stand-alone (Selling Prices) $ 39 91 $130

Incremental (Monaco first) $ 48 82 $130

Incremental (Innocence first) $ 18 112 $130

Shapley $ 33 97 $130

If there is no clear indication of which product is the more ―important‖ product, or, if it can be reasonably assumed that the two products are equally important to the company's strategy, the Shapley value method is the fairest of all the methods because it averages the effect of product rank. In this particular case, note that the allocations from the stand-alone method based on selling price are reasonably similar to the allocations from the Shapley value method, so the managers at Yves may well want to use the much simpler stand-alone method. The stand-alone method also does not require ranking the products in the suite, and so it is less likely to cause debates among product managers in the Men's and Women's Fragrance divisions. If, however, one of the products (Monaco or Innocence) is clearly the product that is driving sales of the bundled product, then that product should be considered the primary product.


15-26 (20-25 min. ) Allocation of Common Costs 1. a. Dandridge’s method based on number of cars sold: Sales Number of Location cars sold Percentage East 3,150 3,150÷ 9,000=0.35 West 1,080 1,080 ÷9,000=0.12 North 2,250 2,250 ÷9,000=0.25 South 2,520 2,520 ÷9,000=0.28 9,000

Joint Cost Allocation $1,800,000 $ 630,000 1,800,000 216,000 1,800,000 450,000 1,800,000 504,000 $1,800,000

1. b. Stand-alone method: Sales Stand-alone Location cost East $ 324,000 West 432,000 North 648,000 South 756,000 $2,160,000

Joint Cost Allocation $1,800,000 $ 270,000 1,800,000 360,000 1,800,000 540,000 1,800,000 630,000 $1,800,000

Percentage (costs in thousands) $324 ÷ $2,160=0.15 $432 ÷ $2,160=0.30 $648 ÷ $2,160=0.30 $756 ÷ $2,160=0.35

1. c. Incremental method (locations ranked in order of largest advertising dollars to smallest advertising dollars): Sales Location Allocated Cost Cost Remaining to Allocate South $ 756,000 ($1,800,000 - $756,000 = $1,044,000) North 648,000 ($1,044,000 - $648,000 = $ 396,000) West 396,000 ($ 396,000 - $396,000 = $ 0) East 0 $1,800,000 2. In this situation, the stand-alone method is probably the best method because the weights it uses for allocation are based on the individual advertising cost for each location as a separate entity. Therefore, each entity gets the same relative proportion of advertising costs and each location will have lower total advertising costs. The sales managers would likely not consider the incremental method fair because the locations with the higher advertising costs would be subsidizing the locations with the lower advertising costs (especially the East location, which would pay nothing in advertising). If the East sales manager is correct in his assertion that most of the advertising cost is for new car sales and not used car sales (the majority of the East location’s business) then Dandridge’s method of allocating costs based on number of cars sold would be particularly unfair to East, which would pay $630,000 of the $1,800,000 in total advertising cost. Dandridge could alternatively separate the total $1,800,000 of advertising cost into two cost pools: one for new car advertising and one for used car advertising and allocate on the basis of new cars sold and used cars sold, to make this method more equitable to the various sales locations.


15-27 (20 min.) Single-rate, dual-rate, and practical capacity allocation. Budgeted number of gifts wrapped = 6,650 Budgeted fixed costs = $6,650 Fixed cost per gift based on budgeted volume = $6,650 ÷ 6,650 =$1.00 Average budgeted variable cost per gift = 0.40 Total cost per gift wrapped $1.40 1.a.

Allocation based on budgeted usage of gift-wrapping services:

Women’s Face Wash (2,470 × $1.40) Men’s Face Wash (825 × $1.40) Fragrances (1,805 × $1.40) Body Wash (430 × $1.40) Hair Products (1,120 × $1.40) Total 1.b.

$3,458 1,155 2,527 602 1,568 $9,310

Allocation based on actual usage of gift-wrapping services:

Women’s Face Wash (2,020 × $1.40) Men’s Face Wash (730 × $1.40) Fragrances (1,560 × $1.40) Body Wash (545 × $1.40) Hair Products (1,495 × $1.40) Total 1.c.

$2,828 1,022 2,184 763 2,093 $8,890

Practical gift-wrapping capacity = 7,000 Budgeted fixed costs = $6,650 Fixed cost per gift based on practical capacity = $6,650 ÷ 7,000 = Average budgeted variable cost per gift = Total cost per gift wrapped

$0.95 0.40 $1.35

Allocation based on actual usage of gift-wrapping services: Women’s Face Wash (2,020 × $1.35) Men’s Face Wash (730 × $1.35) Fragrances (1,560 × $1.35) Body Wash (545 × $1.35) Hair Products (1,495 × $1.35) Total

$2,727.00 985.50 2,106.00 735.75 2,018.25 $8,572.50


2. Budgeted rate for fixed costs

=

Budgeted fixed costs Practical capacity

= $6,650 ÷ 7,000 gifts = $0.95 per gift Fixed costs allocated on budgeted usage. Rate for variable costs = $0.40 per item Variable costs based on actual usage. Allocation: Department Women’s Face Wash Men’s Face Wash

Variable Costs 2,020 × $0.40 = $ 808.00 730 × $0.40 =

292.00

Fragrances

1,560 × $0.40 =

624.00

Body Wash

545 × $0.40 =

218.00

Hair Products Total 3.

1 ,495 × $0.40 =

598.00 $2,540.00

Fixed Costs 2,470 × $0.95 = $2,346.50 825 × $0.95 = 783.75 1,805 × $0.95 = 1,714.75 430 × $0.95 = 408.50 1,120 × $0.95 = 1,064.00 $6,317.50

Total $3,154.50 1,075.75 2,338.75 626.50 1,662.00 $8,857.50

The dual-rate method has two major advantages over the single-rate method: a. Fixed costs and variable costs can be allocated differently—fixed costs based on rates calculated using practical capacity and budgeted usage, and variable costs based on budgeted rates and actual usage. b. Fixed costs are allocated proportionately to the departments causing the incurrence of those costs based on the capacity of each department. c. The costs allocated to a department are not affected by the usage by other departments.

Note: If capacity costs are the result of a long-term decision by top management, it may be desirable to allocate to each department the cost of capacity used based on actual usage. The users are then not allocated the costs of unused capacity.


15-28 (20 min.) Revenue allocation 1. a. Stand-alone method for the BegM + RCC package

DVD BegM RCC

Separate Revenue $ 50 30 $ 80

Joint Percentage Revenue $50 ÷ $80=0.625 $60 $30 ÷ $80=0.375 60

Allocation $37.50 22.50 $60.00

1. b. Incremental method i) BegM RCC

Allocated Revenue (BegM first) $50 10

Revenue Remaining To Allocate $10 ($60 ─ $50)

RCC BegM

Allocated Revenue (RCC first) $30 30

Revenue Remaining To Allocate $30 ($60 ─ $30)

ii)

1. c. Shapley method. (assuming each DVD is demanded in equal proportion) i) BegM ii) RCC

($50 + $30) ÷ 2 = $40 ($30 + $10) ÷ 2 = $20

2. a. Stand-alone method for the ConM + RCC package

DVD ConM RCC

Separate Revenue $ 90 30 $120

2. b. Incremental method i) Allocated Revenue (ConM first) ConM $90 RCC 10 ii)

RCC ConM

Allocated Revenue (RCC first) $30 70

Joint Percentage Revenue $90 ÷ $120=0.75 $100 $30 ÷ $120=0.25 100

Allocation $75 25 $100

Revenue Remaining To Allocate $10 ($100 – $90)

Revenue Remaining To Allocate $70 ($100 – $30)


2. c. Shapley method. (assuming each DVD is demanded in equal proportion) i) ConM ii) RCC

3.

(90+70) ÷ 2 = 80 (30+10) ÷ 2 = 20

For each DVD package, the stand-alone method and the Shapley method give approximately the same allocation to each DVD. These methods are fair if the demand for the DVDs are approximately equal. The stand-alone method might be slightly preferable here since it is simpler and easier to explain. The incremental method would be appropriate if one DVD has a higher level of demand than the other DVD. In this situation, the dominant DVD would be sold anyway so it should receive its stand-alone revenue, and the other DVD should receive the remainder.


15-29 (20 min.) 1.

Fixed cost allocation

i) Allocation using actual usage.

Department Executive Accounting Human Resources Total

Actual Usage 16,250 26,000 22,750 65,000

Percentage of Total Usage 0.25 0.40 0.35

Allocation % × 1,500,000a $ 375,000 600,000 525,000 $1,500,000

a

$30,000,000 building cost/20 years straight-line depreciation = $1,500,000 annual depreciation expense related to building. ii) Allocation using planned usage. Planned Usage 12,400 26,040 23,560 62,000



Allocation % × 1,500,000 $ 300,000 630,000 570,000 $1,500,000

iii) Allocation using practical capacity.


Practical Capacity 18,000 33,000 24,000 75,000


Allocation % × 1,500,000 $ 360,000 660,000 480,000 $1,500,000

2. Usage of Space Office Space (occupied) Vacant Office Space Common Meeting Space Workout Room Cafeteria Total

% of Total Building Space

% of Total Annual Building Cost

52%

$ 780,000

8%

120,000

25%

375,000

5%

75,000

10% 100%

150,000 $1,500,000


a) $120,000 of Vacant Office Space cost will not be allocated to the departments, but will be absorbed by the university’s central administration. b) Allocation of Office Space (occupied) costs ($780,000) using actual usage.


Actual Usage 16,250 26,000 22,750 65,000


Allocation % × 780,000 $195,000 312,000 273,000 $780,000

c) Allocation of all common space cost ($375,000 + $75,000 + $150,000 = $600,000) using practical capacity.


Practical Capacity 18,000 33,000 24,000 75,000


Allocation % × 600,000 $144,000 264,000 192,000 $600,000

The departments would likely consider portions of the allocation method used here ―fair.‖ In particular, the individual departments do not pay for unused office space that is intended for use by other departments (perhaps even ones that are not yet in the building). This creates an incentive for central administration to fill the unoccupied space with departments, so that the $120,000 can be allocated down. As for the allocation of occupied office space costs, it may have been more appropriate to allocate this based on relative practical capacity rather than actual usage by department. The current system does not appropriately consider that the building was constructed based on the practical capacity intended to be dedicated to each department. As a result, departments who are taking up less space than originally assigned to them are not penalized for this. Moreover, the assignment of the cost will change year to year under the present system depending on that period’s relative use of space by all departments, while a practical capacity-based system would yield stable cost allocations. Finally, allocating the common space cost based on practical capacity is the most equitable method, because the allocation of cost is based on ―assigned space‖ by department rather than actual usage of space or planned usage of space by department. The allocation of cost is also not dependent on how departments utilize their office space in relation to one another.


15-30 (45 min.) Allocating costs of support departments; step-down and direct methods.

1. Step-down Method: (1) Building & grounds at $0.10/sq.ft. ($10,000 ÷ 100,000) (2) Personnel at $6/employee ($1,200 ÷ 200) (3) General plant administration at $1/labor-hour ($27,000 ÷ 27,000) (4) Cafeteria at $20/empoloyee ($3,100 ÷ 155) (5) Storeroom at $1.50/requisition ($4,500 ÷ 3,000) (6) Costs allocated to operating depts. (7) Divide (6) by dir. manuf. labor-hrs. (8) Overhead rate per direct manuf. labor-hour 2. Direct method: (1) Building & grounds, 30,000/80,000; 50,000/80,000 (2) Personnel, 50/150; 100/150 (3) General plant administration, 8,000/25,000; 17,000/25,000 (4) Cafeteria, 50/150; 100/150 (5) Storeroom: 2,000/3,000; 1,000/3,000 (6) Costs allocated to operating depts. (7) Divide (6) by direct manufacturing labor-hours (8) Overhead rate per direct manufacturing labor-hour

Building & Grounds $ 10,000 $(10,000)

Personnel $ 1,000

General Plant Admin. $ 26,090

Cafeteria Operating Loss $ 1,640

Storeroom $ 2,670

200

700

400

700

$(1,200)

210

60

30

1,000

1,000

$(27,000)

$(3,100)

Machining $34,700

Assembly $48,900

3,000

5,000

300 8,000

17,000

1,000

2,000

3,000 $50,000 ÷ 5,000

1,500 $75,000 ÷15,000

100 $(4,500)

$ $10,000

$1,000

$26,090

$ 1,640

$2,670

10

3,750 333

6,250 667

8,349 547

17,741 1,093

1,780 $49,459

890 $75,541

÷ 5,000

÷15,000

(26,090) (1,640)

$ 9.892


5 $48,900

(1,000)

15-25

$

$34,700

(10,000)

(2,670)

600

$ 5.036

3.

Comparison of Methods:

Step-down method: Job 88:

Job 89:

Direct method:

Job 88:

Job 89:

Machining Assembly

18 × $10 2×$ 5

$

180 10

Machining Assembly

3 × $10 17 × $ 5

$

30 85

115.00

Machining Assembly

18 × $9.892 2 × $5.036

$178.06 10.07

$188.13

Machining Assembly

3 × $9.892 17 × $5.036

$ 29.68 85.61

115.29

$190.00

4. The manager of Machining Department would prefer the direct method. The direct method results in a lower amount of support departments’ costs being allocated to the Machining Department than the step-down method. This is clear from a comparison of the overhead rate, per direct manufacturing labor-hour, for the Machining Department under the two methods.


15-31 (40–60 min.) Support-department cost allocations; single-department cost pools; direct, step-down, and reciprocal methods. All the following computations are in dollars. 1. Direct method: To X A 250/400 $100,000 = $37,500 B 100/500 $ 40,000 = 32,000 Total

$62,500150/400

To Y $100,000

=

8,000400/500

$ 40,000

=

$70,500

$69,500

Step-down method, allocating A first: A B X $100,000 $40,000 — (100,000) 20,000 $50,000 — (60,000) 12,000 $ 0 $ 0 $62,000

Costs to be allocated Allocate A: (100; 250; 150 ÷ 500) Allocate B: (100; 400 ÷ 500) Total

Y — $30,000 48,000 $78,000

Step-down method, allocating B first: Costs to be allocated Allocate B: (500; 100; 400 ÷ 1,000) Allocate A: (250/400, 150/400) Total $

A B X $100,000 $ 40,000 — 20,000 (40,000) $ 4,000 (120,000) — 75,000 0 $ 0 $79,000

Y — $16,000 45,000 $61,000

Note that these methods produce significantly different results, so the choice of method may frequently make a difference in the budgeted department overhead rates. Reciprocal method: Stage 1: Let (1) (2)

A B A B

= total costs of materials-handling department = total costs of power-generating department = $100,000 + 0.5 B = $ 40,000 + 0.2 A

Stage 2: Substituting in (1):

A A 0.9 A A

Substituting in (2):

= = = =

$100,000 + 0.5($40,000 + 0.2 A) $100,000 + $20,000 + 0.1 A $120,000 $133,333

B = $40,000 + 0.2($133,333) B = $66,666

Stage 3: Original amounts Allocation of A Allocation of B Totals accounted for

$

A B $100,000 $40,000 (133,333) 26,666(20%) 33,333(50%) (66,666) 0 $ 0

X Y — — $66,667(50%) $40,000(30%) 6,667(10%) 26,666(40%) $73,334 $66,666



SOLUTION EXHIBIT 15-31 Reciprocal Method of Allocating Support Department Costs for Manes Company Using Repeated Iterations. Operating Departments X Y

Support Departments A B Budgeted manufacturing overhead costs before any interdepartmental cost allocations 1st Allocation of Dept. A: (2/10, 5/10, 3/10)a 1st Allocation of Dept. B (5/10, 1/10, 4/10)b 2nd Allocation of Dept. A (2/10, 5/10, 3/10)a 2nd Allocation of Dept B: (5/10, 1/10, 4/10)b 3rd Allocation of Dept A: (2/10, 5/10, 3/10)a 3rd Allocation of Dept. B: (5/10, 1/10, 4/10)b 4th Allocation of Dept. A (2/10, 5/10, 3/10)a 4th Allocation of Dept. B (5/10, 1/10, 4/10)b 5th Allocation of Dept A (2/10, 5/10, 3/10) 5th Allocation of Dept B (5/10, 1/10, 4/10) 6th Allocation of Dept A (2/10, 5/10, 3/10) Total budgeted manufacturing overhead of operating departments

$100,000 (100,000)

$40,000 20,000 60,000

$50,000

$30,000

30,000

(60,000)

6,000

24,000

(30,000)

6,000

15,000

9,000

3,000

(6,000)

600

2,400

1,500

900

(3,000)

$

600

300

(600)

60

240

(300)

60

150

90

30

(60)

6

24

(30)

6

15

9

3

(6)

1

2

(3)

0

2

1

0

$73,334

$66,666

0

$

Total accounts allocated and reallocated (the numbers in parentheses in first two columns) Dept A; Materials Handling: $100,000 + $30,000 + $3,000 + $300 + $30 + $3 = $133,333 Dept B; Power Generation: $60,000 + $6,000 + $600 + $60 + $6 = $66,666 a

Base is (100 + 250 +150) or 500 labor-hours; 100 ÷ 500 = 2/10, 250 ÷ 500 = 5/10, 150 ÷ 500 = 3/10. Base is (500 + 100 + 400) or 1,000 kWh ; 500 ÷ 1,000 = 5/10, 100 ÷ 1,000 = 1/10, 400 ÷ 1,000 = 4/10.

b

Comparison of methods: Method of Allocation Direct method Step-down: A first Step-down: B first Reciprocal method

X $70,500 62,000 79,000 73,334

Y $69,500 78,000 61,000 66,666

Note that in this case the direct method produces answers that are the closest to the ―correct‖ answers (that is, those from the reciprocal method), step-down allocating B first is next, and stepdown allocating A first is least accurate.


2. At first glance, it appears that the cost of power is $40 per unit plus the material handling costs. If so, Manes would be better off by purchasing from the power company. However, the decision should be influenced by the effects of the interdependencies and the fixed costs. Note that the power needs would be less (students frequently miss this) if they were purchased from the outside:

X Y A (500 units minus 20% of 500 units, because there is no need to service the nonexistent power department) Total units Total costs, 900

Outside Power Units Needed Needed 100 400

400 900

$40 = $36,000

In contrast, the total costs that would be saved by not producing the power inside would depend on the effects of the decision on various costs: Avoidable Costs of 1,000 Units of Power Produced Inside Variable indirect labor and indirect material costs Supervision in power department Materials handling, 20% of $70,000* Probable minimum cost savings Possible additional savings: a. Can any supervision in materials handling be saved because of overseeing less volume? Minimum savings is probably zero; the maximum is probably 20% of $10,000 or $2,000. b. Is any depreciation a truly variable, wear-and-tear type of cost? Total savings by not producing 1,000 units of power

$10,000 10,000 14,000 $34,000

?

? ______ $34,000 + ?

* Materials handling costs are higher because the power department uses 20% of materials handling. Therefore, materials-handling costs will decrease by 20%.

In the short run (at least until a capital investment in equipment is necessary), the data suggest continuing to produce internally because the costs eliminated would probably be less than the comparable purchase costs.


15-32 (25 min.) Common costs. 1.

Stand-alone cost-allocation method. Wright Inc.

Brown Inc.

=

(800 $50) (1, 000 $42) (800 $50) (200 $50)

=

$40, 000 $42, 000 ($40, 000 $10, 000)

=

(200 $50) (1, 000 $42) (800 $50) (200 $50)

=

$10, 000 $42, 000 ($40, 000 $10, 000)

= $33,600

= $ 8,400 $42,000

2.

With Wright Inc. as the primary party: Party Wright Brown Total

Costs Allocated $40,000 2,000 ($42,000 – $40,000) $42,000

Cumulative Costs Allocated $40,000 $42,000

With Brown Inc. as the primary party: Party Brown Wright Total

Costs Allocated $10,000 32,000 ($42,000 – $10,000) $42,000

Cumulative Costs Allocated $10,000 $42,000


3. To use the Shapley value method, consider each party as first the primary party and then the incremental party. Compute the average of the two to determine the allocation. Wright Inc.: Allocation as the primary party Allocation as the incremental party Total Allocation ($72,000 ÷ 2)

$40,000 32,000 $72,000 $36,000

Brown Inc.: Allocation as the primary party Allocation as the incremental party Total Allocation ($12,000 ÷ 2)

$10,000 2,000 $12,000 $ 6,000

Using this approach, Wright Inc. is allocated $36,000 and Brown, Inc. is allocated $6,000 of the total costs of $42,000.

4.

The results of the four cost-allocation methods are shown below.

Stand-alone method Incremental (Wright primary) Incremental (Brown primary) Shapley value

Wright Inc. $33,600 40,000 32,000 36,000

Brown Inc. $8,400 2,000 10,000 6,000

The allocations are very sensitive to the method used. With the incremental cost-allocation method, Wright Inc. and Brown Inc. would probably have disputes over who is the primary party because the primary party gets allocated all of the primary party’s costs. The stand-alone method is simple and fair since it allocates the common cost of the dyeing machine in proportion to the individual costs of leasing the machine. The Shapley values are also fair. They result in allocations that are similar to those of the stand-alone method. Either of the methods can be chosen. Given its simplicity, the stand-alone method is likely more acceptable.


15-33 (20-25 mins.) Stand-alone revenue allocation

1. Allocation using individual selling price per unit.

Computer Hardware Component PC tower Monitor Color laser printer Total

Individual Selling Price Per Unit $ 840 280 480 $1600

Percentage of Total Price 0.525 0.175 0.300

Allocation % × $1,200 $ 630 210 360 $1,200

2. Allocation using cost per unit


Cost Per Unit $300 180 270 $750

Percentage of Total Cost 0.40 0.24 0.36

Allocation % × $1,200 $ 480 288 432 $1,200

3. Allocation using number of individual units of product sold per bundle


Individual Units of Product Sold per Bundle 1 1 1 3

Percentage of Total Price 0.333 0.333 0.333

Allocation % × $1,200 $ 400 400 400 $1,200


4. Sharing on the basis of revenue makes the most sense. Using this method each division takes a uniform percentage decrease in the revenue received regardless of the cost of the division’s individual products. For example:


Individual Price per Unit (a) $ 840 $ 280

Allocated Revenue per Unit (b) $ 630 $ 210

Decrease in Price (c)=(a)–(b) ($210) ($ 70)

$ 480 $1,600

$ 360 $1,200

($120) ($400)

Percentage Decrease in Price by Product (d) = (c)÷(a) –25% –25% –25%

Furthermore, the cost-based method might actually discourage cost efficiencies. Increasing the cost per unit of product relative to other products would give the division a greater share of the overall revenue. Lastly, under the physical unit allocation method the motivation of the divisional managers to produce for the bundled purchase would likely change significantly. The PC Tower Division would see the largest decrease in revenue and the Monitor Division would see the largest increase in revenue. The PC Tower Division would have much less incentive to produce for the bundled purchase, if the divisional revenue were cut from $840 to $400 dollars per unit. The Monitor Division would be highly motivated to produce for the bundled purchase, as the sales revenue per unit would go from $280 to $400. This method is also not the most reasonable because the relative price of $400 for each component is not representative of the amount individual price customers are willing to pay for each of the components independently.


15-34 (10-15 min.) Support-department cost allocations: single-department cost pools; direct, step-down, and reciprocal methods 1. a. Allocate the total Support Department costs to the production departments under the Direct Allocation Method:

Departmental Costs

Clothing $10,000

From: Information Technology (5,000/8,000) × $2,000 (3,000/8,000) × $2,000 Human Resources (120/160) × $1,000 (40/160) × $1,000

Shoes $8,000

$ 1,250

$ 750 ______

Total Departmental Costs

$12,000

$

750

$

250 $ 9,000

Total Costs to account for: $21,000

b. Allocate the Support Department Costs to the Production Department under the Stepdown (Sequential) Allocation Method IT first sequentially: To: IT $ 2,000

Departmental Costs From: Information Technology (2,000/10,000) × $2,000 (5,000/10,000) × $2,000 (3,000/10,000) × $2,000 Human Resources (120/160) × $1,400 (40/160) × $1,400 Total Departmental Costs

HR $1,000

Clothing $10,000

Shoes $8,000

$(2,000) $ 400 $ 1,000 $ 600 $(1,400) $ 1,050 $

0

$

0

$12,050

$ 350 $8,950

Total Costs to account for: $21,000


c. Allocate the Support Department Costs to the Production Department under the Stepdown (Sequential) Allocation Method HR first sequentially: To: HR $ 1,000

Departmental Costs From: Human Resources (40/200) × $1,000 (120/200) × $1,000 (40/200) × $1,000 Information Technology (5,000/8,000) × $2,200 (3,000/8,000) × $2,200 Total Departmental Costs

IT $ 2,000

Clothing $10,000

Shoes $8,000

$(1,000) $

200 $

600 $ 200

$(2,200) $ 1,375 $

0

$

0

$ 825

$11,975

$9,025

Total Costs to account for: $21,000 d. Allocate the Support Department Costs to the Production Department under the Reciprocal Allocation Method: a. Assign reciprocal equations to the support departments IT = ($2,000 + .20 HR) HR = ($1,000 + .20 IT) (.20 = 40 employees out of a total of 200 supported by HR were in the IT department) (.20= 2,000 of IT’s total 10,000 hours are spent supporting HR) b. Solve the equation to complete the reciprocal costs of the support departments IT = $2,000 + .20 HR IT = $2,000 + .20($1,000 + .20 IT) IT = $2,000 + $200 +.04 IT .96 IT = $2,200 IT = $2,291.67 HR = $1,000 + .20 IT HR = $1,000 + .20(2,291.67) HR = $1,000 + 458.33 HR = $1,458.33


c. Allocate Reciprocal costs to departments (all numbers rounded to nearest dollar) Departmental Costs

IT $2,000

Information Technology (2,000/10,000) × $2,292 (5,000/10,000) × $2,292 (3,000/10,000) × $2,292 Human Resources (40/200) × $1,458 (120/200) × $1,458 (40/200) × $1,458 Total Department Costs Allocated to production Total Departmental Costs

HR $1,000

Clothing $10,000

Shoes $8,000

$ 458 $ 1,146 $ 688 $ G38 292 $ 874 $2,292 ($2,292) $ 0

$1,458 ($1,458) $ 0

$12,020

$ 292 $8,980

$12,020

$8,980

Total Costs to account for 21,000 2. If Spirit decides to outsource its Information Technology needs, the company has to pay $97.50 per hour for the 10,000 hours of IT services it needs, for a total outlay of $975,000. In return, Spirit saves 30% of the IT department’s fixed costs ($1,500,000 × 0.30 = $450,000). The issue then is how much it saves in variable costs. The key is to recognize that Spirit saves more than the $500,000 of variable costs assigned to IT because of the interlinks between the IT and HR groups. To quantify this, we have to calculate the reciprocated cost of the IT department using the variable costs alone. IT = $500,000 + .20 HR IT = $500,000 + .20($100,000 + .20 IT) IT = $520,000 + 04 IT .96 IT = $520,000 IT = $541,667 Spirit’s total savings therefore amount to $450,000 + $541,667 = $991,667, which exceeds the direct outsourcing payment of $975,000. Therefore, on financial grounds alone, Spirit should outsource its Information Technology services. Beyond the financial perspective, Spirit should decide how important it is to the company to have control over its own IT support. It may be critical, especially with information technology, that the knowledge and expertise be maintained within the firm so critical decisions are not dependent on a third party. It may also be critical for security purposes to maintain IT support internally, so that company information is kept confidential. Additionally, by maintaining IT support in-house, the response time to production departments and other support departments will likely be greater than if the services are outsourced. It is also possible that the quality of the service would be higher as well. Finally, Spirit should consider the internal repercussions of dismissing a large portion of its workforce. This could create morale issues for the company’s remaining workers.


Collaborative Learning Problem 15-35 (20–25 min.) Revenue allocation, bundled products. 1.a. The stand-alone revenues (using unit selling prices) of the three components of the $1,000 package are: Lodging $400.00 × 2 = $ 800 Recreation $187.50 × 2 = 375 Food $100.00 × 2 = 200 $1,375 Lodging

$800 $1,000 0.582 $1,000 $582 $1,375

Recreation

$375 $1,000 0.273 $1,000 $273 $1,375

Food

$200 $1,000 0.145 $1,000 $145 $1,375

Total Allocated

=

$1,000

b. Product Recreation Lodging Food

2.

Revenue Allocated $ 375 625 ($1,000 – $375) 0 $1,000

Cumulative Revenue Allocated $ 375 $1,000 $1,000

The pros of the stand-alone-revenue-allocation method include the following: a. Each item in the bundle receives a positive weight, which means the resulting allocations are more likely to be accepted by all parties than a method allocating zero revenues to one or more products. b. It uses market-based evidence (unit selling prices) to decide the revenue allocations— unit prices are one indicator of benefits received . c. It is simple to implement. The cons of the stand-alone revenue-allocation method include: a. It ignores the relative importance of the individual components in attracting consumers to purchase the bundle.


b. It ignores the opportunity cost of the individual components in the bundle. The golf course operates at 100% capacity. Getaway participants must reserve a golf booking one week in advance, or else they are not guaranteed playing time. A getaway participant who does not use the golf option may not displace anyone. Thus, under the stand-alone method, the golf course may be paid twice—once from the non-getaway person who does play and second from an allocation of the $1,000 package amount for the getaway person who does not play (either did not want to play or wanted to play but made a booking too late, or failed to show). c. The weight can be artificially inflated by individual product managers setting ―high‖ list unit prices and then being willing to frequently discount these prices. The use of actual unit prices or actual revenues per product in the stand-alone formula will reduce this problem. d. The weights may change frequently if unit prices are constantly changing. This is not so much a criticism as a reflection that the marketplace may be highly competitive. The pros of the incremental method include: a. It has the potential to reflect that some products in the bundle are more highly valued than others. Not all products in the bundle have a similar ―write-down‖ from unit list prices. Ensuring this ―potential pro‖ becomes an ―actual pro‖ requires that the choice of the primary product be guided by reliable evidence on consumer preferences. This is not an easy task. b. Once the sequence is chosen, it is straightforward to implement. The cons of the incremental method include: a. Obtaining the rankings can be highly contentious and place managers in a ―no-win‖ acrimonious debate. The revenue allocations can be sensitive to the chosen rankings. b. Some products will have zero revenues assigned to them. Consider the Food division. It would incur the costs for the two dinners but receive no revenue. 3. Under the Shapley value method the revenue allocated represents an average of the revenue that would have been received if each product or service were ranked as both the primary party and the incremental party a.

Product Primary party Incremental party

Revenue Received under Incremental Method

Lodging Food

$800 100 $900

($900 – $800)


Primary Party Incremental Party

Revenue Received under Incremental Method $200 700 $900

Product Food Lodging

($900 – $200)

Revenue allocation under the Shapley value method, based on the data from the incremental rankings above is:

Average Lodging

($800 + $700) ÷2

$750

Average Food Total Revenue Dollars Allocated

($200 + $100) ÷ 2

150 $900

b. Assuming that Lodging is three times as likely to be sold as Food, the revenue allocated under

the weighted Shapley value method, using data from the incremental rankings above would be:

Average Lodging

($800 × 3 + $700 × 1) ÷ 4

$775

Average Food Total Revenue Dollars Allocated

($200 × 1 + $100 × 3) ÷ 4

125 $900


CHAPTER 16 COST ALLOCATION: JOINT PRODUCTS AND BYPRODUCTS 16-1 Exhibit 16-1 presents many examples of joint products from four different general industries. These include: Industry Separable Products at the Splitoff Point Food Processing: • Lamb • Lamb cuts, tripe, hides, bones, fat • Turkey • Breasts, wings, thighs, poultry meal Extractive: • Petroleum

• Crude oil, natural gas

16-2 A joint cost is a cost of a production process that yields multiple products simultaneously. A separable cost is a cost incurred beyond the splitoff point that is assignable to each of the specific products identified at the splitoff point. 16-3 The distinction between a joint product and a byproduct is based on relative sales value. A joint product is a product from a joint production process (a process that yields two or more products) that has a relatively high total sales value. A byproduct is a product that has a relatively low total sales value compared to the total sales value of the joint (or main) products. 16-4 A product is any output that has a positive sales value (or an output that enables a company to avoid incurring costs). In some joint-cost settings, outputs can occur that do not have a positive sales value. The offshore processing of hydrocarbons yields water that is recycled back into the ocean as well as yielding oil and gas. The processing of mineral ore to yield gold and silver also yields dirt as an output, which is recycled back into the ground. 16-5 1. 2. 3. 4. 5. 6.

The chapter lists the following six reasons for allocating joint costs: Computation of inventoriable costs and cost of goods sold for financial accounting purposes and reports for income tax authorities. Computation of inventoriable costs and cost of goods sold for internal reporting purposes. Cost reimbursement under contracts when only a portion of a business's products or services is sold or delivered under cost-plus contracts. Insurance settlement computations for damage claims made on the basis of cost information of joint products or byproducts. Rate regulation when one or more of the jointly-produced products or services are subject to price regulation. Litigation in which costs of joint products are key inputs.

16-6 The joint production process yields individual products that are either sold this period or held as inventory to be sold in subsequent periods. Hence, the joint costs need to be allocated between total production rather than just those sold this period. 16-7 This situation can occur when a production process yields separable outputs at the splitoff point that do not have selling prices available until further processing. The result is that selling prices are not available at the splitoff point to use the sales value at splitoff method. Examples include processing in integrated pulp and paper companies and in petro-chemical operations. 16-1 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

16-8 Both methods use market selling-price data in allocating joint costs, but they differ in which sales-price data they use. The sales value at splitoff method allocates joint costs to joint products on the basis of the relative total sales value at the splitoff point of the total production of these products during the accounting period. The net realizable value method allocates joint costs to joint products on the basis of the relative net realizable value (the final sales value minus the separable costs of production and marketing) of the total production of the joint products during the accounting period. 16-9

Limitations of the physical measure method of joint-cost allocation include: a. The physical weights used for allocating joint costs may have no relationship to the revenue-producing power of the individual products. b. The joint products may not have a common physical denominator––for example, one may be a liquid while another a solid with no readily available conversion factor.

16-10 The NRV method can be simplified by assuming (a) a standard set of post-splitoff point processing steps, and (b) a standard set of selling prices. The use of (a) and (b) achieves the same benefits that the use of standard costs does in costing systems. 16-11 The constant gross-margin percentage NRV method takes account of the post-splitoff point ―profit‖ contribution earned on individual products, as well as joint costs, when making cost assignments to joint products. In contrast, the sales value at splitoff point and the NRV methods allocate only the joint costs to the individual products. 16-12 No. Any method used to allocate joint costs to individual products that is applicable to the problem of joint product-cost allocation should not be used for management decisions regarding whether a product should be sold or processed further. When a product is an inherent result of a joint process, the decision to process further should not be influenced by either the size of the total joint costs or by the portion of the joint costs assigned to particular products. Joint costs are irrelevant for these decisions. The only relevant items for these decisions are the incremental revenue and the incremental costs beyond the splitoff point. 16-13 No. The only relevant items are incremental revenues and incremental costs when making decisions about selling products at the splitoff point or processing them further. Separable costs are not always identical to incremental costs. Separable costs are costs incurred beyond the splitoff point that are assignable to individual products. Some separable costs may not be incremental costs in a specific setting (e.g., allocated manufacturing overhead for postsplitoff processing that includes depreciation). 16-14 Two methods to account for byproducts are: a. Production method—recognizes byproducts in the financial statements at the time production is completed. b. Sales method—delays recognition of byproducts until the time of sale. 16-15 The sales byproduct method enables a manager to time the sale of byproducts to affect reported operating income. A manager who was below the targeted operating income could adopt a ―fire-sale‖ approach to selling byproducts so that the reported operating income exceeds the target. This illustrates one dysfunctional aspect of the sales method for byproducts. 16-2 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

16-16

(20-30 min.) Joint-cost allocation, insurance settlement.

1.

(a)

Breasts Wings Thighs Bones Feathers

Sales value at splitoff method: Pounds of Product 100 20 40 80 10 250

Wholesale Selling Price per Pound $0.55 0.20 0.35 0.10 0.05

Sales Value at Splitoff $55.00 4.00 14.00 8.00 0.50 $81.50

Weighting: Joint Sales Value Costs at Splitoff Allocated 0.675 $33.75 0.049 2.45 0.172 8.60 0.098 4.90 0.006 0.30 1.000 $50.00

Allocated Costs per Pound 0.3375 0.1225 0.2150 0.0613 0.0300

Costs of Destroyed Product Breasts: $0.3375 per pound 40 pounds = $13.50 Wings: $0.1225 per pound 15 pounds = 1.84 $15.34 b. Physical measure method:

Breasts Wings Thighs Bones Feathers

Pounds of Product 100 20 40 80 10 250

Weighting: Physical Measures 0.400 0.080 0.160 0.320 0.040 1.000

Costs of Destroyed Product Breast: $0.20 per pound 40 pounds Wings: $0.20 per pound 15 pounds

Joint Costs Allocated $20.00 4.00 8.00 16.00 2.00 $50.00

= =

Allocated Costs per Pound $0.200 0.200 0.200 0.200 0.200

$ 8 3 $11

Note: Although not required, it is useful to highlight the individual product profitability figures:

Product Breasts Wings Thighs Bones Feathers

Sales Value $55.00 4.00 14.00 8.00 0.50

Sales Value at Splitoff Method Joint Costs Gross Allocated Income $33.75 $21.25 2.45 1.55 8.60 5.40 4.90 3.10 0.30 0.20

Physical Measures Method Joint Costs Gross Allocated Income $20.00 $35.00 4.00 0.00 8.00 6.00 16.00 (8.00) 2.00 (1.50)


2. The sales-value at splitoff method captures the benefits-received criterion of cost allocation and is the preferred method. The costs of processing a chicken are allocated to products in proportion to the ability to contribute revenue. Quality Chicken’s decision to process chicken is heavily influenced by the revenues from breasts and thighs. The bones provide relatively few benefits to Quality Chicken despite their high physical volume. The physical measures method shows profits on breasts and thighs and losses on bones and feathers. Given that Quality Chicken has to jointly process all the chicken products, it is nonintuitive to single out individual products that are being processed simultaneously as making losses while the overall operations make a profit. Quality Chicken is processing chicken mainly for breasts and thighs and not for wings, bones, and feathers, while the physical measure method allocates a disproportionate amount of costs to wings, bones and feathers. 16-17 (10 min.) Joint products and byproducts (continuation of 16-16). 1.

Ending inventory: Breasts 15 Wings 4 Thighs 6 Bones 5 Feathers 2

$0.3375 0.1225 0.2150 0.0613 0.0300

= = = = =

$5.06 0.49 1.29 0.31 0.06 $7.21

2. Joint products Breasts Thighs

Net Realizable Values of byproducts: Wings $ 4.00 Bones 8.00 Feathers 0.50 $12.50

Byproducts Wings Bones Feathers

Joint costs to be allocated: Joint costs – Net Realizable Values of byproducts = $50 – $12.50 = $37.50

Breast Thighs

Pounds of Product

Wholesale Selling Price per Pound

Sales Value at Splitoff

Weighting: Sales Value at Splitoff

100 40

$0.55 0.35

$55 14 $69

55 ÷ 69 14 ÷ 69

Ending inventory: Breasts 15 $0.2989 Thighs 6 0.1903

Joint Costs Allocated

$29.89 7.61 $37.50

Allocated Costs Per Pound

$0.2989 0.1903

$4.48 1.14 $5.62

3. Treating all products as joint products does not require judgments as to whether a product is a joint product or a byproduct. Joint costs are allocated in a consistent manner to all products for the purpose of costing and inventory valuation. In contrast, the approach in requirement 2 lowers the joint cost by the amount of byproduct net realizable values and results in inventory values being shown for only two of the five products, the ones (perhaps arbitrarily) designated as being joint products. 16-4 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

16-18 (10 min.) Net realizable value method. A diagram of the situation is in Solution Exhibit 16-18. Corn Syrup Final sales value of total production, 12,500 $50; 6,250 $25 Deduct separable costs Net realizable value at splitoff point Weighting, $250,000; $62,500 $312,500 Joint costs allocated, 0.8; 0.2 $325,000

$625,000 375,000 $250,000 0.8 $260,000

Corn Starch $156,250 93,750 $ 62,500 0.2 $ 65,000

Total $781,250 468,750 $312,500 $325,000

SOLUTION EXHIBIT 16-18 (all numbers are in thousands) Joint Costs

Separable Costs Processing $375,000

Corn Syrup: 12,500 cases at $50 per case

Processing $93,750

Corn Starch: 6,250 cases at $25 per case

Processing $325 000

Splitoff Point


16-19 (40 min.) Alternative joint-cost-allocation methods, further-process decision. A diagram of the situation is in Solution Exhibit 16-19. 1. Physical measure of total production (gallons) Weighting, 2,500; 7,500 10,000 Joint costs allocated, 0.25; 0.75 $120,000 2. Final sales value of total production, 2,500 $21.00; 7,500 $14.00 Deduct separable costs, 2,500 $3.00; 7,500 $2.00 Net realizable value at splitoff point Weighting, $45,000; $90,000 $135,000 Joint costs allocated, 1/3; 2/3 $120,000 3.

Methanol 2,500 0.25 $30,000

Turpentine 7,500 0.75 $ 90,000

Total 10,000 $120,000

Methanol

Turpentine

Total

$52,500

$105,000

$157,500

7,500 $45,000

15,000 $ 90,000

22,500 $135,000

1/3 $40,000

2/3 $ 80,000

$120,000

a. Physical-measure (gallons) method: Revenues Cost of goods sold: Joint costs Separable costs Total cost of goods sold Gross margin

Methanol $52,500

Turpentine $105,000

Total $157,500

30,000 7,500 37,500 $15,000

90,000 15,000 105,000 0

120,000 22,500 142,500 $ 15,000

$

b. Estimated net realizable value method: Methanol $52,500

Revenues Cost of goods sold: Joint costs Separable costs Total cost of goods sold Gross margin

40,000 7,500 47,500 $ 5,000

Turpentine $105,000

Total $157,500

80,000 120,000 15,000 22,500 95,000 142,500 $ 10,000 $ 15,000


4. Alcohol Bev.

Turpentine

$150,000

$105,000

60,000 $ 90,000 0.50 $ 60,000

15,000 $ 90,000 0.50 $ 60,000

Final sales value of total production, 2,500 $60.00; 7,500 $14.00 Deduct separable costs, (2,500 $12.00) + (0.20 $150,000); 7,500 $2.00 Net realizable value at splitoff point Weighting, $90,000; $90,000 $180,000 Joint costs allocated, 0.5; 0.5 $120,000

Total $255,000

75,000 $180,000 $120,000

An incremental approach demonstrates that the company should use the new process: Incremental revenue, ($60.00 – $21.00) 2,500 $ 97,500 Incremental costs: Added processing, $9.00 2,500 $22,500 Taxes, (0.20 $60.00) 2,500 30,000 (52,500) Incremental operating income from further processing $ 45,000 Proof:

Total sales of both products Joint costs Separable costs Cost of goods sold New gross margin Old gross margin Difference in gross margin

$255,000 120,000 75,000 195,000 60,000 15,000 $ 45,000

SOLUTION EXHIBIT 16-19 Joint Costs

Separable Costs 2 500 gallons

Processing $3 per gallon

Methanol: 2 500 gallons at $21 per gallon

7 500 gallons

Processing $2 per gallon

Turpentine: 7 500 gallons at $14 per gallon

Processing $120 000 for 10 000 gallons

Splitoff Point


16-20 (40 min.) Alternative methods of joint-cost allocation, ending inventories. Total production for the year was:

X Y Z

Ending Inventories 175 75 70

Sold 75 225 280

Total Production 250 300 350

A diagram of the situation is in Solution Exhibit 16-20. 1.

a. Net realizable value (NRV) method: X

Final sales value of total production, 250 $1,800; 300 $1,300; 350 $800 Deduct separable costs Net realizable value at splitoff point Weighting, $450; $390; $160

$1,000

Joint costs allocated, 0.45, 0.39, 0.16 $328,000

Y

Z

Total

$450,000 –– $450,000

$390,000 –– $390,000

$280,000 120,000 $160,000

$1,120,000 120,000 $1,000,000

0.45

0.39

0.16

$147,600

$127,920

$ 52,480

X 175 250 70%

Y 75 300 25%

$ 328,000

Ending Inventory Percentages: Ending inventory Total production Ending inventory percentage

Z 70 350 20%

Income Statement X Revenues, 75 $1,800; 225 $1,300; 280 $800 Cost of goods sold: Joint costs allocated Separable costs Production costs Deduct ending inventory, 70%; 25%; 20% of production costs Cost of goods sold Gross margin Gross-margin percentage

Y

Z

Total

$135,000

$292,500

$224,000

$651,500

147,600 –– 147,600

127,920 –– 127,920

52,480 120,000 172,480

328,000 120,000 448,000

103,320 44,280 $ 90,720

31,980 95,940 $196,560

34,496 137,984 $ 86,016

169,796 278,204 $373,296

67.2%

67.2%

38.4%


b.

Constant gross-margin percentage NRV method:

Step 1: Final sales value of prodn., (250 $1,800) + (300 $1,300) + (350 Deduct joint and separable costs, $328,000 + $120,000 Gross margin Gross-margin percentage, $672,000 ÷ $1,120,000

$800)

$1,120,000 448,000 $ 672,000 60%

Step 2: X Final sales value of total production, 250 $1,800; 300 $1,300; 350 $800 Deduct gross margin, using overall Gross-margin percentage of sales, 60% Total production costs Step 3: Deduct separable costs Joint costs allocated

Y

Z

Total

$450,000

$390,000

$280,000

$1,120,000

270,000 180,000

234,000 156,000

168,000 112,000

672,000 448,000

— $180,000

— $156,000

120,000 120,000 $ (8,000) $ 328,000

The negative joint-cost allocation to Product Z illustrates one ―unusual‖ feature of the constant gross-margin percentage NRV method: some products may receive negative cost allocations so that all individual products have the same gross-margin percentage. Income Statement Revenues, 75 $1,800; 225 $1,300; 280 $800 Cost of goods sold: Joint costs allocated Separable costs Production costs Deduct ending inventory, 70%; 25%; 20% of production costs Cost of goods sold Gross margin Gross-margin percentage

X

Y

Z

Total

$135,000

$292,500

$224,000

$651,500

180,000 180,000

156,000 156,000

(8,000) 120,000 112,000

328,000 120,000 448,000

126,000 54,000 $ 81,000 60%

39,000 117,000 $175,500 60%

22,400 89,600 $134,400 60%

187,400 260,600 $390,900 60%


Summary a. NRV method: Inventories on balance sheet Cost of goods sold on income statement

b.

Y

Z

Total

$103,320 44,280

$ 31,980 95,940

$ 34,496 137,984

$169,796 278,204 $448,000

$126,000 54,000

$ 39,000 $ 117,000

22,400 89,600

$187,400 260,600 $448,000

Y 67.2% 60.0%

Z 38.4% 60.0%

Constant gross-margin percentage NRV method

Inventories on balance sheet Cost of goods sold on income statement

2.

X

Gross-margin percentages:

NRV method Constant gross-margin percentage NRV

X 67.2% 60.0%


Joint Costs

Separable Costs Product X: 250 tons at $1,800 per ton

Joint Processing Costs $328,000

Product Y: 300 tons at $1,300 per ton

Processing $120 000

Product Z: 350 tons at $800 per ton

Splitoff Point


16-21 (30 min.) Joint-cost allocation, process further.

Joint Costs = $1 800

ICR8 (Non-Saleable)

Processing $175

Crude Oil 150 bbls × $18 / bbl = $2 700

ING4 (Non-Saleable)

Processing $105

NGL 50 bbls × $15 / bbl = $750

XGE3 (Non-Saleable)

Processing $210

Gas 800 eqvt bbls × $1.30 / eqvt bbl = $1 040

Splitoff Point

1a.

Physical Measure Method

1. Physical measure of total prodn. 2. Weighting (150; 50; 800 ÷ 1,000) 3. Joint costs allocated (Weights $1,800) 1b.

1. 2. 3. 4. 5.

Crude Oil 150 0.15 $270

NGL 50 0.05 $90

Gas 800 0.80 $1,440

Total 1,000 1.00 $1,800

NRV Method

Final sales value of total production Deduct separable costs NRV at splitoff Weighting (2,525; 645; 830 ÷ 4,000) Joint costs allocated (Weights $1,800)

Crude Oil $ 2,700 175 $ 2,525 0.63125 $1,136.25

NGL 750 105 $ 645 0.16125 $290.25 $

Gas $ 1,040 210 $ 830 0.20750 $373.50

Total $4,490 490 $4,000 $1,800


2.

The operating-income amounts for each product using each method is:

(a)

Physical Measure Method

Revenues Cost of goods sold Joint costs Separable costs Total cost of goods sold Gross margin (b)

Crude Oil $2,700 270 175 445 $2,255

NGL $750 90 105 195 $555

Gas $1,040

Total $4,490

1,440 210 1,650 $ (610)

1,800 490 2,290 $2,200

Gas $1,040.00

Total $4,490.00

NRV Method

Revenues Cost of goods sold Joint costs Separable costs Total cost of goods sold Gross margin

Crude Oil NGL $2,700.00 $750.00 1,136.25 290.25 175.00 105.00 1,311.25 395.25 $1,388.75 $354.75

373.50 210.00 583.50 $ 456.50

1,800.00 490.00 2,290.00 $2,200.00

3. Neither method should be used for product emphasis decisions. It is inappropriate to use joint-cost-allocated data to make decisions regarding dropping individual products, or pushing individual products, as they are joint by definition. Product-emphasis decisions should be made based on relevant revenues and relevant costs. Each method can lead to product emphasis decisions that do not lead to maximization of operating income. 4. Since crude oil is the only product subject to taxation, it is clearly in Sinclair’s best interest to use the NRV method since it leads to a lower profit for crude oil and, consequently, a smaller tax burden. A letter to the taxation authorities could stress the conceptual superiority of the NRV method. Chapter 16 argues that, using a benefits-received cost allocation criterion, market-based joint cost allocation methods are preferable to physical-measure methods. A meaningful common denominator (revenues) is available when the sales value at splitoff point method or NRV method is used. The physical-measures method requires nonhomogeneous products (liquids and gases) to be converted to a common denominator.


16-22 (30 min.) Joint-cost allocation, sales value, physical measure, NRV methods. 1a. PANEL A: Allocation of Joint Costs using Sales Value at Splitoff Method Sales value of total production at splitoff point (10,000 tons $10 per ton; 20,000 $15 per ton) Weighting ($100,000; $300,000 ÷ $400,000) Joint costs allocated (0.25; 0.75 $240,000) PANEL B: Product-Line Income Statement for June 2012 Revenues (12,000 tons $18 per ton; 24,000 $25 per ton) Deduct joint costs allocated (from Panel A) Deduct separable costs Gross margin Gross margin percentage

Special B/ Beef Ramen

Special S/ Shrimp Ramen

$100,000 0.25 $60,000

$300,000 0.75 $180,000

Special B

Special S

$216,000 60,000 48,000 $108,000 50%

$600,000 180,000 168,000 $252,000 42%

$816,000 240,000 216,000 $360,000 44%

Special B/ Beef Ramen 10,000 33% $80,000

Special S/ Shrimp Ramen 20,000 67% $160,000

Total 30,000 $240,000

Special B

Special S

Total

Total $400,000 $240,000 Total

1b. PANEL A: Allocation of Joint Costs using Physical-Measure Method Physical measure of total production (tons) Weighting (10,000 tons; 20,000 tons ÷ 30,000 tons) Joint costs allocated (0.33; 0.67 $240,000) PANEL B: Product-Line Income Statement for June 2012 Revenues (12,000 tons $18 per ton; 24,000 $25 per ton) Deduct joint costs allocated (from Panel A) Deduct separable costs Gross margin Gross margin percentage

$216,000 80,000 48,000 $ 88,000 41%

$600,000 160,000 168,000 $272,000 45%

$816,000 240,000 216,000 $360,000 44%

Special B

Special S

Total

1c. PANEL A: Allocation of Joint Costs using Net Realizable Value Method Final sales value of total production during accounting period (12,000 tons $18 per ton; 24,000 tons $25 per ton) Deduct separable costs Net realizable value at splitoff point Weighting ($168,000; $432,000 ÷ $600,000) Joint costs allocated (0.28; 0.72 $240,000) PANEL B: Product-Line Income Statement for June 2012 Revenues (12,000 tons $18 per ton; 24,000 tons $25 per ton) Deduct joint costs allocated (from Panel A) Deduct separable costs Gross margin Gross margin percentage

$216,000 48,000 $168,000 28% $67,200

$600,000 168,000 $432,000 72% $172,800

$816,000 216,000 $600,000

Special B $216,000 67,200 48,000 $100,800 46.7%

Special S $600,000 172,800 168,000 $259,200 43.2%

Total $816,000 240,000 216,000 $360,000 44.1%


$240,000

2. Sherrie Dong probably performed the analysis shown below to arrive at the net loss of $2,228 from marketing the stock: PANEL A: Allocation of Joint Costs using Sales Value at Splitoff Sales value of total production at splitoff point (10,000 tons $10 per ton; 20,000 $15 per ton; 4,000 $5 per ton) Weighting ($100,000; $300,000; $20,000 ÷ $420,000) Joint costs allocated (0.238095; 0.714286; 0.047619 $240,000) PANEL B: Product-Line Income Statement for June 2012 Revenues (12,000 tons $18 per ton; 24,000 $25 per ton; 4,000 $5 per ton) Separable processing costs Joint costs allocated (from Panel A) Gross margin Deduct marketing costs Operating income

Special B/ Beef Ramen

Special S/ Shrimp Ramen

Stock

$100,000

$300,000

$20,000

$420,000

23.8095%

71.4286%

4.7619%

100%

$57,143

$171,429

$11,428

$240,000

Special S

Stock

$600,000 168,000 171,429 $260,571

$20,000 0 11,428 8,572 10,800 $ (2,228)

Special B

$216,000 48,000 57,143 $110,857

Total

Total

$836,000 216,000 240,000 380,000 10,800 $369,200

In this (misleading) analysis, the $240,000 of joint costs are re-allocated between Special B, Special S, and the stock. Irrespective of the method of allocation, this analysis is wrong. Joint costs are always irrelevant in a process-further decision. Only incremental costs and revenues past the splitoff point are relevant. In this case, the correct analysis is much simpler: the incremental revenues from selling the stock are $20,000, and the incremental costs are the marketing costs of $10,800. So, Instant Foods should sell the stock—this will increase its operating income by $9,200 ($20,000 – $10,800).


16-23 (20 min.) Joint cost allocation: sell immediately or process further. 1. a. Sales value at splitoff method:

Sales value of total production at splitoff, 500lbs × $1; 100 gallons × $4 Weighting, $500; $400 $900 Joint costs allocated, 0.556; 0.444 $500

Cookies/ Soymeal

Soyola/ Soy Oil

Total

$ 500 0.556

$ 400 0.444

$900

$ 278

$ 222

$500

Cookies

Soyola

Total

$1,200 300 $ 900 0.75

$

b. Net realizable value method: Final sales value of total production, 600lbs × $2; 400qts × $1.25 Deduct separable costs Net realizable value Weighting, $900; $300 $1,200 Joint costs allocated, 0.75; 0.25 $500

$375

500 200 $ 300 0.25

$1,700 500 $1,200

$125

$500

2. Cookies/Soy Meal Revenue if sold at splitoff Process further NRV Profit (Loss) from processing further a

500 lbs × $ 1 = 100 gal × $ 4 = c 600 lbs × $ 2 – d 400 qts × $1.25 – b

a

$500 900 c $400

Soyola/Soy Oil $ 400 b 300 d $(100)

$500 $400 $300 = $900 $200 = $300

ISP should process the soy meal into cookies because it increases profit by $400 (900-500). However, they should sell the soy oil as is, without processing it into the form of Soyola, because profit will be $100 (400-300) higher if they do. Since the total joint cost is the same under both allocation methods, it is not a relevant cost to the decision to sell at splitoff or process further.


16-24 (30 min.) Accounting for a main product and a byproduct. Production Method 1.

Sales Method

Revenues Main product Byproduct Total revenues

$682,240a ––__ 682,240

$682,240 65,000d 747,240

Cost of goods sold Total manufacturing costs Deduct value of byproduct production Net manufacturing costs Deduct main product inventory Cost of goods sold Gross margin

500,000 85,000b 415,000 74,700c 340,300 $341,940

500,000 0 500,000 90,000e 410,000 $337,240

a

42,640 $16.00 8,500 $10.00 c (9,360/52,000) × $415,000 = $74,700

d

b

2. a

e

6,500 $10.00 (9,360/52,000) × $500,000 = $90,000

Production Method $74,700 20,000a

Main Product Byproduct

Sales Method $90,000 0

Ending inventory shown at unrealized selling price. BI + Production – Sales = EI 0 + 8,500 – 6,500 = 2,000 pounds Ending inventory = 2,000 pounds $10 per pound = $20,000


16-25 (35-45 min.) Joint costs and byproducts. 1.

A B Totals

A B Totals

Computing byproduct deduction to joint costs: Revenues from C, 16,000 $6 Deduct: Gross margin, 10% of revenues Marketing costs, 20% of revenues Peanut Butter Department separable costs Net realizable value (less gross margin) of C

$ 96,000

Joint costs Deduct byproduct contribution Net joint costs to be allocated

$180,000 55,200 $124,800

Quantity 12,000 65,000

Unit Sales Price $12 3

Joint Costs Allocation $ 46,800 78,000 $124,800

Deduct Final Separable Sales Processing Value Cost $144,000 $27,000 195,000 –– $339,000 $27,000

Add Separable Processing Costs $27,000 –– $27,000

9,600 19,200 12,000 $ 55,200

Net Realizable Allocation of Value at $124,800 Splitoff Weighting Joint Costs $117,000 37.5% $ 46,800 195,000 62.5% 78,000 $312,000 $124,800

Total Costs $ 73,800 78,000 $151,800

Units 12,000 65,000 77,000

Unit Cost $6.15 1.20

Unit cost for C: $3.45 ($55,200 ÷ 16,000) + $0.75 ($12,000 ÷ 16,000) = $4.20, or $6.00 – $0.60 (10% $6) – $1.20 (20% $6) = $4.20.


2.

A B C Totals

A B C Totals

If all three products are treated as joint products:

Quantity 12,000 65,000 16,000

Unit Sales Price $12 3 6

Joint Costs Allocation $ 55,892 93,153 30,955 $180,000

Final Sales Value $144,000 195,000 96,000 $435,000

Deduct Separable Processing Cost $27,000 ─ 31,200 $58,200

Add Separable Processing Costs $27,000 –– 12,000 $39,000

Net Realizable Value at Splitoff $117,000 195,000 64,800 $376,800

Total Costs $ 82,892 93,153 42,955 $219,000

Weighting 117 ÷ 376.8 195 ÷ 376.8 64.8 ÷ 376.8

Units 12,000 65,000 16,000 93,000

Allocation of $180,000 Joint Costs $ 55,892 93,153 30,955 $180,000

Unit Cost $6.91 1.43 2.68

Call the attention of students to the different unit ―costs‖ resulting from the two assumptions about the relative importance of Product C. The point is that costs of individual products depend heavily on which assumptions are made and which accounting methods and techniques are used.


16-26 (25 min.) Accounting for a byproduct. 1. Byproduct recognized at time of production: Joint cost = $7,200 Joint cost to be charged to main product = Joint Cost - NRV of Byproduct = $7,200 - (900 lbs. × $2) = $5,400 $5400 Inventoriable cost of main product = = $1.80 per half-gallon 1500×2 Inventoriable cost of byproduct = NRV = $2.00 per pound Gross Margin Calculation under Production Method Revenues Main product: Juice (2800 half-gallons × $2.50) Byproduct: Pulp and peel Cost of goods sold Main product: Juice (2800 half-gallons × $1.80) Gross margin Gross-margin percentage ($1,960 ÷ $7,000) Inventoriable costs (end of period): Main product: Juice (200 half-gallons × $1.80) = $360 Byproduct: Pulp and peel (40 pounds × $2.00) = $80 2.

$7,000 0 7,000 5,040 $1,960 28.00%

Byproduct recognized at time of sale: Joint cost to be charged to main product = Total joint cost = $7,200 $7, 200 Inventoriable cost of main product = = $2.40 per half-gallon 1,500×2 Inventoriable cost of byproduct = $0 Gross Margin Calculation under Sales Method Revenues Main product: Juice (2800 half-gallons × $2.50) $7,000 Byproduct: Pulp and peel (860 pounds × $2.00) 1,720 8,720 Cost of goods sold Main product: Juice (2800 half-gallons × $2.40) 6,720 Gross margin $2,000 Gross-margin percentage ($2,000 ÷ $8,720) 22.94% Inventoriable costs (end of period): Main product: Juice (200 half-gallons × $2.40) = $480 Byproduct: Pulp and peel (40 pounds × $ 0) = $ 0

3. The production method recognizes the byproduct cost as inventory in the period it is produced. This method sets the cost of the byproduct inventory equal to its net realizable value. When the byproduct is sold, inventory is reduced without being expensed through the income statement. The sales method associates all of the production cost with the main product. Under this method, the byproduct has no inventoriable cost and is recognized only when it is sold.


16-27 (40 min.) Alternative methods of joint-cost allocation, product-mix decisions. A diagram of the situation is in Solution Exhibit 16-27. 1.

Computation of joint-cost allocation proportions: a.

Sales Value of Total Production at Splitoff A $ 84,000 B 72,000 C 24,000 D 60,000 $240,000

Weighting 84 ÷ 240 = 0.35 72 ÷ 240 = 0.30 24 ÷ 240 = 0.10 60 ÷ 240 = 0.25 1.00

Allocation of $96,000 Joint Costs $33,600 28,800 9,600 24,000 $96,000

b.

A B C D

Physical Measure of Total Production 322,400 gallons 119,600 gallons 52,000 gallons 26,000 gallons 520,000 gallons

Weighting 322.4 ÷ 520 = 0.62 119.6 ÷ 520 = 0.23 52.0 ÷ 520 = 0.10 26.0 ÷ 520 = 0.05 1.00


c. Final Sales Value of Total Separable Production Costs Super A $300,000 $249,600 Super B 160,000 102,400 C 24,000 – Super D 160,000 152,000

Net Realizable Value at Splitoff Weighting $ 50,400 50.4 ÷ 140 = 0.36 57,600 57.6 ÷ 140 = 0.41 24,000 24.0 ÷ 140 = 0.17 8,000 8.0 ÷ 140 = 0.06 $140,000 1.00



Computation of gross-margin percentages: a. Sales value at splitoff method:

Revenues Joint costs Separable costs Total cost of goods sold Gross margin Gross-margin percentage

Super A $300,000 33,600 249,600 283,200 $ 16,800 5.6%

Super B $160,000 28,800 102,400 131,200 $ 28,800 18%

C $24,000 9,600 0 9,600 $14,400 60%

Super D Total $160,000 $644,000 24,000 96,000 152,000 504,000 176,000 600,000 $ (16,000) $ 44,000 (10%) 6.83%

Super B $160,000 22,080 102,400 124,480 $ 35,520 22.2%

C $24,000 9,600 0 9,600 $14,400 60%

Super D Total $160,000 $644,000 4,800 96,000 152,000 504,000 156,800 600,000 $ 3,200 $ 44,000 2% 6.83%

Super B $160,000 39,360 102,400 141,760 $ 18,240 11.4%

C $24,000 16,320 0 16,320 $ 7,680 32%

Super D Total $160,000 $644,000 5,760 96,000 152,000 504,000 157,760 600,000 $ 2,240 $ 44,000 1.4% 6.83%

b. Physical-measure method:


Super A $300,000 59,520 249,600 309,120 $ (9,120) (3.04%)

c. Net realizable value method:


Super A $300,000 34,560 249,600 284,160 $ 15,840 5.28%

Summary of gross-margin percentages: Joint-Cost Allocation Method Sales value at splitoff Physical measure Net realizable value

Super A 5.60% 3.04% 5.28%

Super B 18.00% 22.20% 11.40%

C 60.00% 60.00% 32.00%

Super D (10.00)% 2.00% 1.40%


2.

Further Processing of A into Super A: Incremental revenue, $300,000 – $84,000 Incremental costs Incremental operating loss from further processing

$216,000 249,600 $ (33,600)

Further processing of B into Super B: Incremental revenue, $160,000 – $72,000 Incremental costs Incremental operating loss from further processing

$ 88,000 102,400 $ (14,400)

Further Processing of D into Super D: Incremental revenue, $160,000 – $60,000 Incremental costs Incremental operating loss from further processing

$ 100,000 152,000 $ (52,000)

Operating income can be increased by $100,000 if A,B and D are sold at their splitoff point rather than processing them further into Super A, Super B and Super D.


Revenues at Splitoff and Separable Costs

Joint Costs

A, 322 400 gallons Revenue = $84 000 B, 119 600 gallons Revenue = $72 000 Processing $96 000

Processing $249 600

Super A $300 000

Processing $102 400

Super B $160 000

Processing $152 000

Super D $160 000

C, 52 000 gallons Revenue = $24 000 D, 26 000 gallons Revenue = $60 000

Splitoff Point


16-28 (40–60 min.) Comparison of alternative joint-cost allocation methods, furtherprocessing decision, chocolate products.

Joint Costs $30,000

Separable Costs

ChocolatePowder Liquor Base

Cocoa Beans

Processing $12,750

Chocolate Powder

Processing

Milk-Chocolate Liquor Base

Processing $26,250

Milk Chocolate

SPLITOFF POINT

1a.

Sales value at splitoff method: ChocolatePowder/ Liquor Base Sales value of total production at splitoff, 600 $21; 900 $26 Weighting, $12,600; $23,400 $36,000 Joint costs allocated, 0.35; 0.65 $30,000

MilkChocolate/ Liquor Base

Total

$12,600 0.35

$23,400 0.65

$36,000

$10,500

$19,500

$30,000

1b. Physical-measure method: Physical measure of total production (15,000 1,500) 60; 90 Weighting, 600; 900 1,500 Joint costs allocated, 0.40; 0.60 $30,000

600 gallons 0.40 $12,000

900 gallons 0.60

1,500 gallons

$18,000


$30,000

1c.

Net realizable value method: ChocolatePowder

Final sales value of total production, 6,000 $4; 10,200 $5 Deduct separable costs Net realizable value at splitoff point Weighting, $11,250; $24,750 $36,000 Joint costs allocated, 0.3125; 0.6875 $30,000 d.

MilkChocolate

$24,000 12,750 $11,250 0.3125 $ 9,375

Total

$51,000 26,250 $24,750 0.6875

$75,000 39,000 $36,000

$20,625

$30,000


Step 1: Final sales value of total production, (6,000 $4) + (10,200 $5) Deduct joint and separable costs, ($30,000 + $12,750 + $26,250) Gross margin Gross-margin percentage ($6,000 ÷ $75,000)

$75,000 69,000 $ 6,000 8%

Step 2: ChocolatePowder Final sales value of total production, 6,000 $4; 10,200 $5 Deduct gross margin, using overall gross-margin percentage of sales (8%) Total production costs

MilkChocolate

Total

$24,000

$51,000

$75,000

1,920 22,080

4,080 46,920

6,000 69,000

12,750 $ 9,330

26,250 $20,670

39,000 $30,000

Step 3: Deduct separable costs Joint costs allocated


2. a.

b.

c.

Revenues Joint costs Separable costs Total cost of goods sold Gross margin

ChocolatePowder $24,000 10,500 12,750 23,250 $ 750

Gross-margin percentage

3.125%


$24,000 12,000 12,750 24,750 $ (750)


(3.125)%


d.

3.

$24,000 9,375 12,750 22,125 $ 1,875 7.812%

MilkChocolate $51,000 19,500 26,250 45,750 $ 5,250

Total $75,000 30,000 39,000 69,000 $ 6,000

10.294% $51,000 18,000 26,250 44,250 $ 6,750 13.235% $51,000 20,625 26,250 46,875 $ 4,125 8.088%

8% $75,000 30,000 39,000 69,000 $ 6,000 8% $75,000 30,000 39,000 69,000 $ 6,000 8%


$24,000 9,330 12,750 22,080 $ 1,920

$51,000 20,670 26,250 46,920 $ 4,080

$75,000 30,000 39,000 69,000 $ 6,000


8%

8%

8%

Further processing of chocolate-powder liquor base into chocolate powder: Incremental revenue, $24,000 – $12,600 ($21× 600) $11,400 Incremental costs 12,750 Incremental operating income from further processing $ (1,350) Further processing of milk-chocolate liquor base into milk chocolate: Incremental revenue, $51,000 – $23,400 ($26× 900) $27,600 Incremental costs 26,250 Incremental operating income from further processing $ 1,350

Chocolate Factory should continue to process milk-chocolate liquor base into milk chocolate. However, it could increase operating income by $1,350 (to $7,350) if it sold chocolate-powder liquor base at the splitoff point rather than process it into chocolate powder.


16-29 (30 min.) Joint-cost allocation, process further or sell. A diagram of the situation is in Solution Exhibit 16-29. 1. a. Sales value at splitoff method.

Studs (Building) Decorative Pieces Posts Totals

Monthly Unit Output 75,000 5,000 20,000

Selling Price Per Unit $ 8 60 20

Sales Value of Total Prodn. at Splitoff $ 600,000 300,000 400,000 $1,300,000

Weighting 46.1539% 23.0769 30.7692 100.0000%

Joint Costs Allocated $ 461,539 230,769 307,692 $1,000,000

Physical Measure of Total Prodn. 75,000 5,000 20,000 100,000

Weighting 75.00% 5.00 20.00 100.00%


Net Realizable Value at Splitoff $ 600,000 350,000b 400,000 $1,350,000

Weighting 44.4445% 25.9259 29.6296 100.0000%


b. Physical measure method.

Studs (Building) Decorative Pieces Posts Totals

c. Net realizable value method.

Studs (Building) Decorative Pieces Posts Totals a b

Monthly Units of Total Prodn. 75,000 4,500a 20,000

Fully Processed Selling Price per Unit $ 8 100 20

5,000 monthly units of output – 10% normal spoilage = 4,500 good units. 4,500 good units $100 = $450,000 – Further processing costs of $100,000 = $350,000

2. Presented below is an analysis for Sonimad Sawmill, Inc., comparing the processing of decorative pieces further versus selling the rough-cut product immediately at splitoff:

Monthly unit output Less: Normal further processing shrinkage Units available for sale Final sales value (4,500 units $100 per unit) Less: Sales value at splitoff Incremental revenue Less: Further processing costs Additional contribution from further processing

Units 5,000 500 4,500

Dollars

$450,000 300,000 150,000 100,000 $ 50,000


3. Assuming Sonimad Sawmill, Inc., announces that in six months it will sell the rough-cut product at splitoff due to increasing competitive pressure, behavior that may be demonstrated by the skilled labor in the planing and sizing process include the following: lower quality, reduced motivation and morale, and job insecurity, leading to nonproductive employee time looking for jobs elsewhere. Management actions that could improve this behavior include the following: Improve communication by giving the workers a more comprehensive explanation as to the reason for the change so they can better understand the situation and bring out a plan for future operation of the rest of the plant. The company can offer incentive bonuses to maintain quality and production and align rewards with goals. The company could provide job relocation and internal job transfers. SOLUTION EXHIBIT 16-29 Separable Costs

Joint Costs $1,000,000

Studs $8 per unit

Raw Decorative Pieces $60 per unit

Processing

Processing $100 000

Decorative Pieces $100 per unit

Posts $20 per unit

Splitoff Point


16-30 (40 min.) Joint-cost allocation. 1. Joint Costs $31,680

Separable Costs

Butter

Processing $1.60 per pound

Spreadable Butter

Milk Processing

Processing $0.35 per pint

Buttermilk

Buttermilk

SPLITOFF POINT

a. Physical-measure method:

Physical measure of total production (12,000 gal × 3; 12,000 gal × 9) Weighting, 36,000; 108,000 144,000 Joint costs allocated, 0.25; 0.75 × $31,680

Butter

Buttermilk

Total

36,000 cups 0.25

108,000 cups 0.75

144,000 cups

$7,920

$23,760

$31,680

Butter

Buttermilk

Total

$39,600 0.55

$32,400 0.45

$72,000

b. Sales value at splitoff method: Sales value of total production at splitoff, 18,000 lbs × $2.20; 27,000 quarts × $1.20 Weighting, $39,600; $32,400 $72,000 Joint costs allocated, 0.55; 0.45 $31,680

$17,424

$14,256

$31,680


c.

Net realizable value method: Butter

Final sales value of total production, 36,000 tubs $2.30; 27,000 quarts $1.20 Deduct separable costs Net realizable value Weighting, $54,000; $32,400 $86,400 Joint costs allocated, 0.625; 0.375 $31,680 d.

Buttermilk

Total

$82,800 28,800 $54,000 0.625

$32,400 0 $32,400 0.375

$115,200 28,800 $ 86,400

$19,800

$11,880

$ 31,680


Step 1: Final sales value of total production (see 1c.) Deduct joint and separable costs ($31,680 + $28,800) Gross margin Gross-margin percentage ($54,720 ÷ $115,200)

$115,200 60,480 $ 54,720 47.50%

Step 2:

Final sales value of total production Deduct gross margin, using overall gross-margin percentage of sales (47.50%) Total production costs

Butter Buttermilk $82,800 $32,400


Total $115,200

39,330 43,470

15,390 17,010

54,720 60,480

28,800 $14,670

0 $17,010

28,800 $ 31,680


2.

Advantages and disadvantages:

- Physical-Measure Advantage: Low information needs. Only knowledge of joint cost and physical distribution is needed. Disadvantage: Allocation is unrelated to the revenue-generating ability of products. - Sales Value at Splitoff Advantage: Considers market value of products as basis for allocating joint cost. Relative sales value serves as a proxy for relative benefit received by each product from the joint cost. Disadvantage: Uses selling price at the time of splitoff even if product is not sold by the firm in that form. Selling price may not exist for product at splitoff. - Net Realizable Value Advantages: Allocates joint costs using ultimate net value of each product; applicable when the option to process further exists Disadvantages: High information needs; Makes assumptions about expected outcomes of future processing decisions - Constant Gross-Margin percentage method Advantage: Since it is necessary to produce all joint products, they all look equally profitable. Disadvantages: High information needs. All products are not necessarily equally profitable; method may lead to negative cost allocations so that unprofitable products are subsidized by profitable ones. 3. When selling prices for all products exist at splitoff, the sales value at split off method is the preferred technique. It is a relatively simple technique that depends on a common basis for cost allocation – revenues. It is better than the physical method because it considers the relative market values of the products generated by the joint cost when seeking to allocate it (which is a surrogate for the benefits received by each product from the joint cost). Further, the sales value at splitoff method has advantages over the NRV method and the constant gross margin percentage method because it does not penalize managers by charging more for developing profitable products using the output at splitoff, and it requires no assumptions about future processing activities and selling prices.


16-31 (10 min.) Further processing decision (continuation of 16-30). 1.and 2. The decision about which combination of products to produce is not affected by the method of joint cost allocation. For both the sales value at splitoff and physical measure methods, the relevant comparisons are as shown below:

Revenue if sold at splitoff Process further NRV Profit (Loss) from processing further

Butter $39,600a 54,000c $15,600

Buttermilk $ 32,400b 21,600d $(10,800)

a

18,000 lbs × $2.20 = $39,600 27,000 quarts × $1.2 = $32,400 c 36,000 tubs × $2.3 – 18,000 lbs × $1.6 = $54,000 d 54,000 pints × $0.75 – 54,000 pints × $.35 = $21,600 b

To maximize profits, Elsie should process butter further into spreadable butter. However, Elsie should sell the buttermilk at the splitoff point in quart containers. The extra cost to convert to pint containers ($0.35 per pint × 2 pints per quart = $0.70 per quart) exceeds the increase in selling price ($0.75 per pint × 2 pints per quart = $1.50 per quart – $1.20 original price = $0.30 per quart) and leads to a loss of $10,800. 3. The decision to sell a product at split off or to process it further should have nothing to do with the allocation method chosen. For each product, you need to compare the revenue from selling the product at split off to the NRV from processing the product further. Other things being equal, management should choose the higher alternative. The total joint cost is the same regardless of the alternative chosen and is therefore irrelevant to the decision.


16-32 (20 min.) Joint-cost allocation with a byproduct.

1. Sales value at splitoff method: Byproduct recognized at time of production method Rubber Floor Mats Car Mats Shreds (lbs) Products manufactured 31,250a 93,750b 50,000c Products sold 25,000 85,000 43,000 Ending inventory 6,250 8,750 7,000 a 25 floor mats/100 tires = .25 floor mats per tire 125,000 tires = 31,250 floor mats b 75 car mats/100 tires = .75 car mats per tire 125,000 tires = 93,750 car mats c (125,000 tires/100) 40 lbs = 50,000 lbs rubber shreds Joint cost to be charged to joint products = Joint Cost – NRV of Byproduct = $600,000 – (50,000 lbs 0.70 per lb) = $600,000 – $35,000 = $565,000 Floor Mats Sales value of mats at splitoff, 31,250 × $12; 93,750 × $6 Weighting, $375,000; $562,500 $937,500 Joint costs allocated, 0.40; 0.60 × $565,000

Revenues, 25,000 × $12; 85,000 × $6 Cost of goods sold Joint costs allocated, 0.40; 0.60 × $565,000 Less: Ending inventory Cost of goods sold Gross margin b c

Car Mats

Total

$375,000 0.40 $226,000

$562,500 0.60 $339,000

$937,500

Floor Mats $300,000

Car Mats $510,000

Total $810,000

226,000 (45,200)b 180,800 $119,200

339,000 (31,640)c 307,360 $202,640

565,000 (76,840) 488,160 $321,840

$565,000

6,250 × $226,000/31,250 = $45,200 8,750 × $339,000/93,750 = $31,640

2. Sales value at splitoff method: Byproduct recognized at time of sale method Joint cost to be charged to joint products = Joint Cost = $600,000

Sales value of mats at splitoff, 31,250 × $12; 93,750 × $6 Weighting, $375,000; $562,500 $937,500 Joint costs allocated, 0.40; 0.60 × $600,000

Floor Mats

Car Mats

Total

$375,000 0.40 $240,000

$562,500 0.60 $360,000

$937,500 $600,000


Revenues, 25,000 × $12; 85,000 × $6 Cost of goods sold Joint costs allocated, 0.40; 0.60 × $600,000 Less: Ending inventory Cost of goods sold Gross margin

Floor Mats $300,000

Car Mats $510,000

240,000 (48,000)e 192,000 $108,000

360,000 (33,600)f 326,400 $183,600

Rubber Shreds $30,100d

Total $840,100

$30,100

600,000 (81,600) 518,400 $321,700

d

43,000 lbs × $0.70 per lb. = $30,100 6,250 × $240,000/31,250 = $48,000 f 8,750 × $360,000/93,750 = $33,600 e

3.

The production method of accounting for the byproduct is only appropriate if The Mat Place is positive they can sell the byproduct at the expected selling price. Moreover, The Mat Place should view the byproduct’s contribution to the firm as material enough to find it worthwhile to record and track any inventory that may arise. The sales method is appropriate if either the disposition of the byproduct is unsure or the selling price is unknown, or if the amounts involved are so negligible as to make it economically infeasible for The Mat Place to keep track of byproduct inventories.


16-33 (15 min.) Byproduct journal entries (continuation of 16-32). 1. Byproduct – production method journal entries i) At time of production: Work-in-process Inventory Accounts Payable, etc.

600,000 600,000

For byproduct: Finished Goods Inv – Shreds Work-in-process Inventory

35,000

For Joint Products Finished Goods Inv – Floor Finished Goods Inv – Car Work-in-process Inventory

226,000 339,000

ii) At time of sale: For byproduct Cash or A/R Finished Goods Inv – Shreds For Joint Products Cash or A/R Sales Revenue – Floor Sales Revenue – Car

35,000

565,000

30,100 30,100

810,000 300,000 510,000

Cost of goods sold - Floor Cost of goods sold – Car Finished Goods Inv – Floor Finished Goods Inv – Car

180,800 307,360 180,800 307,360


2. Byproduct – sales method journal entries i) At time of production: Work-in-process Inventory Accounts Payable, etc.

600,000 600,000

For byproduct: No entry For Joint Products Finished Goods Inv – Floor Finished Goods Inv – Car Work-in-process Inventory ii) At time of sale For byproduct Cash or A/R Sales Revenue – Shreds For Joint Products Cash or A/R Sales Revenue – Floor Sales Revenue – Car

240,000 360,000 600,000

30,100 30,100

810,000 300,000 510,000

Cost of goods sold - Floor Cost of goods sold - Car Finished Goods Inv – Floor Finished Goods Inv – Car

192,000 326,400 192,000 326,400


16-34 (40 min.) Process further or sell, byproduct. 1. The analysis shown below indicates that it would be more profitable for Rochester Mining Company to continue to sell bulk raw coal without further processing. This analysis ignores any value related to coal fines. It also assumes that the costs of loading and shipping the bulk raw coal on river barges will be the same whether Rochester sells the bulk raw coal directly or processes it further. Incremental sales revenues: Sales revenue after further processing (8,820,000a tons $35) Sales revenue from bulk raw coal (9,800,000 tons $27) Incremental sales revenue

$308,700,000 264,600,000 44,100,000

Incremental costs: Direct labor Supervisory personnel Heavy equipment costs ($15,000 12 months) Sizing and cleaning (9,800,000 tons $3.60) Outbound rail freight (8,820,000 tons 60 tons) Incremental costs Incremental gain (loss)

820,000 225,000 180,000 35,280,000 30,870,000 67,375,000 $ (23,275,000)

a

9,800,000 tons

$210 per car

(1– 0.10)

2. The cost of producing the raw coal is irrelevant to the decision to process further or not. As we see from requirement 1, the cost of producing raw coal does not enter any of the calculations related to either the incremental revenues or the incremental costs of further processing. The answer would the same as in requirement 1: do not process further. 3. The analysis shown below indicates that the potential revenue from the coal fines byproduct would result in additional revenue, ranging between $8,820,000 and $18,375,000, depending on the market price of the fines. Coal fines

= = =

75% of 10% of raw bulk tonnage 0.75 (9,800,000 .10) 735,000 tons

Potential incremental income from preparing and selling the coal fines:

Incremental income per ton (Market price – Incremental costs) Incremental income ($12; $25 735,000)

Minimum $12 ($16 – $4) $8,820,000

Maximum $25 ($27 – $2) $18,375,000

The incremental loss from sizing and cleaning the raw coal is $23,275,000, as calculated in requirement 1. Analysis indicates that relative to selling bulk raw coal, the effect of further


processing and selling coal fines is still not enough to make profits. Hence, further processing is not preferred. Note that other than the financial implications, some factors that should be considered in evaluating a sell-or-process-further decision include: Stability of the current customer market for raw coal and how it compares to the market for sized and cleaned coal. Storage space needed for the coal fines until they are sold and the handling costs of coal fines. Reliability of cost (e.g., rail freight rates) and revenue estimates, and the risk of depending on these estimates. Timing of the revenue stream from coal fines and impact on the need for liquidity. Possible environmental problems, i.e., dumping of waste and smoke from unprocessed coal. 16-35 (30 min.) Joint Cost Allocation 1. (a) The Net Realizable Value Method allocates joint costs on the basis of the relative net realizable value (final sales value minus the separable costs of production and marketing). Joint costs would be allocated as follows:

Final sales value of total production Deduct separable costs Net realizable value at splitoff point Weighting ($12,950; $24,050 ÷ $37,000) Joint costs allocated (0.35; 0.65 × $28,900) Total production costs ($10,115 + $1,050; $18,785 + $2,450) Production costs per unit ($11,165÷ 400 ; $21,235 ÷ 600 units)

Standard Module $14,000 1,050 $12,950 0.35 $10,115

Deluxe Module $26,500 2,450 $24,050 0.65 $18,785

$11,165

$21,235

$ 27.91

$ 35.39

Total $40,500 3,500 $37,000 $28,900 $32,400

(b) The constant gross-margin percentage NRV method allocates joint costs in such a way that the overall gross-margin percentage is identical for all individual products as follows: Step 1 Final sales value of total production: (Standard $14,000; Deluxe, $26,500) Deduct joint and separable costs (Joint, $28,900 + Separable Standard $1,050 + Separable Deluxe, $2,450) Gross margin Gross-margin percentage ($8,100 ÷ $40,500)

$40,500 32,400 $ 8,100 20.0%


Step 2

Final sales value of total production Deduct gross margin using overall gross margin percentage (20.0%) Total production costs

Standard Module $14,000

Deluxe Module $26,500

Total $40,500

2,800 11,200

5,300 21,200

8,100 32,400

1,050 $10,150

2,450 $18,750

3,500 $28,900

$11,200

$ 21,200

$32,400

$ 28.00

$35.33

Step 3 Deduct separable costs Joint costs allocated Total production costs ($10,150 + $1,050; $18,750 + $2,450) Production costs per unit ($11,200 ÷ 400 units; $21,200 ÷ 600 units)

(c) The physical measure method allocates joint costs on the basis of the relative proportions of total production at the splitoff point, using a common physical measure such as the number of bits produced for each type of module. Allocation on the basis of the number of bits produced for each type of module follows:

Physical measure of total production (bits) Weighting (200,000; 600,000 ÷ 800,000) Joint costs allocated (0.25; 0.75 × $28,900) Total production costs ($7,225 + $1,050; $21,675 + $2,450) Production costs per unit ($8,275 ÷ 400 units; $24,125 ÷ 600 units)

Standard Module/ Chips

Deluxe Module/ Chips

200,000 0.25 $ 7,225

600,000 0.75 $21,675

800,000

$ 8,275

$24,125

$32,400

$ 20.69

$ 40.21

Total

$28,900

Each of the methods for allocating joint costs has weaknesses. Because the costs are joint in nature, managers cannot use the cause-and-effect criterion in making this choice. Managers cannot be sure what causes the joint costs attributable to individual products. The net realizable value (NRV) method (or sales value at splitoff method) is widely used when selling price data are available. The NRV method provides a meaningful common denominator to compute the weighting factors. It allocates costs on the ability-to-pay principle. It is preferred to the constant gross-margin percentage method which also uses sales values to allocate costs to products. That’s because the constant gross-margin percentage method makes the further tenuous assumption that all products have the same ratio of cost to sales value.


The physical measure method bears little relationship to the revenue-producing power of the individual products. Several physical measures could be used such as the number of chips and the number of good bits. In each case, the physical measure only relates to one aspect of the chip that contributes to its value. The value of the module as determined by the marketplace is a function of multiple physical features. Another key question is whether the physical measure chosen portrays the amount of joint resources used by each product. It is possible that the resources required by each type of module depend on the number of good bits produced during chip manufacturing. But this cause-and-effect relationship is hard to establish. MMC should use the NRV method. But the choice of method should have no effect on their current control and measurement systems. 2. The correct approach in deciding whether to process further and make DRAM modules from the standard modules is to compare the incremental revenue with the incremental costs: Incremental revenue from making DRAMs ($46 × 350) – $14,000 Incremental costs of DRAMs, further processing Incremental operating income from converting standard modules into DRAMs

$2,100 1,600 $ 500

It is profitable to extend processing and to incur additional costs on the standard module to convert it into a DRAM module as long as the incremental revenue exceeds incremental costs. The amount of joint costs incurred up to splitoff ($28,900) –– and the fact that these joint costs are allocated using the physical-measure method –– are irrelevant to the decision of whether to process further and make DRAMS. That’s because the joint costs of $28,900 remain the same whether or not further processing is done on the standard modules.


16-36 (60 min.) Joint cost allocation, ending w ork in process inventories a. Sales value at splitoff method: Extreme Chocolate Sales value of total production at splitoff, 5,000 × $2; 3,000 × $2 Weighting, $10,000; $6,000 $16,000 Joint costs allocated, 0.625; 0.375 $5,200 b.

Very Strawberry

$10,000 0.625

Total

$6,000

$16,000

$1,950

$5,200

0.375 $ 3,250

Net realizable value method:

Since some of the inventory is still in process, to determine total separable costs associated with total production, a cost per equivalent whole gallon must be computed. Chocolate: Production started Gallons in ending work in process Gallons started and completed

5,000 gallons 1,200 3,800

Gallons in ending work in process Percent complete Equivalent whole gallons completed

1,200 30% 360

Total equivalent gallons completed Processing cost for the month

4,160 (3,800 + 360) $9,152

Cost per equivalent whole gallon

$2.20 ($9,152 ÷ 4,160)

Total separable costs associated with 5,000 gallons = 5,000 × $2.20 = $11,000 Strawberry: Production started Gallons in ending work in process Gallons started and completed

3,000 gallons 200 2,800

Gallons in ending work in process Percent complete Equivalent whole gallons completed

200 80% 160

Total equivalent gallons completed Processing cost for the month

2,960 (2,800 + 160) $8,880

Cost per equivalent whole gallon

$3.00 ($8,880 ÷ 2,960)

Total separable costs associated with 3,000 gallons = 3,000 × $3.00 = $9,000


Final sales value, 5,000 × $4; 3,000 × $5 Deduct final separable costs Net realizable value Weighting, $9,000; $6,000 $15,000 Joint costs allocated, 0.60; 0.40 $5,200

Extreme Chocolate $20,000 11,000 $ 9,000 0.60

Very Strawberry $ 15,000 9,000 $ 6,000 0.40

$3,120

$ 2,080

Total $35,000 20,000 $15,000

$5,200

c. Constant gross-margin percentage NRV method: Step 1: Final sales value of total production, Deduct joint and separable costs, ($5,200 + $20,000) Gross margin Gross-margin percentage ($9,800 ÷ $35,000)

$35,000 25,200 $ 9,800 28%

Step 2:

Final sales value, 5,000 × $4; 3,000 × $5 Deduct gross margin, using overall gross-margin percentage of sales (28%) Total production costs

Extreme Very Chocolate Strawberry $20,000 $15,000

Total $35,000

5,600 14,400

4,200 10,800

9,800 25,200

11,000 $ 3,400

9,000 $ 1,800

20,000 $ 5,200

Step 3: Deduct final separable costs Joint costs allocated 2. Extreme Chocolate Gross Margin before joint cost allocations, $20,000 - $11,000; $15,000 - $9,000

Sales value at splitoff, $9,000 $3,250; $6,000 - $1,950 Net realizable Value, $9,000 – $3,120; $6,000 - $2,080 Constant gross margin % NRV, $9,000 - $3,400; $6,000 $1,800 a $5,750 $20,000 = 28.75% b $4,050 $15,000 = 27.00%

$9,000 Gross Gross Margin Margin %

Very Strawberry

$6,000 Gross Margin

Gross Margin %

$5,750

28.75%a

$4,050

27.00%b

$5,880

29.40%

$3,920

26.13%

$5,600

28.00%

$4,200

28.00%


16-37 (60 min.) Joint cost allocation with further processing, pricing and ethics issues 1. Total joint costs = (15,000 × $12) + (15,000 × $30) = $630,000 a. Sales value at splitoff method: Sales value of total production at splitoff, 12,000 × $76.50; 3,000 × $144 Weighting, $918,000; $432,000 $1,350,000

Alpha

Beta

Total

$918,000 0.68

$432,000 0.32

$1,350,000

Joint costs allocated, 0.68; 0.32 $630,000

$ 428,400

$201,600

$630,000

b. Physical-measure method:

Physical measure of total production (15,000 lbs × 8/10; 15,000 lbs × 2/10) Weighting, 12,000; 3,000 15,000 Joint costs allocated, 0.80; 0.20 × $630,000

c.

Alpha

Beta

Total

12,000 pounds 0.80

3,000 pounds 0.20

15,000 pounds

$504,000

$126,000

$630,000

Net realizable value method: Alphalite

Final sales value of total production, 12,000 $105.00; 3,000 $285.00 Deduct separable costs Net realizable value Weighting, $959,400; $516,600 $1,476,000 Joint costs allocated, 0.65; 0.35 $630,000 d.

$1,260,000 300,600 $ 959,400 0.65 $ 409,500

Betalite $855,000 338,400 $516,600

Total $2,115,000 639,000 $1,476,000

0.35 $220,500

$ 630,000


Step 1: Final sales value of total production, Deduct joint and separable costs, ($630,000 + $639,000) Gross margin Gross-margin percentage ($846,000 ÷ $2,115,000)

$2,115,000 1,269,000 $ 846,000 40%

Step 2: 16-42 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Alpha Final sales value of total production (see 1c.) Deduct gross margin, using overall gross-margin percentage of sales (40%) Total production costs

Beta

Total

$1,260,000

$855,000

$2,115,000

504,000 756,000

342,000 513,000

846,000 1,269,000

300,600 $ 455,400

338,400 $174,600

639,000 $ 630,000


2. Should the company sell Betalite or Ultra-Betalite? Additional revenue from selling Ultra-Betalite Sales value of Ultra-Betalite, 3,000 $360 Sales value of Betalite, 3,000 $285 Additional revenue Additional cost of processing and selling Ultra-Betalite Processing costs, 3,000 $85 Packaging costs, 3,000 $15 Additional costs Additional revenue less additional costs

$1.080,000 855,000 225,000

255.000 45,000 300,000 $

(75,000)

Unified Chemical should sell Betalite and not process it further into Ultra-Betalite. The company would lose $25 per pound ($75,000 ÷ 3,000) if it sold Ultra-Betalite. The company would be indifferent between selling Betalite and Ultra-Betalite at a selling price for the latter of $385 ($360 current price + $25 current loss) per pound. 3. According to the IMA Statement of Ethical Professional Practice, the ethical issues surrounding Danny include: a. Competence – the responsibility to provide decision support information that is accurate. b. Credibility – the responsibility to disclose all relevant information that could reasonably influence the intended user’s understanding of the analysis and recommendations. Danny should follow the guidelines outlined in the IMA’s ―Resolution of Conflict‖. From a practical standpoint, Danny should present the numbers as calculated above, but include a ―what-if‖ analysis that highlights the difference if costs were reduced by, say, 5%, 10% or 20%. Sally could be called on at this point to present her best estimate of the likelihood of this decrease in costs.


CHAPTER 17 PROCESS COSTING 17-1 Industries using process costing in their manufacturing area include chemical processing, oil refining, pharmaceuticals, plastics, brick and tile manufacturing, semiconductor chips, beverages, and breakfast cereals. 17-2 Process costing systems separate costs into cost categories according to the timing of when costs are introduced into the process. Often, only two cost classifications, direct materials and conversion costs, are necessary. Direct materials are frequently added at one point in time, often the start or the end of the process. All conversion costs are added at about the same time, but in a pattern different from direct materials costs. Conversion costs are often added throughout the process, which can of any length of time, lasting from seconds to several months. 17-3 Equivalent units is a derived amount of output units that takes the quantity of each input (factor of production) in units completed or in incomplete units in work in process, and converts the quantity of input into the amount of completed output units that could be made with that quantity of input. Each equivalent unit is comprised of the physical quantities of direct materials or conversion costs inputs necessary to produce output of one fully completed unit. Equivalent unit measures are necessary since all physical units are not completed to the same extent at the same time. 17-4 The accuracy of the estimates of completion depends on the care and skill of the estimator and the nature of the process. Semiconductor chips may differ substantially in the finishing necessary to obtain a final product. The amount of work necessary to finish a product may not always be easy to ascertain in advance. 17-5 The five key steps in process costing follow: Step 1: Summarize the flow of physical units of output. Step 2: Compute output in terms of equivalent units. Step 3: Summarize total costs to account for. Step 4: Compute cost per equivalent unit. Step 5: Assign total costs to units completed and to units in ending work in process. 17-6

Three inventory methods associated with process costing are: Weighted average. First-in, first-out. Standard costing.

17-7 The weighted-average process-costing method calculates the equivalent-unit cost of all the work done to date (regardless of the accounting period in which it was done), assigns this cost to equivalent units completed and transferred out of the process, and to equivalent units in ending work-in-process inventory.


17-8 FIFO computations are distinctive because they assign the cost of the previous accounting period’s equivalent units in beginning work-in-process inventory to the first units completed and transferred out of the process and assign the cost of equivalent units worked on during the current period first to complete beginning inventory, next to start and complete new units, and finally to units in ending work-in-process inventory. In contrast, the weighted-average method costs units completed and transferred out and in ending work in process at the same average cost. 17-9 FIFO should be called a modified or departmental FIFO method because the goods transferred in during a given period usually bear a single average unit cost (rather than a distinct FIFO cost for each unit transferred in) as a matter of convenience. 17-10 A major advantage of FIFO is that managers can judge the performance in the current period independently from the performance in the preceding period. 17-11 The journal entries in process costing are basically similar to those made in job-costing systems. The main difference is that, in process costing, there is often more than one work-inprocess account––one for each process. 17-12 Standard-cost procedures are particularly appropriate to process-costing systems where there are various combinations of materials and operations used to make a wide variety of similar products as in the textiles, paints, and ceramics industries. Standard-cost procedures also avoid the intricacies involved in detailed tracking with weighted-average or FIFO methods when there are frequent price variations over time. 17-13 There are two reasons why the accountant should distinguish between transferred-in costs and additional direct materials costs for a particular department: (a) All direct materials may not be added at the beginning of the department process. (b) The control methods and responsibilities may be different for transferred-in items and materials added in the department. 17-14 No. Transferred-in costs or previous department costs are costs incurred in a previous department that have been charged to a subsequent department. These costs may be costs incurred in that previous department during this accounting period or a preceding accounting period. 17-15 Materials are only one cost item. Other items (often included in a conversion costs pool) include labor, energy, and maintenance. If the costs of these items vary over time, this variability can cause a difference in cost of goods sold and inventory amounts when the weighted-average or FIFO methods are used. A second factor is the amount of inventory on hand at the beginning or end of an accounting period. The smaller the amount of production held in beginning or ending inventory relative to the total number of units transferred out, the smaller the effect on operating income, cost of goods sold, or inventory amounts from the use of weighted-average or FIFO methods.


17-16 (25 min.) Equivalent units, zero beginning inventory. 1.

Direct materials cost per unit ($750,000 ÷ 10,000) Conversion cost per unit ($798,000 ÷ 10,000) Assembly Department cost per unit

$ 75.00 79.80 $154.80

2a. Solution Exhibit 17-16A calculates the equivalent units of direct materials and conversion costs in the Assembly Department of Nihon, Inc. in February 2012. Solution Exhibit 17-16B computes equivalent unit costs. 2b. Direct materials cost per unit Conversion cost per unit Assembly Department cost per unit

$ 75 84 $159

3. The difference in the Assembly Department cost per unit calculated in requirements 1 and 2 arises because the costs incurred in January and February are the same but fewer equivalent units of work are done in February relative to January. In January, all 10,000 units introduced are fully completed resulting in 10,000 equivalent units of work done with respect to direct materials and conversion costs. In February, of the 10,000 units introduced, 10,000 equivalent units of work is done with respect to direct materials but only 9,500 equivalent units of work is done with respect to conversion costs. The Assembly Department cost per unit is, therefore, higher. SOLUTION EXHIBIT 17-16A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Assembly Department of Nihon, Inc. for February 2012. (Step 1) Physical Units 0 10,000 10,000

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period Work in process, ending* (given) 1,000 100%; 1,000 50% Accounted for Equivalent units of work done in current period

9,000 1,000

(Step 2) Equivalent Units Direct Conversion Materials Costs

9,000 1,000

9,000 500

10,000 10,000

9,500

*Degree of completion in this department: direct materials, 100%; conversion costs, 50%.


SOLUTION EXHIBIT 17-16B Compute Cost per Equivalent Unit, Assembly Department of Nihon, Inc. for February 2012.

(Step 3) Costs added during February Divide by equivalent units of work done in current period (Solution Exhibit 17-l6A) Cost per equivalent unit

Total Production Direct Conversion Costs Materials Costs $1,548,000 $750,000 $798,000

$

10,000 75 $

9,500 84

17-17 (20 min.) Journal entries (continuation of 17-16). 1.

2.

3.

Work in Process––Assembly Accounts Payable To record $750,000 of direct materials purchased and used in production during February 2012 Work in Process––Assembly Various accounts To record $798,000 of conversion costs for February 2012; examples include energy, manufacturing supplies, all manufacturing labor, and plant depreciation Work in Process––Testing Work in Process––Assembly To record 9,000 units completed and transferred from Assembly to Testing during February 2012 at $159 9,000 units = $1,431,000

750,000 750,000

798,000 798,000

1,431,000 1,431,000

Postings to the Work in Process––Assembly account follow. Work in Process –– Assembly Department Beginning inventory, Feb. 1 0 3. Transferred out to 1. Direct materials 750,000 Work in Process––Testing 2. Conversion costs 798,000 Ending inventory, Feb. 29 117,000

1,431,000


17-18 (25 min.) Zero beginning inventory, materials introduced in middle of process. 1. Solution Exhibit 17-18A shows equivalent units of work done in the current period of Chemical P, 50,000; Chemical Q, 35,000; Conversion costs, 45,000. 2. Solution Exhibit 17-18B summarizes the total Mixing Department costs for July 2012, calculates cost per equivalent unit of work done in the current period for Chemical P, Chemical Q, and Conversion costs, and assigns these costs to units completed (and transferred out) and to units in ending work in process. SOLUTION EXHIBIT 17-18A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Mixing Department of Roary Chemicals for July 2012. (Step 1)

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period Work in process, ending* (given) 15,000 100%; 15,000 0%; 15,000 66 2/3% Accounted for Equivalent units of work done in current period

(Step 2) Equivalent Units

Physical Units Chemical P 0 50,000 50,000 35,000 15,000

35,000

15,000

Chemical Q

Conversion Costs

35,000

0

35,000

10,000

50,000 50,000

35,000

45,000

*Degree of completion in this department: Chemical P, 100%; Chemical Q, 0%; conversion costs, 66 2/3%.


SOLUTION EXHIBIT 17-18B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Mixing Department of Roary Chemicals for July 2012. Total Production Costs (Step 3) Costs added during July Total costs to account for

$455,000 $455,000

(Step 4) Costs added in current period Divide by equivalent units of work done in current period (Solution Exhibit 17-l8A) Cost per equivalent unit (Step 5) Assignment of costs: Completed and transferred out (35,000 units) Work in process, ending (15,000 units) Total costs accounted for

Chemical P

Chemical Q

Conversion Costs

$250,000 $250,000

$70,000 $70,000

$135,000 $135,000

$250,000

$70,000

$135,000

$

$350,000 (35,000*

50,000 5

$

$5)

+ (35,000*

105,000 (15,000† $5) + $250,000 + $455,000

35,000 2

(0† $2) $70,000

$

45,000 3

$2) + (35,000*

$3)

+ (10,000† $3) + $135,000

*Equivalent units completed and transferred out from Solution Exhibit 17-18A, Step 2. † Equivalent units in ending work in process from Solution Exhibit 17-18A, Step 2.

17-19 (15 min.) Weighted-average method, equivalent units. Under the weighted-average method, equivalent units are calculated as the equivalent units of work done to date. Solution Exhibit 17-19 shows equivalent units of work done to date for the Assembly Division of Fenton Watches, Inc., for direct materials and conversion costs. SOLUTION EXHIBIT 17-19 Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing, Assembly Division of Fenton Watches, Inc., for May 2012. (Step 2) (Step 1) Equivalent Units Physical Direct Conversion Flow of Production Units Materials Costs Work in process beginning (given) 80 Started during current period (given) 500 To account for 580 Completed and transferred out during current period 460 460 460 Work in process, ending* (120 60%; 120 30%) 120 72 36 Accounted for 580 ___ ___ Equivalent units of work done to date 532 496 *Degree of completion in this department: direct materials, 60%; conversion costs, 30%.


17-20 (20 min.) Weighted-average method, assigning costs (continuation of 17-19). Solution Exhibit 17-20 summarizes total costs to account for, calculates cost per equivalent unit of work done to date in the Assembly Division of Fenton Watches, Inc., and assigns costs to units completed and to units in ending work-in-process inventory. SOLUTION EXHIBIT 17-20 Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Assembly Division of Fenton Watches, Inc., for May 2012. Total Production Costs $ 584,400 4,612,000 $5,196,400

(Step 3)

Work in process, beginning (given) Costs added in current period (given) Total costs to account for

(Step 4)

Costs incurred to date Divide by equivalent units of work done to date (Solution Exhibit 17-19) Cost per equivalent unit of work done to date

(Step 5)

Assignment of costs: Completed and transferred out (460 units) Work in process, ending (120 units) Total costs accounted for

Direct Materials $ 493,360 3,220,000 $3,713,360

Conversion Costs $ 91,040 1,392,000 $1,483,040

$3,713,360

$1,483,040

$

$4,586,200 610,200 $5,196,400

532 6,980

$

496 2,990

(460* $6,980) + (460* $2,990) (72† $6,980) + (36† $2,990) $3,713,360 + $1,483,040

* †

Equivalent units completed and transferred out from Solution Exhibit 17-19, Step 2. Equivalent units in work in process, ending from Solution Exhibit 17-19, Step 2.


17-21 (15 min.) FIFO method, equivalent units. Under the FIFO method, equivalent units are calculated as the equivalent units of work done in the current period only. Solution Exhibit 17-21 shows equivalent units of work done in May 2012 in the Assembly Division of Fenton Watches, Inc., for direct materials and conversion costs. SOLUTION EXHIBIT 17-21 Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; FIFO Method of Process Costing, Assembly Division of Fenton Watches, Inc., for May 2012.

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period: From beginning work in process§ 80 (100% 90%); 80 (100% 40%) Started and completed 380 100%, 380 100% Work in process, ending* (given) 120 60%; 120 30% Accounted for Equivalent units of work done in current period

(Step 1) Physical Units 80 500 580

(Step 2) Equivalent Units Direct Conversion Materials Costs (work done before current period)

80 380

†

120 ___ 580

8

48

380

380

72

36

460

464

§

Degree of completion in this department: direct materials, 90%; conversion costs, 40%. 460 physical units completed and transferred out minus 80 physical units completed and transferred out from beginning work-in-process inventory. *Degree of completion in this department: direct materials, 60%; conversion costs, 30%. †


17-22 (20 min.) FIFO method, assigning costs (continuation of 17-21). Solution Exhibit 17-22 summarizes total costs to account for, calculates cost per equivalent unit of work done in May 2012 in the Assembly Division of Fenton Watches, Inc., and assigns total costs to units completed and to units in ending work-in-process inventory. SOLUTION EXHIBIT 17-22 Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Assembly Division of Fenton Watches, Inc., for May 2012. Total Production Costs $ 584,400 4,612,000 $5,196,400

(Step 3) Work in process, beginning (given) Costs added in current period (given) Total costs to account for (Step 4) Costs added in current period Divide by equivalent units of work done in current period (Solution Exhibit 17-21) Cost per equiv. unit of work done in current period (Step 5) Assignment of costs: Completed and transferred out (460 units): Work in process, beginning (80 units) Costs added to beginning work in process in current period Total from beginning inventory Started and completed (380 units) Total costs of units completed and transferred out Work in process, ending (120 units) Total costs accounted for

$ 584,400

Direct Materials $ 493,360 3,220,000 $3,713,360


$3,220,000 460

$1,392,000 464

$

$

7,000

$493,360

+

3,000

$91,040

200,000 (8* $7,000) + (48* $3,000) 784,400 3,800,000 (380† $7,000) + (380† $3,000) 4,584,400 612,000 (72# $7,000) + (36# $3,000) $5,196,400 $3,713,360 + $1,483,040

*

Equivalent units used to complete beginning work in process from Solution Exhibit 17-21, Step 2. Equivalent units started and completed from Solution Exhibit 17-21, Step 2. # Equivalent units in work in process, ending from Solution Exhibit 17-21, Step 2. †


17-23 (20-25 min.) Operation costing. 1. To obtain the conversion-cost rates, divide the budgeted cost of each operation by the number of packages that are expected to go through that operation.

Mixing Shaping Cutting Baking Slicing Packaging

Budgeted Conversion Cost $ 9,040 1,625 720 7,345 650 8,475

Budgeted number of packages 11,300 6,500 4,800 11,300 6,500 11,300

Conversion Cost per Package $0.80 0.25 0.15 0.65 0.10 0.75

2. Work Order #215 Dinner Roll 1,200 $ 660 960 0 180 780 0 900 $3,480

Bread type: Quantity: Direct Materials Mixing Shaping Cutting Baking Slicing Packaging Total

Work Order #216 Multigrain Loaves 1,400 $1,260 1,120 350 0 910 140 1,050 $4,830

The direct materials costs per unit vary based on the type of bread ($2,640 ÷ 4,800 = $0.55 for the dinner rolls, and $5,850 ÷ 6,500 = $0.90 for the multi-grain loaves). Conversion costs are charged using the rates computed in part (1), taking into account the specific operations that each type of bread actually goes through. 3.

Work order #215 (Dinner rolls):

Work order #216 (Mulit-grain loaves):

Total cost Divided by number of packages: Cost per package of dinner rolls:

Total cost: Divided by number of packages: Cost per package of multigrain loaves:

$3,480 ÷1,200 $ 2.90

$4,830 ÷1,400 $ 3.45


17-24 (25 min.) Weighted-average method, assigning costs. 1. & 2. Solution Exhibit 17-24A shows equivalent units of work done to date for Bio Doc Corporation for direct materials and conversion costs.

Solution Exhibit 17-24B summarizes total costs to account for, calculates the cost per equivalent unit of work done to date for direct materials and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work-in-process inventory.

SOLUTION EXHIBIT 17-24A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing, Bio Doc Corporation for July 2011.

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period Work in process, ending* (given) 10,500 100%; 10,500 60% Accounted for Equivalent units of work done to date

(Step 1) Physical Units 8,500 35,000 43,500 33,000 10,500


33,000

33,000

10,500

6,300

43,500

39,300

43,500

*Degree of completion: direct materials, 100%; conversion costs, 60%.


SOLUTION EXHIBIT 17-24B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Bio Doc Corporation for July 2011. Total Production Costs $108,610 769,940 $878,550

(Step 3)


(Step 4)

Costs incurred to date Divide by equivalent units of work done to date (Solution Exhibit 17-24A) Cost per equivalent unit of work done to date

(Step 5)

Assignment of costs: Completed and transferred out (33,000 units) Work in process, ending (10,500 units) Total costs accounted for

Direct Materials $ 63,100 284,900 $348,000

Conversion Costs $ 45,510 485,040 $530,550

$348,000

$530,550

$

$709,500 169,050 $878,550

43,500 8.00

$

39,300 13.50

(33,000* $8.00) + (33,000* $13.50) (10,500† $8.00) + (6,300† $13.50) $348,000 + $530,550

*Equivalent units completed and transferred out (given). † Equivalent units in ending work in process (given).


17-25 (30 min.) FIFO method, assigning costs. 1. & 2. Solution Exhibit 17-25A calculates the equivalent units of work done in the current period. Solution Exhibit 17-25B summarizes total costs to account for, calculates the cost per equivalent unit of work done in the current period for direct materials and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work-in-process inventory. SOLUTION EXHIBIT 17-25A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; FIFO Method of Process Costing, Bio Doc Corporation for July 2011. (Step 2) Equivalent Units Direct Conversion Materials Costs 8,500(work done before current period)

(Step 1) Physical Units

Flow of Production

Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period: From beginning work in process§ 8,500 (100% 100%); 8,500 (100% – 20%) Started and completed 24,500 100%, 24,500 100% Work in process, ending* (given) 10,500 100%; 10,500 60% Accounted for Equivalent units of work done in current period

35,000 43,500

0

6,800

24,500†

24,500

24,500

10,500 43,500

10,500

6,300

35,000

37,600

8,500

§

Degree of completion in this department: direct materials, 100%; conversion costs, 20%. 33,000 physical units completed and transferred out minus 8,500 physical units completed and transferred out from beginning work-in-process inventory. *Degree of completion in this department: direct materials, 100%; conversion costs, 60%. †


SOLUTION EXHIBIT 17-25B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Bio Doc Corporation for July 2011.

(Step 3) Work in process, beginning (given) Costs added in current period (given) Total costs to account for

Total Production Costs $108,610 769,940

Direct Materials $ 63,100 284,900

Conversion Costs $ 45,510 485,040

$878,550

$348,000

$530,550

$284,900

$485,040

35,000

37,600

(Step 4) Costs added in current period Divide by equivalent units of work done in current period (Solution Exhibit 17-25A) Cost per equivalent unit of work done in current period (Step 5) Assignment of costs: Completed and transferred out (33,000 units): Work in process, beginning (8,500 units) Cost added to beginning work in process in current period Total from beginning inventory Started and completed (24,500 units) Total costs of units completed and transferred out Work in process, ending (10,500 units) Total costs accounted for

$

8.14

$

12.90

$108,610 $63,100 + $45,510 * 87,720 (0 $8.14) + (6,800* $12.90) 196,330 515,480 (24,500† $8.14) + (24,500† $12.90) 711,810 166,740 (10,500# $8.14) + (6,300# $12.90) $878,550 $348,000 + $530,550

*Equivalent units used to complete beginning work in process from Solution Exhibit 17-25A, Step 2. † Equivalent units started and completed from Solution Exhibit 17-25A, Step 2. # Equivalent units in ending work in process from Solution Exhibit 17-25A, Step 2.


17-26 (30 min.) Standard-costing method, assigning costs. 1. The calculations of equivalent units for direct materials and conversion costs are identical to the calculations of equivalent units under the FIFO method. Solution Exhibit 17-25A shows the equivalent unit calculations for standard costing and computes the equivalent units of work done in July 2011. Solution Exhibit 17-26 uses the standard costs (direct materials, $8.25; conversion costs, $12.70) to summarize total costs to account for, and to assign these costs to units completed and transferred out and to units in ending work-in-process inventory. 2.

Solution Exhibit 17-26 shows the direct materials and conversion costs variances for Direct materials Conversion costs

$3,850 F $7,520 U

SOLUTION EXHIBIT 17-26 Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Standard Costing Method of Process Costing, Bio Doc Corporation for July 2011.

(Step 3) Work in process, beginning Costs added in current period at standard costs Total costs to account for (Step 4) Standard cost per equivalent unit (given) (Step 5) Assignment of costs at standard costs: Completed and transferred out (33,000 units): Work in process, beginning (8,500 units) Costs added to beg. work in process in current period Total from beginning inventory Started and completed (24,500 units) Total costs of units transferred out Work in process, ending (10,500 units) Total costs accounted for Summary of variances for current performance: Costs added in current period at standard costs (see Step 3 above) Actual costs incurred (given) Variance

Total Production Direct Conversion Costs Materials Costs $ 91,715 (8,500 $8.25) + (1,700 $12.70) 766,270 (35,000 $8.25) + (37,600 $12.70) $857,985 $358,875 + $499,110 $ 8.25

$ 12.70

$91,715 (8,500 $8.25) + (1,700 $12.70) 86,360 (0* $8.25) + (6,800* $12.70) 178,075 513,275 (24,500† $8.25) + (24,500† $12.70) 691,350 166,635 (10,500# $8.25) + (6,300# $12.70) $857,985 $358,875 + $499,110 $288,750 284,900 $ 3,850 F

*Equivalent units to complete beginning work in process from Solution Exhibit 17-25A, Step 2. † Equivalent units started and completed from Solution Exhibit 17-25A, Step 2. # Equivalent units in ending work in process from Solution Exhibit 17-25A, Step 2.


$477,520 485,040 $ 7,520 U

17-27 (35–40 min.) Transferred-in costs, weighted-average method. 1, 2. & 3. Solution Exhibit 17-27A calculates the equivalent units of work done to date. Solution Exhibit 17-27B summarizes total costs to account for, calculates the cost per equivalent unit of work done to date for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work-in-process inventory. SOLUTION EXHIBIT 17-27A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units Weighted-Average Method of Process Costing; Finishing Department of Asaya Clothing for June 2012. (Step 1)

Flow of Production

Work in process, beginning (given) Transferred in during current period (given) To account for Completed and transferred out during current period Work in process, ending* (given) 60 100%; 60 0%; 60 75% Accounted for Equivalent units of work done to date

Physical Units

(Step 2) Equivalent Units TransferredDirect Conversion in Costs Materials Costs

75 135 210 150 60

150

150

150

60

0

45

210

150

195

210

*Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 75%.


SOLUTION EXHIBIT 17-27B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Finishing Department of Asaya Clothing for June 2012.

(Step 3)


(Step 4)


(Step 5)

a b

Assignment of costs: Completed and transferred out (150 units) Work in process, ending (60 units): Total costs accounted for

Total Production Costs $105,000 258,000 $363,000

$275,934 87,066 $363,000

Transferred-in Costs $ 75,000 142,500 $ 217,500

Direct Materials $ 0 37,500 $37,500


$ 217,500

$37,500

$108,000

÷ 210 $1,035.71

÷ $

÷ 195 $ 553.85

150 250

(150 a $1,035.71) + (150 a $250) + (150a $553.85) (60b $1,035.71) + (0b $250) + (45b $553.85)

$ 217,500

+

$37,500

Equivalent units completed and transferred out from Sol. Exhibit 17-27, step 2. Equivalent units in ending work in process from Sol. Exhibit 17-27A, step 2.


+

$108,000

17-28 (35–40 min.) Transferred-in costs, FIFO method. Solution Exhibit 17-28A calculates the equivalent units of work done in the current period (for transferred-in costs, direct-materials, and conversion costs) to complete beginning work-inprocess inventory, to start and complete new units, and to produce ending work in process. Solution Exhibit 17-28B summarizes total costs to account for, calculates the cost per equivalent unit of work done in the current period for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending workin-process inventory. SOLUTION EXHIBIT 17-28A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units FIFO Method of Process Costing; Finishing Department of Asaya Clothing for June 2012.

(Step 1)

Flow of Production Work in process, beginning (given) Transferred-in during current period (given) To account for Completed and transferred out during current period: From beginning work in processa [75 (100% – 100%); 75 (100% – 0%); 75 (100% – 60%)] Started and completed (75 100%; 75 100%; 75 100%) Work in process, endingc (given) (60 100%; 60 0%; 60 75%) Accounted for Equivalent units of work done in current period


Physical Transferred-in Direct Conversion Units Costs Materials Costs 75 (work done before current period) 135 210 75 0

75

30

75

75

75

60 ___ 135

0 ___ 150

45 ___ 150

75b 60 ___ 210

a

Degree of completion in this department: Transferred-in costs, 100%; direct materials, 0%; conversion costs, 60%. 150 physical units completed and transferred out minus 75 physical units completed and transferred out from beginning

b

work-in-process inventory. Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 75%.

c


SOLUTION EXHIBIT 17-28B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Finishing Department of Asaya Clothing for June 2012.

(Step 3)


(Step 4)

Costs added in current period Divide by equivalent units of work done in current period (Solution Exhibit 17-28A) Cost per equivalent unit of work done in current period

(Step 5)

Total Production Costs $ 90,000 246,300 $336,300

Assignment of costs: Completed and transferred out (150 units) Work in process, beginning (75 units) Costs added to beginning work in process in current period Total from beginning inventory Started and completed (75 units) Total costs of units completed and transferred out Work in process, ending (60 units): Total costs accounted for

$ 90,000 34,350 124,350 130,416 254,766 81,534 $336,300

Transferred-in Costs Direct Materials Conversion Costs $ 60,000 $ 0 $ 30,000 130,800 37,500 78,000 $190,800 $37,500 $108,000

(0a (75b (60c

$130,800

$37,500

$ 78,000

÷ 135 $ 968.89

÷ $

÷ $

$ 60,000 $968.89)

150 250

$ 0 + (75a $250)

$968.89) + (75b

$250)

$968.89) + (0c $250) $190,800 + $37,500

a

Equivalent units used to complete beginning work in process from Solution Exhibit 17-28A, step 2. Equivalent units started and completed from Solution Exhibit 17-28A, step 2. c Equivalent units in ending work in process from Solution Exhibit 17-28A, step 2. b


150 520

$ 30,000 + (30 a $520) + (75b

$520)

+ (45c $520) + $108,000

17-29 (15-20 min.) Operation Costing.

1.

Calculate the conversion cost rates for each department:

Vitamin A Vitamin B Multi-vitamin Budgeted 200-unit bottles 12,000 9,000 18,000 a Budgeted labor hours 300 225 450 b Budgeted machine hours 200 150 300 a 12,000 1.5 minutes ÷ 60 minutes/hour = 300 hours b 12,000 1 minute ÷ 60 minutes/hour = 200 hours

Mixing Tableting Encapsulating Bottling 2.

Budgeted Conversion Cost $ 8,190 24,150 25,200 3,510

Cost Driver Labor hours Number of bottles Number of bottles Machine hours

Budgeted Quantity of Cost Driver 975 21,000 18,000 650

Conversion Cost Rate $8.40 per labor hour 1.15 per bottle 1.40 per bottle 5.40 per machine hour

Budgeted cost of goods manufactured: Vitamin A Vitamin B Direct Materials $23,040 $21,600 c 2,520 1,890 Mixing d 13,800 10,350 Tableting 0 0 Encapsulating e 1,080 810 Bottling Total $40,440 $34,650 c $8.40 per labor hour 300 labor hours = $2,520 d $1.15 per bottle 12,000 bottles = $13,800 e $5.40 per machine hour 200 machine hours = $1,080

3.

Total 39,000 975 650

Multi-vitamin $47,520 3,780 0 25,200 1,620 $78,120

Budgeted cost per bottle

Total budgeted costs Number of bottles Budgeted cost per bottle

Vitamin A $40,440 12,000 $ 3.37

Vitamin B $34,650 9,000 $ 3.85

Multi-vitamin $78,120 18,000 $ 4.34


17-30 (25 min.) Weighted-average method. 1. Since direct materials are added at the beginning of the assembly process, the units in this department must be 100% complete with respect to direct materials. Solution Exhibit 17-30A shows equivalent units of work done to date: Direct materials Conversion costs

25,000 equivalent units 24,250 equivalent units

2. & 3. Solution Exhibit 17-30B summarizes the total Assembly Department costs for October 2012, calculates cost per equivalent unit of work done to date, and assigns these costs to units completed (and transferred out) and to units in ending work in process using the weightedaverage method. SOLUTION EXHIBIT 17-30A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing, Assembly Department of Larsen Company, for October 2012. (Step 1)

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period Work in process, ending* (given) 2,500 100%; 2,500 70% Accounted for Equivalent units of work done to date

Physical Units 5,000 20,000 25,000 22,500 2,500


22,500

22,500

2,500

1,750

25,000

24,250

25,000

*Degree of completion in this department: direct materials, 100% (since they are added at the start of the process); conversion costs, 70%.


SOLUTION EXHIBIT 17-30B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Assembly Department of Larsen Company, for October 2012. Total Production Costs $1,652,750 6,837,500 $8,490,250

(Step 3)


(Step 4)


(Step 5)

* †


Direct Materials $1,250,000 4,500,000 $5,750,000


$5,750,000

$2,740,250

$

25,000 230

$

24,250 113

$7,717,500 (22,500* $230) + (22,500* $113) 772,750 (2,500† $230) + (1,750† $113) $8,490,250 $5,750,000 + $2,740,250

Equivalent units completed and transferred out from Solution Exhibit 17-30A, Step 2. Equivalent units in work in process, ending from Solution Exhibit 17-30A, Step 2.

17-31 (10 min.) Journal entries (continuation of 17-30). 1.

2.

3.

Work in Process––Assembly Department Accounts Payable Direct materials purchased and used in production in October.

4,500,000

Work in Process––Assembly Department Various accounts Conversion costs incurred in October.

2,337,500

4,500,000

Work in Process––Testing Department 7,717,500 Work in Process––Assembly Department Cost of goods completed and transferred out in October from the Assembly Department to the Testing Department. Work in Process––Assembly Department Beginning inventory, October 1 1,652,750 3. Transferred out to 1. Direct materials 4,500,000 Work in Process–Testing 2. Conversion costs 2,337,500 Ending Inventory, October 31 772,750

2,337,500

7,717,500

7,717,500


17-32 (20 min.) FIFO method (continuation of 17-30). 1. The equivalent units of work done in the current period in the Assembly Department in October 2012 for direct materials and conversion costs are shown in Solution Exhibit 17-32A. 2. The cost per equivalent unit of work done in the current period in the Assembly Department in October 2012 for direct materials and conversion costs is calculated in Solution Exhibit 17-32B. 3. Solution Exhibit 17-32B summarizes the total Assembly Department costs for October 2012, and assigns these costs to units completed (and transferred out) and units in ending work in process under the FIFO method. The cost per equivalent unit of beginning inventory and of work done in the current period differ:

Direct materials Conversion costs Total cost per unit

Beginning Inventory $250.00 ($1,250,000 5,000 equiv. units) 134.25 ($ 402,750 3,000 equiv. units) $384.25 Direct Materials

Cost per equivalent unit (weighted-average) Cost per equivalent unit (FIFO)

$230* $225**

Work Done in Current Period $225.00 110.00 $335.00 Conversion Costs $113* $110**

*

from Solution Exhibit 17-30B from Solution Exhibit 17-32B

**

The cost per equivalent unit differs between the two methods because each method uses different costs as the numerator of the calculation. FIFO uses only the costs added during the current period whereas weighted-average uses the costs from the beginning work-in-process as well as costs added during the current period. Both methods also use different equivalent units in the denominator. The following table summarizes the costs assigned to units completed and those still in process under the weighted-average and FIFO process-costing methods for our example. Weighted Average FIFO (Solution (Solution Exhibit 17-30B) Exhibit 17-32B) Difference Cost of units completed and transferred out $7,717,500 $7,735,250 + $17,750 Work in process, ending 772,750 755,000 $17,750 Total costs accounted for $8,490,250 $8,490,250


The FIFO ending inventory is lower than the weighted-average ending inventory by $17,750. This is because FIFO assumes that all the higher-cost prior-period units in work in process are the first to be completed and transferred out while ending work in process consists of only the lower-cost current-period units. The weighted-average method, however, smoothes out cost per equivalent unit by assuming that more of the lower-cost units are completed and transferred out, while some of the higher-cost units in beginning work in process are placed in ending work in process. So, in this case, the weighted-average method results in a lower cost of units completed and transferred out and a higher ending work-in-process inventory relative to the FIFO method. SOLUTION EXHIBIT 17-32A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; FIFO Method of Process Costing, Assembly Department of Larsen Company for October 2012. (Step 1)

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period: From beginning work in process§ 5,000 (100% 100%); 5,000 (100% 60%) Started and completed 17,500 100%, 17,500 100% Work in process, ending* (given) 2,500 100%; 2,500 70% Accounted for Equivalent units of work done in current period


Physical Units 5,000 (work done before current period) 20,000 25,000

5,000

0

2,000

17,000† 2,500

17,500

17,500

2,500

1,750

20,000

______ 21,250

25,000

§

Degree of completion in this department: direct materials, 100%; conversion costs, 60%. 22,500 physical units completed and transferred out minus 5,000 physical units completed and transferred out from beginning work-in-process inventory. *Degree of completion in this department: direct materials, 100%; conversion costs, 70%. †


SOLUTION EXHIBIT 17-32B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Assembly Department of Larsen Company for October 2012. Total Production Costs $1,652,750 6,837,500 $8,490,250

(Step 3) Work in process, beginning (given) Costs added in current period (given) Total costs to account for (Step 4) Costs added in current period Divide by equivalent units of work done in current period (Solution Exhibit 17-32A) Cost per equivalent unit of work done in current period

Direct Materials $1,250,000 4,500,000 $5,750,000


$4,500,000

$2,337,500

$

(Step 5) Assignment of costs: Completed and transferred out (22,500 units): Work in process, beginning (5,000 units) Costs added to beg. work in process in current period Total from beginning inventory Started and completed (17,500 units) Total costs of units completed & transferred out Work in process, ending (2,500 units) Total costs accounted for

20,000 225

$1,652,750 $1,250,000 220,000 (0* $225) 1,872,750 5,862,500 (17,500† $225) 7,735,250 755,000 (2,500# $225) $8,490,250 $5,750,000

$

21,250 110

+ $ 402,750 + (2,000* $110) + (17,500† $110) + (1,750# $110) + $2,740,250



17-33 (30 min.) Transferred-in costs, weighted-average method (related to 17-30 to 17-32). 1. Transferred-in costs are 100% complete, and direct materials are 0% complete in both beginning and ending work-in-process inventory. The reason is that transferred-in costs are always 100% complete as soon as they are transferred in from the Assembly Department to the Testing Department. Direct materials in beginning or ending work in process for the Testing Department are 0% complete because direct materials are added only when the testing process is 90% complete and the units in beginning and ending work in process are only 70% and 60% complete, respectively. 2. Solution Exhibit 17-33A computes the equivalent units of work done to date in the Testing Department for transferred-in costs, direct materials, and conversion costs. 3. Solution Exhibit 17-33B summarizes total Testing Department costs for October 2012, calculates the cost per equivalent unit of work done to date in the Testing Department for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work in process using the weighted-average method. 4.

Journal entries: a. Work in Process––Testing Department Work in Process––Assembly Department Cost of goods completed and transferred out during October from the Assembly Department to the Testing Department b. Finished Goods Work in Process––Testing Department Cost of goods completed and transferred out during October from the Testing Department to Finished Goods inventory

7,717,500 7,717,500

23,459,600 23,459,600


SOLUTION EXHIBIT 17-33A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing, Testing Department of Larsen Company for October 2012. (Step 1) Physical Flow of Production Units Work in process, beginning (given) 7,500 Transferred in during current period (given) 22,500 To account for 30,000 Completed and transferred out during current period 26,300 26,300 Work in process, ending* (given) 3,700 3,700 100%; 3,700 0%; 3,700 60% 2,220 Accounted for 30,000 Equivalent units of work done to date 28,520

(Step 2) Equivalent Units Transferred-in Direct Conversion Costs Materials Costs

26,300

26,300

3,700

0

30,000

26,300



SOLUTION EXHIBIT 17-33B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Testing Department of Larsen Company for October 2012.


Total Production Costs $ 3,767,960 21,378,100 $25,146,060

(Step 4) Costs incurred to date Divide by equivalent units of work done to date (Solution Exhibit 17-33A) Equivalent unit costs of work done to date (Step 5) Assignment of costs: Completed and transferred out (26,300 units) Work in process, ending (3,700 units) Total costs accounted for

Transferred -in Costs $ 2,932,500 7,717,500 $10,650,000

Direct Materials $ 0 9,704,700 $9,704,700


$10,650,000

$9,704,700

$4,791,360

30,000 355

26,300 369

28,520 168

$

$23,459,600 1,686,460 $25,146,060

$

(26,300* $355) + (26,300* $369) (3,700† $355) + (0† $369) $10,650,000 + $9,704,700

*Equivalent units completed and transferred out from Solution Exhibit 17-33A, Step 2. † Equivalent units in ending work in process from Solution Exhibit 17-33A, Step 2.


$

+ (26,300* $168) + (2,220† $168) + $4,791,360

17-34 (30 min.) Transferred-in costs, FIFO method (continuation of 17-33). 1. As explained in Problem 17-33, requirement 1, transferred-in costs are 100% complete and direct materials are 0% complete in both beginning and ending work-in-process inventory. 2. The equivalent units of work done in October 2012 in the Testing Department for transferred-in costs, direct materials, and conversion costs are calculated in Solution Exhibit 1734A. 3. Solution Exhibit 17-34B summarizes total Testing Department costs for October 2012, calculates the cost per equivalent unit of work done in October 2012 in the Testing Department for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work in process using the FIFO method. 4.

Journal entries: a. Work in Process––Testing Department Work in Process––Assembly Department Cost of goods completed and transferred out during October from the Assembly Dept. to the Testing Dept. b. Finished Goods Work in Process––Testing Department Cost of goods completed and transferred out during October from the Testing Department to Finished Goods inventory.

7,735,250 7,735,250

23,463,766 23,463,766


SOLUTION EXHIBIT 17-34A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; FIFO Method of Process Costing, Testing Department of Larsen Company for October 2012.

Flow of Production Work in process, beginning (given) Transferred-in during current period (given) To account for Completed and transferred out during current period: From beginning work in process§ 7,500 (100% 100%); 7,500 (100% 0%); 7,500 (100% 70%) Started and completed 18,800 100%; 18,800 100%; 18,800 100% Work in process, ending* (given) 3,700 100%; 3,700 0%; 3,700 60% Accounted for Equivalent units of work done in current period

(Step 2) (Step 1) Equivalent Units Physical TransferredDirect Conversion Units in Costs Materials Costs 7,500 (work done before current period) 22,500 30,000

7,500 18,800† 3,700 _____ 30,000

0

7,500

2,250

18,800

18,800

18,800

3,700

0

2,220

22,500

26,300

23,270

§

Degree of completion in this department: Transferred-in costs, 100%; direct materials, 0%; conversion costs, 70%. 26,300 physical units completed and transferred out minus 7,500 physical units completed and transferred out from beginning work-in-process inventory. *Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 60%. †


SOLUTION EXHIBIT 17-34B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Testing Department of Larsen Company for October 2012.


Total Production Costs $ 3,717,335 21,395,850 $25,113,185

Transferred-in Costs $ 2,881,875 7,735,250 $10,617,125

Direct Materials $ 0 9,704,700 $9,704,700


$ 7,735,250

$9,704,700

$3,955,900

(Step 4) Costs added in current period Divide by equivalent units of work done in current period (Solution Exhibit 17-34A) Cost per equiv. unit of work done in current period (Step 5) Assignment of costs: Completed and transferred out (26,300 units): Work in process, beginning (7,500 units) Costs added to beg. work in process in current period Total from beginning inventory Started and completed (18,800 units) Total costs of units completed & transferred out Work in process, ending (3,700 units) Total costs accounted for

$

$ 3,717,335 3,150,000 6,867,335 16,596,431 23,463,766 1,649,419 $25,113,185

22,500 343.79

$2,881,875 (0* $343.79)

$

26,300 369.00

$

23,270 170.00

+ $0 + $835,460 + (7,500* $369.00) + (2,250* $170.00)

(18,800† $343.79) + (18,800†

$369.00) + (18,800† $170.00)

(3,700# $343.79) + (0# $369.00) $10,617,125 + $9,704,700



+ (2,220# $170.00) + $4,791,360

17-35 (25 min.) Weighted-average method. Solution Exhibit 17-35A shows equivalent units of work done to date of: Direct materials Conversion costs

625 equivalent units 525 equivalent units

Note that direct materials are added when the Assembly Department process is 10% complete. Both the beginning and ending work in process are more than 10% complete and hence are 100% complete with respect to direct materials. Solution Exhibit 17-35B summarizes the total Assembly Department costs for April 2012, calculates cost per equivalent unit of work done to date for direct materials and conversion costs, and assigns these costs to units completed (and transferred out), and to units in ending work in process using the weighted-average method. SOLUTION EXHIBIT 17-35A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing, Assembly Department of Ashworth Handcraft for April 2012. (Step 1)

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period Work in process, ending* (given) 130 100%; 130 30% Accounted for Equivalent units of work done to date *

Physical Units 95 490 585 455 130


455

455

130

39

585

494

585

Degree of completion in this department: direct materials, 100%; conversion costs, 30%.


SOLUTION EXHIBIT 17-35B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Assembly Department of Ashworth, April 2012. Total Production Costs


$ 2,653 29,496 $32,149

(Step 4) Costs incurred to date Divide by equivalent units of work done to date (Solution Exhibit 17-35A) Cost per equivalent unit of work done to date (Step 5) Assignment of costs: Completed and transferred out (455 units) Work in process, ending (130 units) Total costs accounted for * †

Direct Materials

$ 1,665 17,640 $19,305

Conversion Costs

$

$19,305

$

$26,845 5,304 $32,149

585 33

988 11,856 $12,844 $12,844

$

494 26

(455* $33) + (455* $26) (130† $33) + (39† $26) $19,305 + $12,844

Equivalent units completed and transferred out from Solution Exhibit 17-35A, Step 2. Equivalent units in ending work in process from Solution Exhibit 17-35A, Step 2.


17-36 (5–10 min.)

Journal entries (continuation of 17-35).

1. Work in Process–– Assembly Department Accounts Payable To record direct materials purchased and used in production during April

17,640

2. Work in Process–– Assembly Department Various Accounts To record Assembly Department conversion costs for April

11,856

3. Work in Process––Finishing Department Work in Process–– Assembly Department To record cost of goods completed and transferred out in April from the Assembly Department to the Finishing Department

26,845

17,640

11,856

Work in Process –– Assembly Department Beginning inventory, April 1 2,653 3. Transferred out to 1. Direct materials 17,640 Work in Process––Finishing 2. Conversion costs 11,856 Ending inventory, April 30 5,304

26,845

26,845


17-37 (20 min.) FIFO method (continuation of 17-35). The equivalent units of work done in April 2012 in the Assembly Department for direct materials and conversion costs are shown in Solution Exhibit 17-37A. Solution Exhibit 17-37B summarizes the total Assembly Department costs for April 2012, calculates the cost per equivalent unit of work done in April 2012 in the Assembly Department for direct materials and conversion costs, and assigns these costs to units completed (and transferred out) and to units in ending work in process under the FIFO method. The equivalent units of work done in beginning inventory is: direct materials, 95 100% = 95; and conversion costs 95 40% = 38. The cost per equivalent unit of beginning inventory and of work done in the current period are:

Direct materials Conversion costs

Beginning Inventory $17.53 ($1,665 95) $26.00 ($988 38)

Work Done in Current Period (Calculated Under FIFO Method) $36 $26

The following table summarizes the costs assigned to units completed and those still in process under the weighted-average and FIFO process-costing methods for our example.

Cost of units completed and transferred out Work in process, ending Total costs accounted for

Weighted Average FIFO (Solution (Solution Exhibit 17-35B) Exhibit 17-37B) Difference $26,845 $26,455 –$390 5,304 5,694 +$390 $32,149 $32,149

The FIFO ending inventory is higher than the weighted-average ending inventory by $390. This is because FIFO assumes that all the lower-cost prior-period units in work in process are the first to be completed and transferred out while ending work in process consists of only the higher-cost current-period units. The weighted-average method, however, smoothes out cost per equivalent unit by assuming that more of the higher-cost units are completed and transferred out, while some of the lower-cost units in beginning work in process are placed in ending work in process. Hence, in this case, the weighted-average method results in a higher cost of units completed and transferred out and a lower ending work-in-process inventory relative to the FIFO method.


SOLUTION EXHIBIT 17-37A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; FIFO Method of Process Costing, Assembly Department of Ashworth Handcraft for April 2012. (Step 1) Physical Units 95 490 585

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period: From beginning work in process§ 95 (100% 100%); 95 (100% 40%) Started and completed 455 100%; 455 100% Work in process, ending* (given) 130 100%; 130 30% Accounted for Equivalent units of work done in current period

(Step 2) Equivalent Units Direct Conversion Materials Costs (work done before current period)

95 0

57

360

360

130

39

490

456

360† 130 585

§

Degree of completion in this department: direct materials, 100%; conversion costs, 40%. 455 physical units completed and transferred out minus 95 physical units completed and transferred out from beginning work-in-process inventory. *Degree of completion in this department: direct materials, 100%; conversion costs, 20%. †

SOLUTION EXHIBIT 17-37B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Assembly Department of Ashworth Handcraft for April 2012.

(Step 3) Work in process, beginning (given) Costs added in current period (given) Total costs to account for (Step 4) Costs added in current period Divide by equivalent units of work done in current period (Exhibit 17-37A) Cost per equivalent unit of work done in current period (Step 5) Assignment of costs: Completed and transferred out (455 units): Work in process, beginning (95 units) Costs added to begin. work in process in current period Total from beginning inventory Started and completed (360 units) Total costs of units completed & tsfd. out Work in process, ending (130 units) Total costs accounted for


Direct Materials $ 1,665 17,640 $19,305 $17,640

Conversion Costs $ 988 11,856 $12,844 $11,856

490 $

$ 2,653 1,482 4,135 22,320 26,455 5,694 $32,149

36

$1,665 (0*

456 $

+

$988

+

(57*

$36)

+

(360†

(130# $36) $19,305

+ +

(360†

$36)

26

$26) $26)

(39# $26) $12,844



17-38 (30 min.) Transferred-in costs, weighted average. 1. Solution Exhibit 17-38A computes the equivalent units of work done to date in the Binding Department for transferred-in costs, direct materials, and conversion costs. Solution Exhibit 17-38B summarizes total Binding Department costs for April 2012, calculates the cost per equivalent unit of work done to date in the Binding Department for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work in process using the weighted-average method. 2.

Journal entries: a. Work in Process–– Binding Department Work in Process––Printing Department Cost of goods completed and transferred out during April from the Printing Department to the Binding Department b. Finished Goods Work in Process–– Binding Department Cost of goods completed and transferred out during April from the Binding Department to Finished Goods inventory

129,600 129,600

220,590 220,590

SOLUTION EXHIBIT 17-38A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing, Binding Department of Bookworm, Inc. for April 2012. (Step 1)

Flow of Production Work in process, beginning (given) Transferred-in during current period (given) To account for Completed and transferred out during current period: Work in process, endinga (given) (750 100%; 750 0%; 750 70%) Accounted for Equivalent units of work done to date a

(Step 2) Equivalent Units Physical Transferred- Direct Conversion Units in Costs Materials Costs 1,050 2,400 3,450 2,700 2,700 2,700 2,700 750 750 0 525 3,450 3,450 2,700 3,225

Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 70%.


SOLUTION EXHIBIT 17-38B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Binding Department of Bookworm, Inc. for April 2012.

(Step 3)


(Step 4)


(Step 5)

a b

Assignment of costs: Completed and transferred out (2,700 units) Work in process, ending (750 units): Total costs accounted for


$220,590 48,900 $269,490

Transferred-in Costs $ 32,550 129,600 $162,150


$162,150

$23,490

$83,850

÷ $

÷ 2,700 $ 8.70

÷ 3,225 $ 26.00

3,450 47.00

Conversion Costs $13,650 70,200 $83,850

(2,700a × $47.00) + (2,700a × $8.70) + (750b × $47.00) + (0b × $8.70) +

$162,150

+ $23,490

Equivalent units completed and transferred out from Sol. Exhibit 17-38A, step 2. Equivalent units in ending work in process from Sol. Exhibit 17-38A, step 2.


+

(2,700a × $26) (525b × $26)

$83,850

17-39 (30 min.) Transferred-in costs, FIFO method (continuation of 17-38). 1. Solution Exhibit 17-39A calculates the equivalent units of work done in April 2012 in the Binding Department for transferred-in costs, direct materials, and conversion costs. Solution Exhibit 17-39B summarizes total Binding Department costs for April 2012, calculates the cost per equivalent unit of work done in April 2012 in the Binding Department for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work in process using the FIFO method. Journal entries: a. Work in Process–– Binding Department Work in Process––Printing Department Cost of goods completed and transferred out during April from the Printing Department to the Binding Department. b.

Finished Goods Work in Process–– Binding Department Cost of goods completed and transferred out during April from the Binding Department to Finished Goods inventory.

124,800 124,800

216,240 216,240

2.

The equivalent units of work done in beginning inventory is: Transferred-in costs, 1,050 100% = 1,050; direct materials, 1,050 0% = 0; and conversion costs, 1,050 50% = 525. The cost per equivalent unit of beginning inventory and of work done in the current period are: Beginning Inventory Transferred-in costs (weighted average) $31.00 ($32,550 1,050) Transferred-in costs (FIFO) $35.00 ($36,750 1,050) Direct materials — Conversion costs $26.00 ($13,650 525)

Work Done in Current Period $54.00 ($129,600 2,400) $52.00 ($124,800 2,400) $ 8.70 $26.00

The following table summarizes the costs assigned to units completed and those still in process under the weighted-average and FIFO process-costing methods for the Binding Department.

Cost of units completed and transferred out Work in process, ending Total costs accounted for

Weighted Average FIFO (Solution (Solution Exhibit 17-38B) Exhibit 17-39B) $220,590 $216,240 48,900 52,650 $269,490 $268,890

Difference –$4,350 +$3,750


The FIFO ending inventory is higher than the weighted-average ending inventory by $3,750. This is because FIFO assumes that all the lower-cost prior-period units in work in process (resulting from the lower transferred-in costs in beginning inventory) are the first to be completed and transferred out while ending work in process consists of only the higher-cost current-period units. The weighted-average method, however, smoothes out cost per equivalent unit by assuming that more of the higher-cost units are completed and transferred out, while some of the lower-cost units in beginning work in process are placed in ending work in process. Hence, in this case, the weighted-average method results in a higher cost of units completed and transferred out and a lower ending work-in-process inventory relative to FIFO. Note that the difference in cost of units completed and transferred out (–$4,350) does not exactly offset the difference in ending work-in-process inventory (+$3,750). This is because the FIFO and weighted-average methods result in different values for transferred-in costs with respect to both beginning inventory and costs transferred in during the period. SOLUTION EXHIBIT 17-39A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; FIFO Method of Process Costing, Binding Department of Bookworm, Inc. for April 2012. (Step 1)

Flow of Production Work in process, beginning (given) Transferred-in during current period (given) To account for Completed and transferred out during current period: From beginning work in processa [1,050 (100% – 100%); 1,050 (100% – 0%); 1,050 Started and completed (1,650 100%; 1,650 100%; 1,650 100%) Work in process, endingc (given) (750 100%; 750 0%; 750 70%) Accounted for Equivalent units of work done in current period


Physical Transferred-in Direct Conversion Units Costs Materials Costs 1,050 (work done before current period) 2,400 3,450 1,050 (100% – 50%)]

0

1,050

525

1,650

1,650

1,650

750 ____ 2,400

0 ____ 2,700

525 ____ 2,700

1,650b 750 ____ 3,450

a

Degree of completion in this department: Transferred-in costs, 100%; direct materials, 0%; conversion costs, 50%. 2,700 physical units completed and transferred out minus 1,050 physical units completed and transferred out from beginning work-in-process inventory. c Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 70%. b


SOLUTION EXHIBIT 17-39B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Binding Department of Bookworm, Inc. for April 2012. Total Production Costs $ 50,400 218,490 $268,890

(Step 3) Work in process, beginning (given) Costs added in current period (given) Total costs to account for (Step 4) Costs added in current period Divide by equivalent units of work done in current period (Sol. Exhibit 17-39A) Cost per equivalent unit of work done in current period (Step 5) Assignment of costs: Completed and transferred out (2,700 units) Work in process, beginning (1,050 units) Costs added to beginning work in process in current period Total from beginning inventory Started and completed (1,650 units) Total costs of units completed and transferred out Work in process, ending (750 units): Total costs accounted for

$ 50,400 22,785 73,185 143,055 216,240 52,650 $268,890


Transferred-in Costs $ 36,750 124,800 $161,550

Conversion Costs $13,650 70,200 $83,850

$124,800

$23,490

$70,200

÷ 2,400 $ 52.00

÷ 2,700 $ 8.70

÷ 2,700 $ 26.00

$36,750 (0a × $52.00) (1,650b × $52.00) (750c × $52.00) $161,550

+ $0 + + (1,050a × $8.70) +

$13,650 (525a × $26)

+ (1,650b × $8.70) + (1,650b × $26) + +

a

Equivalent units used to complete beginning work in process from Solution Exhibit 17-39A, step 2. Equivalent units started and completed from Solution Exhibit 17-39A, step 2. c Equivalent units in ending work in process from Solution Exhibit 17-39A, step 2. b


(0c × $8.70) $23,490

+ +

(525c × $26) $83,850

17-40 (45 min.) Transferred-in costs, weighted-average and FIFO methods. 1. Solution Exhibit 17-40A computes the equivalent units of work done to date in the Drying and Packaging Department for transferred-in costs, direct materials, and conversion costs. Solution Exhibit 17-40B summarizes total Drying and Packaging Department costs for week 37, calculates the cost per equivalent unit of work done to date in the Drying and Packaging Department for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work in process using the weighted-average method. 2. Solution Exhibit 17-40C computes the equivalent units of work done in week 37 in the Drying and Packaging Department for transferred-in costs, direct materials, and conversion costs. Solution Exhibit 17-40D summarizes total Drying and Packaging Department costs for week 37, calculates the cost per equivalent unit of work done in week 37 in the Drying and Packaging Department for transferred-in costs, direct materials, and conversion costs, and assigns these costs to units completed and transferred out and to units in ending work in process using the FIFO method. SOLUTION EXHIBIT 17-40A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing, Drying and Packaging Department of Frito-Lay Inc. for Week 37. (Step 1) Physical Flow of Production Units Work in process, beginning (given) 1,200 Transferred in during current period (given) 4,200 To account for 5,400 Completed and transferred out during current period 4,000 Work in process, ending* (given) 1,400 1,400 100%; 1,400 0%; 1,400 50% Accounted for 5,400 Equivalent units of work done to date


4,000

4,000

4,000

1,400

0

700

5,400

4,000

4,700



SOLUTION EXHIBIT 17-40B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Drying and Packaging Department of Frito-Lay Inc. for Week 37.

(Step 3)


(Step 4)

Costs incurred to date Divide by equivalent units of work done to date (Solution Exhibit 17-40A) Equivalent unit costs of work done to date

(Step 5)

a b


Transferred Direct -in Costs Materials $ 26,750 $ 0 91,510 23,000 $118,260 $23,000

$


$137,800 35,420 $173,220


$118,260

$23,000

$31,960

5,400 21.90

4,000 5.75

4,700

$

$

6.80

(4,000a $21.90) + (4,000a $5.75) + (4,000a $6.80) (1,400b $21.90) +

$118,260

+

(0b $5.75)

$23,000

Equivalent units completed and transferred out from Solution Exhibit 17-40A, Step 2. Equivalent units in ending work in process from Solution Exhibit 17-40A, Step 2.


+ (700b $6.80)

+

$31,960

SOLUTION EXHIBIT 17-40C Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; FIFO Method of Process Costing, Drying and Packaging Department of Frito-Lay Inc. for Week 37.

Flow of Production Work in process, beginning (given) Transferred-in during current period (given) To account for Completed and transferred out during current period: From beginning work in process§ 1,200 (100% 100%); 1,200 (100% 0%); 1,200 (100% 25%) Started and completed 2,800 100%; 2,800 100%; 2,800 100% Work in process, ending* (given) 1,400 100%; 1,400 0%; 1,400 50% Accounted for Equivalent units of work done in current period

(Step 2) (Step 1) Equivalent Units Physical TransferredDirect Conversion Units in Costs Materials Costs 1,200 (work done before current period) 4,200 5,400 1,200 2,800†

0

1,200

2,800

2,800

1,400

0

4,200

4,000

900 2,800

1,400 700

5,400 4,400

§

Degree of completion in this department: Transferred-in costs, 100%; direct materials, 0%; conversion costs, 25%. 4,000 physical units completed and transferred out minus 1,200 physical units completed and transferred out from beginning work-in-process inventory. *Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 50%. †


SOLUTION EXHIBIT 17-40D Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; FIFO Method of Process Costing, Drying and Packaging Department of Frito-Lay Inc. for Week 37. Total Production Costs


Transferred-in Costs

$ 32,940 144,600 $177,540

$ 28,920 93,660 $122,580

(Step 4) Costs added in current period Divide by equivalent units of work done in current period (Solution Exhibit 17-40C) Cost per equivalent unit of work done in current period

Direct Materials

$

0 23,000 $23,000

$ 4,020 27,940 $31,960

$ 93,660

$23,000

$27,940

4,200

4,000

4,400

22.30

$

Conversion Costs

$

5.75

$

6.35

(Step 5) Assignment of costs: Completed and transferred out (5,40 units): Work in process, beginning (1,200 units) Costs added to beg. work in process in current period Total from beginning inventory Started and completed (2,800 units) Total costs of units completed & transferred out Work in process, ending (1,400 units) Total costs accounted for

$28,290 + $0 + $4,020 $ 32,940 a a a (0 $22.30) + (1,200 $5.75) + (900 $6.35) 12,615 45,555 96,320 (2,800b $22.30) + (2,800b $5.75) + (2,800b $6.35) 141,875 c c c 35,665 (1,400 $22.30) + (0 $5.75) + (700 $6.35) $177,540 $122,580 + $23,000 + $31,960

a

Equivalent units used to complete beginning work in process from Solution Exhibit 17-40C, Step 2. Equivalent units started and completed from Solution Exhibit 17-40C, Step 2. c Equivalent units in ending work in process from Solution Exhibit 17-40C, Step 2 b


17-41 (30-35 min.) Weighted-average and standard-costing method. 1. Solution Exhibit 17-41A computes the equivalent units of work done in November 2010 by Penelope’s Pearls Company for direct materials and conversion costs. 2. and 3. Solution Exhibit 17-41B summarizes total costs of the Penelope’s Pearls Company for November 30, 2012 and, using the standard cost per equivalent unit for direct materials and conversion costs, assigns these costs to units completed and transferred out and to units in ending work in process. The exhibit also summarizes the cost variances for direct materials and conversion costs for November 2012. SOLUTION EXHIBIT 17-41A Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units; Standard Costing Method of Process Costing, Penelope’s Pearls Company for the month ended November 30, 2012.

Flow of Production

Work in process, beginning (given) Started during current period (given) To account for Completed and transferred out during current period: From beginning work in process§ 24,000 (100% 100%); 24,000 (100% – 70%) Started and completed 99,000 100%, 99,000 100% Work in process, ending* (given) 25,400 100%; 25,400 50% Accounted for Equivalent units of work done in current period § †

(Step 2) Equivalent Units Direct Conversion Materials Costs 24,000(work done before current period)

(Step 1) Physical Units

124,400 148,400 24,000 0

7,200

99,000

99,000

25,400 _______ 148,400 _______ 124,400

12,700

99,000† 25,400

_______ 118,900

Degree of completion in this department: direct materials, 100%; conversion costs, 70%. 123,000 physical units completed and transferred out minus 24,000 physical units completed and transferred out from beginning work-in-process inventory.

*Degree of completion in this department: direct materials, 100%; conversion costs, 50%.


SOLUTION EXHIBIT 17-41B Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed and to Units in Ending Work in Process; Standard-Costing Method of Process Costing, Penelope’s Pearls Company for the month ended November 30, 2012.

(Step 3) Work in process, beginning (given) Costs added in current period at standard costs Total costs to account for (Step 4) Standard cost per equivalent unit (given) (Step 5) Assignment of costs at standard costs: Completed and transferred out (123,000 units): Work in process, beginning (24,000 units) Costs added to beg. work in process in current period Total from beginning inventory Started and completed (99,000 units) Total costs of units transferred out Work in process, ending (25,400 units) Total costs accounted for Summary of variances for current performance: Costs added in current period at standard costs (see Step 3 above) Actual costs incurred (given) Variance

Total Production Direct Costs Materials $ 248,400 $ 72,000 1,621,650 (124,400 3.00) $1,870,050 $445,200 $

Conversion Costs + $ 176,400 + (118,900 $10.50) + $1,424,850

3.00

#

10.50

$72,000 + $176,400 $ 248,400 (0* $3.00) + (7,200* $10.50) 75,600 324,000 1,336,500 (99,000† $3.00) + (99,000† $10.50) 1,660,500 209,550 (25,400# $3.00) + (12,700# $10.50) $1,870,050 $445,200 + $1,424,850 $373,200 329,000 $ 44,200 F

*Equivalent units to complete beginning work in process from Solution Exhibit 17-41A, Step 2. †

$

Equivalent units started and completed from Solution Exhibit 17-41A, Step 2. Equivalent units in ending work in process from Solution Exhibit 17-41A, Step 2.


$1,248,450 1,217,000 $ 31,450 F

17-42 (30 min.) Standard-costing method. 1. Since there was no additional work needed on the beginning inventory with respect to materials, the initial mulch must have been 100% complete with respect to materials. For conversion costs, the work done to complete the opening inventory was 434,250 ÷ 965,000 = 45%. Therefore, the unfinished mulch in opening inventory must have been 55% complete with respect to conversion costs. 2. It is clear that the ending WIP is also 100% complete with respect to direct materials (1,817,000 ÷ 1,817,000), and it is 60% (1,090,200 ÷ 1,817,000) complete with regard to conversion costs. 3. We can first obtain the total standard costs per unit. The number of units started and completed during August is 845,000, and a total cost of $6,717,750 is attached to them. The per unit standard cost is therefore ($6,717,750 ÷ 845,000) = $7.95. If x and y represent the per unit cost for direct materials and conversion costs, respectively, we know that: x + y = 7.95 We also know that the ending inventory is costed at $12,192,070 and contains 1,817,000 equivalent units of materials and 1,090,200 equivalent units of conversion costs. This provides a second equation: 1,817,000 x + 1,090,200 y = 12,192,070. Solving these two equations reveals that the direct materials cost per unit, x, is $4.85, while the conversion cost per unit, y, is $3.10. 4. The opening WIP inventory contained 965,000 equivalent units of materials and (965,000 – 434,250) = 530,750 equivalent units of conversion costs. Applying the standard costs computed in step (3), the cost of the opening inventory must have been: (965,000 × $4.85) + (530,750 × $3.10) = $6,325,575.


CHAPTER 18 SPOILAGE, REWORK, AND SCRAP 18-1 Managers have found that improved quality and intolerance for high spoilage have lowered overall costs and increased sales. 18-2 Spoilage—units of production that do not meet the standards required by customers for good units and that are discarded or sold at reduced prices. Rework—units of production that do not meet the specifications required by customers but which are subsequently repaired and sold as good finished units. Scrap—residual material that results from manufacturing a product. It has low total sales value compared to the total sales value of the product. 18-3 Yes. Normal spoilage is spoilage inherent in a particular production process that arises even under efficient operating conditions. Management decides the spoilage rate it considers normal depending on the production process. 18-4 Abnormal spoilage is spoilage that is not inherent in a particular production process and would not arise under efficient operating conditions. Costs of abnormal spoilage are ―lost costs,‖ measures of inefficiency that should be written off directly as losses for the accounting period. 18-5 Management effort can affect the spoilage rate. Many companies are relentlessly reducing their rates of normal spoilage, spurred on by competitors who, likewise, are continuously reducing costs. 18-6 Normal spoilage typically is expressed as a percentage of good units passing the inspection point. Given actual spoiled units, we infer abnormal spoilage as follows: Abnormal spoilage = Actual spoilage – Normal spoilage. 18-7 Accounting for spoiled goods deals with cost assignment, rather than with cost incurrence, because the existence of spoiled goods does not involve any additional cost beyond the amount already incurred. 18-8 Yes. Normal spoilage rates should be computed from the good output or from the normal input, not the total input. Normal spoilage is a given percentage of a certain output base. This base should never include abnormal spoilage, which is included in total input. Abnormal spoilage does not vary in direct proportion to units produced, and to include it would cause the normal spoilage count to fluctuate irregularly and not vary in direct proportion to the output base. 18-9 Yes, the point of inspection is the key to the assignment of spoilage costs. Normal spoilage costs do not attach solely to units transferred out. Thus, if units in ending work in process have passed inspection, they should have normal spoilage costs added to them. 18-10 No. If abnormal spoilage is detected at a different point in the production cycle than normal spoilage, then unit costs would differ. If, however normal and abnormal spoilage are detected at the same point in the production cycle, their unit costs would be the same.


18-11 No. Spoilage may be considered a normal characteristic of a given production cycle. The costs of normal spoilage caused by a random malfunction of a machine would be charged as a part of the manufacturing overhead allocated to all jobs. Normal spoilage attributable to a specific job is charged to that job. 18-12 No. Unless there are special reasons for charging normal rework to jobs that contained the bad units, the costs of extra materials, labor, and so on are usually charged to manufacturing overhead and allocated to all jobs. 18-13 Yes. Abnormal rework is a loss just like abnormal spoilage. By charging it to manufacturing overhead, the abnormal rework costs are spread over other jobs and also included in inventory to the extent a job is not complete. Abnormal rework is rework over and above what is expected during a period, and is recognized as a loss for that period. 18-14 A company is justified in inventorying scrap when its estimated net realizable value is significant and the time between storing it and selling or reusing it is quite long. 18-15 Companies measure scrap to measure efficiency and to also control a tempting source of theft. Managers of companies that report high levels of scrap focus attention on ways to reduce scrap and to use the scrap the company generates more profitably. Some companies, for example, might redesign products and processes to reduce scrap. Others may also examine if the scrap can be reused to save substantial input costs. 18-16 (5–10 min.) Normal and abnormal spoilage in units. 1.

2.

Total spoiled units Normal spoilage in units, 5% Abnormal spoilage in units

132,000

Abnormal spoilage, 5,400 $10 Normal spoilage, 6,600 $10 Potential savings, 12,000 $10

12,000 6,600 5,400 $ 54,000 66,000 $120,000

Regardless of the targeted normal spoilage, abnormal spoilage is non-recurring and avoidable. The targeted normal spoilage rate is subject to change. Many companies have reduced their spoilage to almost zero, which would realize all potential savings. Of course, zero spoilage usually means higher-quality products, more customer satisfaction, more employee satisfaction, and various beneficial effects on nonmanufacturing (for example, purchasing) costs of direct materials.


18-17 (20 min.) Weighted-average method, spoilage, equivalent units. Solution Exhibit 18-17 calculates equivalent units of work done to date for direct materials and conversion costs. SOLUTION EXHIBIT 18-17 Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing with Spoilage, Gray Manufacturing Company for November 2012. (Step 1) Physical Units

Flow of Production Work in process, beginning (given) Started during current period To account for Good units completed and transferred out during current period: Normal spoilage* 100 100%; 100 100% Abnormal spoilage† 50 100%; 50 100% Work in process, ending‡ (given) 2,000 100%; 2,000 30% Accounted for Equivalent units of work done to date


1,000 10,150a 11,150 9,000 100

9,000

9,000

100

100

50

50

50 2,000 2,000

600

11,150 11,150

a

9,750

From below, 11,150 total units are accounted for. Therefore, units started during current period must be = 11,150 – 1,000 = 10,150. *Degree of completion of normal spoilage in this department: direct materials, 100%; conversion costs, 100%. † Degree of completion of abnormal spoilage in this department: direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: direct materials, 100%; conversion costs, 30%.


18-18 (20 25 min.) Weighted-average method, assigning costs (continuation of 18-17). Solution Exhibit 18-18 summarizes total costs to account for, calculates the costs per equivalent unit for direct materials and conversion costs, and assigns total costs to units completed and transferred out (including normal spoilage), to abnormal spoilage, and to units in ending work in process. SOLUTION EXHIBIT 18-18 Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Gray Manufacturing Company, November 2012. Total Production Costs $ 2,533 39,930 $42,463

(Step 3)


(Step 4)

Costs incurred to date Divided by equivalent units of work done to date Cost per equivalent unit

Assignment of costs Good units completed and transferred out (9,000 units) Costs before adding normal spoilage Normal spoilage (100 units) (A) Total cost of good units completed & transf. out (B) Abnormal spoilage (50 units) (C) Work in process, ending (2,000 units) (A)+(B)+(C) Total costs accounted for

$



$13,603 11,150 1.22

$28,860 9,750 2.96

$

(Step 5)

#

$37,620 (9,000# $1.22) + (9,000# $2.96) 418 (100# $1.22) + (100# $2.96) 38,038 (50# $1.22) + (50# $2.96) 209 4,216 (2,000# $1.22) + (600# $2.96) $42,463 $13,603 + $28,860

Equivalent units of direct materials and conversion costs calculated in Step 2 in Solution Exhibit 18-17.


18-19 (15 min.) FIFO method, spoilage, equivalent units. Solution Exhibit 18-19 calculates equivalent units of work done in the current period for direct materials and conversion costs. SOLUTION EXHIBIT 18-19 Summarize Output in Physical Units and Compute Output in Equivalent Units; First-in, First-out (FIFO) Method of Process Costing with Spoilage, Gray Manufacturing Company for November 2012. (Step 1) Physical Units 1,000 10,150a 11,150


Flow of Production Work in process, beginning (given) Started during current period To account for Good units completed and transferred out during current period: From beginning work in process|| 1,000 0 500 1,000 (100% 100%); 1,000 (100% 50%) 8,000# Started and completed 8,000 8,000 8,000 100%; 8,000 100% 100 Normal spoilage* 100 100 100 100%; 100 100% 50 Abnormal spoilage† 50 50 50 100%; 50 100% 2,000 Work in process, ending‡ 2,000 600 ____ 2,000 100%; 2,000 30% 11,150 Accounted for 10,150 9,250 Equivalent units of work done in current period a From below, 11,150 total units are accounted for. Therefore, units started during current period must be 11,150 – 1,000 = 10,150. || Degree of completion in this department: direct materials, 100%; conversion costs, 50%. # 9,000 physical units completed and transferred out minus 1,000 physical units completed and transferred out from beginning work-in-process inventory. *Degree of completion of normal spoilage in this department: direct materials, 100%; conversion costs, 100%. † Degree of completion of abnormal spoilage in this department: direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: direct materials, 100%; conversion costs, 30%.


18-20 (20 25 min.) FIFO method, assigning costs (continuation of 18-19). Solution Exhibit 18-20 summarizes total costs to account for, calculates the costs per equivalent unit for direct materials and conversion costs, and assigns total costs to units completed and transferred out (including normal spoilage), to abnormal spoilage, and to units in ending work in process. SOLUTION EXHIBIT 18-20 Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process; FIFO Method of Process Costing, Gray Manufacturing Company, November 2012. Total Production Costs $ 2,533 39,930 $42,463

(Step 3) Work in process, beginning (given) Costs added in current period (given) Total costs to account for (Step 4) Costs added in current period Divided by equivalent units of work done in current period Cost per equivalent unit (Step 5) Assignment of costs: Good units completed and transferred out (9,000 units) Work in process, beginning (1,000 units) Costs added to beg. work in process in current period Total from beginning inventory before normal spoilage Started and completed before normal spoilage (8,000 units) Normal spoilage (100 units) (A) Total costs of good units completed and transferred out (B) Abnormal spoilage (50 units) (C) Work in process, ending (2,000 units) (A)+(B)+(C) Total costs accounted for a



$12,180 10,150 1.20

$27,750 9,250 $ 3

$

$ 2,533 1,500

$1,423 + (0a $1.20) +

$1,110 (500a $3)

4,033 a a 33,600 (8,000 $1.20) + (8,000 $3) a a $3) 420 (100 $1.20) + (100 38,053 210 (50a $1.20) + (50a $3) a 4,200 (2,000 $1.20) + (600a $3) $42,463 $13,603 + $28,860

Equivalent units of direct materials and conversion costs calculated in Step 2 in Solution Exhibit 18-19.


18-21 (35 min.) Weighted-average method, spoilage. 1. Solution Exhibit 18-21A calculates equivalent units of work done in the current period for direct materials and conversion costs. SOLUTION EXHIBIT 18-21A Summarize Output in Physical Units and Compute Output in Equivalent Units; Weighted-Average Method of Process Costing with Spoilage, Appleton Company for August 2012. (Step 1)

(Step 2) Equivalent Units Physical Direct Conversion Units Materials Costs

Flow of Production

Work in process, beginning (given) 2,000 Started during current period (given) 10,000 To account for 12,000 Good units completed and tsfd. out during current period: 9,000 a Normal spoilage 900 (900 100%; 900 100%) Abnormal spoilageb 300 (300 100%; 300 100%) Work in process, endingc (given) 1,800 (1,800 100%; 1,800 75%) ______ Accounted for 12,000 Equivalent units of work done to date

9,000

9,000

900

900

300

300

1,800 _____ 12,000

1,350 _____ 11,550

a

Normal spoilage is 10% of good units transferred out: 10% × 9,000 = 900 units. Degree of completion of normal spoilage

in this department: direct materials, 100%; conversion costs, 100%. b Total spoilage = Beg. units + Units started - Good units transferred out – Ending units = 2,000 + 10,000 - 9,000 - 1,800 = 1,200; Abnormal spoilage = Total spoilage – Normal spoilage = 1,200 – 900 = 300 units. Degree of completion of abnormal spoilage in this department: direct materials, 100%; conversion costs, 100%. c Degree of completion in this department: direct materials, 100%; conversion costs, 75%.


2. Solution Exhibit 18-21B summarizes total costs to account for, calculates the costs per equivalent unit for direct materials and conversion costs, and assigns total costs to units completed and transferred out (including normal spoilage), to abnormal spoilage, and to units in ending work in process, using the weighted-average method. SOLUTION EXHIBIT 18-21B Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process; Weighted-Average Method of Process Costing, Appleton Company, August 2012. Total Production Costs $ 28,600 174,300 $202,900

(Step 3)


(Step 4)

Costs incurred to date Divide by equivalent units of work done to date Cost per equivalent unit

(Step 5)

(A) (B) (C) (A) + (B) + (C) d

Assignment of costs Good units completed and transferred out (9,000 units) Costs before adding normal spoilage Normal spoilage (900 units) Total costs of good units completed and transferred out Abnormal spoilage (300 units) Work in process, ending (1,800 units): Total costs accounted for

Direct Materials $17,700 81,300 $99,000


$99,000 12,000

$103,900 ÷11,550 $ 8.9957

$ 8.250

$155,211 15,521 170,732 5,174 26,994 $202,900

(9,000d (900d

$8.25) + (9,000 d $8.9957) $8.25) + (900d $8.9957)

(300d $8.25) + (300d $8.9957) (1,800d $8.25) + (1,350d $8.9957) $99,000 + $103,900

Equivalent units of direct materials and conversion costs calculated in step 2 of Solution Exhibit 18-21A.


18-22 (10 min.) Standard costing method, spoilage, journal entries. Spoilage represents the amount of resources that go into the process, but do not result in finished product. A simple way to account for spoilage in process costing is to calculate the amount of direct material that was spoiled. The journal entry to record the spoilage incurred in Jordan’s production process is: Manufacturing overhead control (normal spoilage) Work-in-process inventory (cost of spoiled sheet metal)

475 475

18-23 (15 min.) Recognition of loss from spoilage. 1. The unit cost of making the 8,000 units is: $320,000 ÷ 8,000 units = $40 per unit 2. The total cost of the 300 spoiled units is: $40 × 300 units = $12,000 3. The increase in the per-unit cost of goods sold as a result of the normal spoilage is: $12,000 ÷ 7,700 good units = $1.56 Unit cost of goods sold for units remaining after the spoilage = $40 + $1.56 = $41.56. (Or $320,000 ÷ 7,700 = $41.56) 4. The $12,000 cost for the 300 spoiled units is taken out of manufacturing costs and expensed in the period of the spoilage. The journal entry to record the abnormal spoilage incurred is: Loss from abnormal spoilage 12,000 Work-in-process control 12,000


18-24 (25 min.) Weighted-average method, spoilage. 1. Solution Exhibit 18-24, Panel A, calculates the equivalent units of work done to date for each cost category in September 2011. 2. Solution Exhibit 18-24, Panel B, summarizes total costs to account for, calculates the costs per equivalent unit for each cost category, and assigns total costs to units completed (including normal spoilage), to abnormal spoilage, and to units in ending work in process using the weighted-average method. SOLUTION EXHIBIT 18-24 Weighted-Average Method of Process Costing with Spoilage; Chipcity, September 2011. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units (Step 1) Physical Units 600 2,550 3,150

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Good units completed and transferred out during current period: Normal spoilage* 315 100%; 315 100% Abnormal spoilage† 285 100%; 285 100% Work in process, ending‡ (given) 450 100%; 450 40% Accounted for Equivalent units of work done to date

2,100 315


2,100

2,100

315

315

285

285

450

180

285 450 3,150 3,150

2,880

*Normal spoilage is 15% of good units transferred out: 15%

2,100 = 315 units. Degree of completion of normal spoilage in this department: direct materials, 100%; conversion costs, 100%. † Total spoilage = 600 + 2,550 – 2,100 – 450 = 600 units; Abnormal spoilage = Total spoilage Normal spoilage = 600 315 = 285 units. Degree of completion of abnormal spoilage in this department: direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: direct materials, 100%; conversion costs, 40%.


SOLUTION EXHIBIT 18-24 PANEL B: Steps 3, 4, and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process

(Step 3)


(Step 4)


Assignment of costs Good units completed and transferred out (2,100 units) Costs before adding normal spoilage Normal spoilage (315 units) (A) Total cost of good units completed and transferred out (B) Abnormal spoilage (285 units) (C) Work-in-process, ending (450 units) (A)+(B)+(C) Total costs accounted for




$663,000 3,150 $210.476

$245,700 2,880 $85.3125

(Step 5)

#

$621,156 (2,100# $210.476) + (2,100# $85.3125) 93,173 (315# $210.476) + (315# $85.3125) 714,329 # # 84,300 (285 $210.476) + (285 $85.3125) # # 110,071 (450 $210.476) + (180 $85.3125) $908,700 $663,000 $245,700

Equivalent units of direct materials and conversion costs calculated in Step 2 in Panel A.


18-25 (25 min.) FIFO method, spoilage. 1. Solution Exhibit 18-25, Panel A, calculates the equivalent units of work done in the current period for each cost category in September 2011. 2. Solution Exhibit 18-25, Panel B, summarizes Chipcity’s production costs for September 2011, calculates the costs per equivalent unit for each cost category, and assigns total costs to units completed and transferred out (including normal spoilage), to abnormal spoilage, and to units in ending work in process under the FIFO method. SOLUTION EXHIBIT 18-25 First-in, First-out (FIFO) Method of Process Costing with Spoilage; Chipcity, September 2011. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units (Step 2) (Step 1) Equivalent Units Physical Direct Conversion Flow of Production Units Materials Costs Work in process, beginning (given) 600 Started during current period (given) 2,550 To account for 3,150 Good units completed and transferred out during current period: From beginning work in process|| 600 0 420 600 (100% 100%); 600 (100% 30%) 1,500# Started and completed 1,500 1,500 1,500 100%; 1,500 100% 315 Normal spoilage* 315 315 315 100%; 315 100% † 285 Abnormal spoilage 285 285 285 100%; 285 100% ‡ 450 Work in process, ending 450 180 450 100%; 450 40% 3,150 Accounted for 2,550 2,700 Equivalent units of work done in current period ||

Degree of completion in this department: direct materials, 100%; conversion costs, 30%. 2,100 physical units completed and transferred out minus 600 physical units completed and transferred out from beginning work in process inventory. *Normal spoilage is 15% of good units transferred out: 15% 2,100 = 315 units. Degree of completion of normal spoilage in this department: direct materials, 100%; conversion costs, 100%. † Abnormal spoilage = Actual spoilage Normal spoilage = 600 315 = 285 units. Degree of completion of abnormal spoilage in this department: direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: direct materials, 100%; conversion costs, 40%. #


SOLUTION EXHIBIT 18-25 PANEL B: Steps 3, 4 and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process Total Production Costs $111,300 797,400 $908,700

(Step 3)


(Step 4)

Costs added in current period Divided by equivalent units of work done in current

period



$567,000 2,550 $222.353

$230,400 2,700 $ 85.333

Cost per equivalent unit (Step 5)

Assignment of costs: Good units completed and transferred out (2,100 units) Work in process, beginning (600 units) Costs added to beg. work in process in current period Total from beginning inventory before normal spoilage Started and completed before normal spoilage (1,500 units) Normal spoilage (315 units) (A) Total costs of good units completed and transferred out (B) Abnormal spoilage (285 units) (C) Work in process, ending (450 units) (A)+(B)+(C) Total costs accounted for §

$111,300 35,840

(0§

$96,000 + $15,300 $222.353) + (420§ $85.333)

147,140 461,529 96,921

(1,500§ $222.353)+(1,500§ $85.333) (315§ $222.353) + (315§ $85.333)

705,590 87,691 115,419 $908,700

(285§ $222.353) + (285§ $85.333) (450§ $222.353) + (180§ $85.333) $663,000 + $245,700



18-26 (30 min.) Standard-costing method, spoilage. 1. Solution Exhibit 18-25, Panel A, shows the computation of the equivalent units of work done in September 2011 for direct materials (2,550 units) and conversion costs (2,700 units). (This computation is the same for FIFO and standard-costing.) 2. The direct materials cost per equivalent unit of beginning work in process and of work done in September 2011 is the standard cost of $200 given in the problem. The conversion cost per equivalent unit of beginning work in process and of work done in September 2011 is the standard cost of $75 given in the problem. Solution Exhibit 18-26 summarizes the total costs to account for, and assigns these costs to units completed (including normal spoilage), to abnormal spoilage, and to units in ending work in process using the standard costing method. SOLUTION EXHIBIT 18-26 Standard Costing Method of Process Costing with Spoilage; Chipcity, September 2011. Steps 3, 4, and 5—Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process

(Step 3) Work in process, beginning* Costs added in current period at standard prices Costs to account for


(Step 4) Standard costs per equivalent unit (given)

$

(Step 5) Assignment of costs at standard costs: Good units completed and transferred out (2,100 units) Work in process, beginning (600 units)* Costs added to beg. work in process in current period Total from beginning inventory before normal spoilage Started and completed before normal spoilage (1,500 units) Normal spoilage (315 units) (A) Total costs of good units completed and transferred out (B) Abnormal spoilage (285 units) (C) Work in process, ending (450 units) (A)+(B)+(C) Total costs accounted for

275

$133,500 31,500

Direct Materials (600 $200) (2,550 $200) $630,000 $

200

(600 (0§

$200) $200)

Conversion Costs (180 $75) (2,700

$75)

$216,000 $

+ +

75

(180 $75) (420§ $75)

165,000 412,500 (1,500§ $200) + (1,500§ $75) 86,625 (315§ $200) + (315§ $75) 664,125 78,375 103,500 $846,000

(285§ (450§

$200) + $200) +

$630,000

+

(285§ (180§

$75) $75)

$216,000

*

Work in process, beginning has 600 equivalent units (600 physical units 100%) of direct materials and 180 equivalent units (600 physical units 30%) of conversion costs. § Equivalent units of direct materials and conversion costs calculated in Step 2 in Solution Exhibit 18-25, Panel A.


18-27 (20–30 min.) Spoilage and job costing. 1.

Cash Loss from Abnormal Spoilage Work-in-Process Control Loss = ($9.00 420) – $420 = $3,360

420 3,360 3,780

Remaining cases cost = $9.00 per case. The cost of these cases is unaffected by the loss from abnormal spoilage. 2.

a.

Cash

840 Work-in-Process Control

840

The cost of the remaining good cases = [($9.00 2,100) – $840] = $18,060 The unit cost of a good case now becomes $18,060 1,680 = $10.75 b.

Cash Manufacturing Department Overhead Control Work-in-Process Control

840 2,940 3,780

The unit cost of a good case remains at $9.00.

3.

c.

The unit costs in 2a and 2b are different because in 2a the normal spoilage cost is charged as a cost of the job which has exacting job specifications. In 2b however, normal spoilage is due to the production process, not the particular attributes of this specific job. These costs are, therefore, charged as part of manufacturing overhead and the manufacturing overhead cost of $2 per case already includes a provision for normal spoilage.

a.

Work-in-Process Control Materials Control, Wages Payable Control, Manufacturing Overhead Allocated

420 420

The cost of the good cases = [($9.00 2,100) + $420] = $19,320 The unit cost of a good case is $19,320 2,100 = $9.20 b.

Manufacturing Department Overhead Control Materials Control, Wages Payable Control, Manufacturing Overhead Allocated The unit cost of a good case = $9.00 per case c.

420 420

The unit costs in 3a and 3b are different because in 3a the normal rework cost is charged as a cost of the job which has exacting job specifications. In 3b however, normal rework is due to the production process, not the particular attributes of this specific job. These costs are, therefore, charged as part of manufacturing overhead and the manufacturing overhead cost of $2 per case already includes a provision for this normal rework.


18-28 (15 min.) Reworked units, costs of rework. 1.

The two alternative approaches to account for the materials costs of reworked units are: a. To charge the costs of rework to the current period as a separate expense item as abnormal rework. This approach would highlight to White Goods the costs of the supplier problem. b. To charge the costs of the rework to manufacturing overhead as normal rework.

2. The $50 tumbler cost is the cost of the actual tumblers included in the washing machines. The $44 tumbler units from the first supplier were eventually never used in any washing machine, and that supplier is now bankrupt. The units have now been disposed of at zero disposal value. 3.

The total costs of rework due to the defective tumbler units include the following: a. the labor and other conversion costs spent on substituting the new tumbler units; b. the costs of any extra negotiations to obtain the replacement tumbler units; c. any higher price the existing supplier may have charged to do a rush order for the replacement tumbler units; and d. ordering costs for the replacement tumbler units.


18-29 (25 min.) Scrap, job costing. 1. Journal entry to record scrap generated by a specific job and accounted for at the time scrap is sold is: Cash or Accounts Receivable Work-in-Process Control To recognize asset from sale of scrap. A memo posting is also made to the specific job record.

520 520

2. Scrap common to various jobs and accounted for at the time of its sale can be accounted for in two ways: a. Regard scrap sales as a separate line item of revenues (the method generally used when the dollar amount of scrap is immaterial): Cash or Accounts Receivable Scrap Revenues To recognize revenue from sale of scrap.

4,400 4,400

b. Regard scrap sales as offsets against manufacturing overhead (the method generally used when the dollar amount of scrap is material): Cash or Accounts Receivable Manufacturing Department Overhead Control To record cash raised from sale of scrap.

4,400 4,400

3. Journal entry to record scrap common to various jobs at the time scrap is returned to storeroom: Materials Control 4,400 Manufacturing Department Overhead Control 4,400 To record value of scrap returned to storeroom. When the scrap is reused as direct material on a subsequent job, the journal entry is: Work-in-Process Control 4,400 Materials Control 4,400 To record reuse of scrap on a job. Explanations of journal entries are provided here but are not required.


18-30 (30 min.) Weighted-average method, spoilage. Solution Exhibit 18-30 summarizes total costs to account for, calculates the equivalent units of work done to date for each cost category, and assigns total costs to units completed (including normal spoilage), to abnormal spoilage, and to units in ending work in process using the weighted-average method. SOLUTION EXHIBIT 18-30 Weighted-Average Method of Process Costing with Spoilage; Cleaning Department of the Boston Company for May. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units (Step 1) Physical Units 3,000 25,000 28,000

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Good units completed and transferred out during current period: Normal spoilage* 2,050 100%; 2,050 100% Abnormal spoilage† 1,250 100%; 1,250 100% Work in process, ending‡ (given) 4,200 100%; 4,200 30% Accounted for Equivalent units of work done to date


20,500

20,500

20,500

2,050

2,050

2,050

1,250

1,250

1,250

4,200

4,200

1,260

28,000

28,000

25,060

*Normal spoilage is 10% of good units transferred out: 10% 20,500 = 2,050 units. Degree of completion of normal spoilage in this department: direct materials, 100%; conversion costs, 100%. † Total spoilage = 3000 + 25,000 – 20,500 – 4,200 = 3,300 units; Abnormal spoilage = 3,300 – 2,050 = 1,250 units. Degree of completion of abnormal spoilage in this department: direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: direct materials, 100%; conversion costs, 30%.


SOLUTION EXHIBIT 18-30 PANEL B: Steps 3, 4, and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process Total Production Costs $ 7,200 83,466 $90,666

(Step 3)


(Step 4)


(Step 5)



$50,750 28,000

$39,916 25,060 $1.5928

$1.8125

Assignment of costs Good units completed and transferred out (20,500 units)

Costs before adding normal spoilage Normal spoilage (2,050 units) (A) Total costs of good units completed and transferred out (B) Abnormal spoilage (1,250 units) (C) Work in process, ending (4,200 units) (A)+(B)+(C) Total costs accounted for

# # $69,809 (20,500 1.8125) + (20,500 1.5928) # # 6,981 (2,050 1.8125) + (2,050 1.5928)

76,790 4,257 9,619 $90,666

(1,250# 1.8125) + (4,200# 1.8125) + $50,750 +

(1,250# 1.5928) (1,260# 1.5928) $39,916

*These numbers are all calculated using the unit costs carried out to three decimal places. #

Equivalent units of direct materials and conversion costs calculated in Step 2 in Panel A above.


18-31 (25 min.) FIFO method, spoilage. For the Cleaning Department, Solution Exhibit 18-31 summarizes the total costs for May, calculates the equivalent units of work done in the current period for direct materials and conversion costs, and assigns total costs to units completed and transferred out (including normal spoilage), to abnormal spoilage, and to units in ending work in process under the FIFO method. SOLUTION EXHIBIT 18-31 First-in, First-out (FIFO) Method of Process Costing with Spoilage; Cleaning Department of the Boston Company for May. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Good units completed and transferred out during current period: From beginning work in process|| 3,000 (100% 100%); 3,000 (100% 60%) Started and completed 17,500 100%; 17,500 100% Normal spoilage* 2,050 100%; 2,050 100% Abnormal spoilage† 1,250 100%; 1,250 100% Work in process, ending‡ 4,200 100%; 4,200 30% Accounted for Equivalent units of work done in current period

(Step 1) Physical Units 3,000 25,000 28,000


3,000 0

1200

17,500# 17,500

17,500

2,050

2,050

1,250

1,250

4,200

1,260

25,000

23,260

2,050 1,250 4,200 28,000

||

Degree of completion in this department: direct materials, 100%; conversion costs, 60%. 20,500 physical units completed and transferred out minus 3,000 physical units completed and transferred out from beginning work-in-process inventory. *Normal spoilage is 10% of good units transferred out: 10% 20,500 = 2,050 units. Degree of completion of normal spoilage in this department: direct materials, 100%; conversion costs, 100%. † Total spoilage = = 3000 + 25,000 – 20,500 – 4,200 = 3,300 units; Abnormal spoilage = 3,300 – 2,050 = 1,250 units. Degree of completion of abnormal spoilage in this department: direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: direct materials, 100%; conversion costs, 30%. #


SOLUTION EXHIBIT 18-31 PANEL B: Steps 3, 4, and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process Total Production Costs $ 7,200 83,466 $90,666

(Step 3)


(Step 4)

Costs added in current period Divided by equivalent units of work done in current period Cost per equivalent unit

Assignment of costs: Good units completed and transferred out (20,500 units) Work in process, beginning (3000 units) Costs added to beg. work in process in current period Total from beginning inventory before normal spoilage Started and completed before normal spoilage (17,500 units) Normal spoilage (2,050 units) (A) Total costs of good units completed and transferred out (B) Abnormal spoilage (1,250 units) (C) Work in process, ending (4,200 units) (A)+(B)+(C) Total costs accounted for



$46,250 25,000 $ 1.85

$37,216 23,260 1.60

$

(Step 5)

§

$ 7,200 1,920 9,120 60,375 7,073 76,568 4,312 9,786 $90,666

$4,500 + $2,700 (0§ $1.85) + (1200§ 1.6) (17,500§ 1.85) + (17,500§ 1.6) (2,050§ 1.85) + (2,050§ 1.6) (1,250§ 1.85) + (1,250§ 1.6) (4,200§ 1.85) + (1,260§ 1.6) $50,750 + $39,916



18-32 30).

(35 min.) Weighted-average method, Packaging Department (continuation of 18-

For the Packaging Department, Solution Exhibit 18-32 summarizes total costs to account for, calculates the equivalent units of work done to date for each cost category, and assigns costs to units completed (including normal spoilage), to abnormal spoilage, and to units in ending work in process using the weighted-average method. SOLUTION EXHIBIT 18-32 Weighted-Average Method of Process Costing with Spoilage; Packaging Department of the Boston Company for May. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units (Step 1)

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Good units completed and transferred out during current period: Normal spoilage* 1760 100%; 1,760 100%; 1,760 100% Abnormal spoilage† 240 100%; 240 100%, 240 100% Work in process, ending‡ (given) 7,000 100%; 7,000 0%; 7,000 40% Accounted for Equivalent units of work done to date

Physical Units 10,500 20,500 31,000 22,000 1,760


22,000

22,000

22,000

1,760

1,760

1,760

240 240

240

240

7,000 7,000 31,000 31,000

0 ______ 24,000

2,800 _____ 26,800

*Normal spoilage is 8% of good units transferred out: 8% 22,000 = 1,760 units. Degree of completion of normal spoilage in this department: transferred-in costs, 100%; direct materials, 100%; conversion costs, 100%. † Total spoilage =10,500 + 20,500 – 22,000 – 7,000 = 2,000 units. Abnormal spoilage = 2,000 – 1,760 = 240 units. Degree of completion of abnormal spoilage in this department: transferred-in costs, 100%; direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 40%.


SOLUTION EXHIBIT 18-32 PANEL B: Steps 3, 4, and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process Total Production Transferred-in Costs costs (Step 3)

(Step 4)


$ 54,160 120,490 $174,650


Assignment of costs Good units completed and transferred out (22,000 units) Costs before adding normal spoilage Normal spoilage (1,760 units) (A) Total cost of good units completed and transferred out (B) Abnormal spoilage (240 units) (C) Work in process, ending (7,000 units) (A)+(B)+(C)Total costs accounted for

Direct Materials

$ 39,460 76,790* $116,250

$

$

0 4,800 4,800

$14,700 38,900 $53,600

4,800 24,000 0.20

53,600 26,800 2.00

$

116,250 31,000 3.75 $

Conversion Costs

$

(Step 5)

$130,900 10,472

22,000# 1,760#

($3.75 + $0.20 + $2) ($3.75 + $0.20 + $2)

141,372 1,428 240# ($3.75 + $0.20 + $2) # 31,850 (7,000 $3.75) + (0# $0.20) + (2,800# $2) $174,650 $116,250 + $4,800 + $53,600

*Total costs of good units completed and transferred out in Panel B (Step 5) of Solution Exhibit 18-30. # Equivalent units of direct materials and conversion costs calculated in Step 2 in Panel A above.


18-33 (25 min.) FIFO method, Packaging Department (continuation of 18-31). Solution Exhibit 18-33 summarizes the total Packaging Department costs for May, shows the equivalent units of work done in the Packaging Department in the current period for transferredin costs, direct materials, and conversion costs, and assigns total costs to units completed and transferred out (including normal spoilage), to abnormal spoilage, and to units in ending workin-process under the FIFO method. SOLUTION EXHIBIT 18-33 First-in, First-out (FIFO) Method of Process Costing with Spoilage; Packaging Department of the Boston Company for May. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Good units completed and transferred out during current period: From beginning work in process|| 10,500 (100% 100%); 10,500 (100% 0%); 10,500 (100% 70%) Started and completed 11,500 100%; 11,500 100%; 11,500 100% Normal spoilage* 1,760 100%; 1,760% 100%; 1,760 100% Abnormal spoilage† 240 100%; 240 100%; 240 100% Work in process, ending‡ 7,000 100%; 7,000 0%; 7,000 40% Accounted for Equivalent units of work done in current period

(Step 1) Physical Units 10,500 20,500 31,000


10,500 0

10,500

3,150

11,500

11,500

11,500

1,760

1,760

1,760

11,500#

1,760

240 240

240

240

7,000 7,000

0

2,800

20,500

24,000

19,450

31,000

||

Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 70%. 22,000 physical units completed and transferred out minus 10,500 physical units completed and transferred out from beginning work-in-process inventory. *Normal spoilage is 8% of good units transferred out: 8% 22,000 = 1,760 units. Degree of completion of normal spoilage in this department: transferred-in costs, 100%; direct materials, 100%; conversion costs, 100%. † Total spoilage = 10,500 + 20,500 – 22,000 – 7,000 = 2,000 units. Abnormal spoilage = 2,000 – 1,760 = 240 units. Degree of completion of abnormal spoilage in this department: transferred-in costs, 100%; direct materials, 100%; conversion costs, 100%. ‡ Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 40%. #


SOLUTION EXHIBIT 18-33 PANEL B: Steps 3, 4, and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process Total Production Costs (Step 3)

(Step 4)


$ 54,160 120,268 $174,428

Costs added in current period Divided by equivalent units of work done in current period Cost per equivalent unit

Assignment of costs: Good units completed and transferred out (22,000 units) Work in process, beginning (10,500 units) Costs added to beg. work in process in current period Total from beginning inventory before normal spoilage Started and completed before normal spoilage (11,500 units) Normal spoilage (1,760 units) (A) Total costs of good units completed and transferred out (B) Abnormal spoilage (240 units) (C) Work in process, ending (7,000 units) (A)+(B)+(C) Total costs accounted for

Transferredin Costs $ 39,460 76,568* $116,028

$

$ 76,568 20,500 3.735

Direct Materials $

Conversion Costs

0 4,800 4,800

$14,700 38,900 $53,600

$4,800 ÷24,000 $ 0.20

$38,900 19,450 $ 2

$

(Step 5)

$54,160 8,400

$39,640 +

$0

+

$14,700

(0 $3.735) + (10,500§ 0.20)+(3,150§ $2)

62,560 68,253 10,446 141,259 1,424 31,745 $174,428

11,500§ 1,760§

($3.735 + $0.20 + $2) ($3.735 + $0.20 + $2)

240§ ($3.735 + $0.20 + $2) (7,000§ $3.735)+(0§ $0.20)+(2,800§ $2) $116,028 + $4,800 + $53,600

*Total costs of good units completed and transferred out in Step 5 Panel B of Solution Exhibit 18-31. § Equivalent units of direct materials and conversion costs calculated in Step 2 in Panel A.


18-34 (20 25 min.) Job-costing spoilage and scrap. If the scrap sale is material, then it will reduce the costs of the job by 200 lb × $3 = $600 Total costs of the job are $240,000 +$620,000 + $620,000 150% = $1,790,000 Unit cost of the job is $1,790,000/100,000 units = $17.90

a. Cost of job Less: Abnormal spoilage (10,000 units × $17.90) Less: Revenue from scrap Total cost of job

$1,790,000 (179,000) (600) $1,610,400

So Gross Margin will be: Sales $2,000,000 Cost of job 1,610,400 Gross margin $ 389,600 b. Cost of job Less: Abnormal spoilage (2,800* units × $17.90) Less: Revenue from scrap Total cost of job

$1,790,000 (50,120) (600) $1,739,280

So Gross Margin will be: Sales $2,000,000 Cost of job 1,739,280 Gross margin $ 260,720 *In this case the normal spoilage is 8% of 90,000 good units = 7,200 units. Cost of normal spoilage is included in the job cost. Abnormal units are 10,000 – 7,200 = 2,800 units c. Cost of job Less: Abnormal spoilage (0** units ×$17.90) Less: Revenue from scrap Total cost of job

$1,790,000 (0) (600) $1,789,400

So Gross Margin will be: Sales $2,000,000 Cost of job 1,789,400 Gross margin $ 210,600 ** If normal spoilage is 12% of 90,000 = 10,800 units, then all 10,000 spoiled units for this job are considered normal spoilage. This is all part of the cost of the job. 2. If scrap sales were considered immaterial, they would be reported separately as scrap revenue, and the gross margin for this job would decrease by $600 in all three cases above.


18-35 (15 min.) Spoilage in job costing 1. Normal spoilage rate= Units of normal spoilage ÷ Total good units completed = 7 ÷ 25 = 28%. 2. a) Journal entry for spoilage related to a specific job: Materials Control (spoiled goods at current disposal value) 7 × $230 Work-in-Process Control (Job #10)

1,610 1,610

Note: The costs incurred on the bad units (7 × $1,450) are already part of the balance in WIP. The cost of the 25 good units is (25 × 1,450) + (7 × $1,220) = $44,790 b) Journal entry for spoilage common to all jobs: Materials Control (spoiled goods at current disposal value) 7 × $230 Manufacturing Overhead Control (normal spoilage) Work-in-Process Control (Job #10)

1,610 8,540 10,150

Note: In developing the predetermined O/H rate, the budgeted manufacturing overhead would include expected normal spoilage costs. c) Journal entry for abnormal spoilage: Materials Control (spoiled goods at current disposal value) 7 × $230 Loss from Abnormal Spoilage 7 × $1,220 Work-in-Process Control (Job #10)

1,610 8,540 10,150

Note: If the spoilage is abnormal, the net loss is highlighted and always charged to an abnormal loss account.

18-36 (10 min.) Rework in job costing, journal entry (continuation of 18-35) a) Journal entry for rework related to a specific job: Work-in-Process Control (Job #10) Various Accounts (To charge rework costs to the job)

1,700 1,700

b) Journal entry for rework common to all jobs: Manufacturing Overhead Control (rework costs) Various Accounts

1,700

c) Journal entry for abnormal rework: Loss from Abnormal Rework Various Accounts

1,700

1,700

1,700


18-37 (10 min.) Scrap at time of sale or at time of production, journal entries (continuation of 18-35) a) Journal entry for recognizing immaterial scrap at time of sale: Cash or Accounts Receivable 650 Scrap Revenues 650 (To record other revenue sale of scrap) b) Journal entry for recognizing material scrap related to a specific job at time of sale: Cash or Accounts Receivable 650 Work-in-Process Control (Job #10) 650 c) Journal entry for recognizing material scrap common to all jobs at time of sale: Cash or Accounts Receivable 650 Manufacturing Overhead Control 650 d) Journal entry for recognizing material scrap as inventory at time of production and recording at net realizable value: Materials Control 650 Work-in-Process Control (Job #10) 650 Cash or Accounts Receivable Materials Control (When later sold)

650 650

18-38 (20 25 min.) Physical units, inspection at various stages of completion (chapter appendix).

Work in process, beginning (20%)* Started during March To account for

Inspection at 15% 1,400 12,000 13,400

Inspection at 40% 1,400 12,000 13,400

Inspection at 100% 1,400 12,000 13,400

11,300a 660b 340 1,100 13,400

11,300a 744c 256 1,100 13,400

11,300a 678d 322 1,100 13,400

Good units completed and transferred out Normal spoilage Abnormal spoilage (1,000 – Normal spoilage) Work in process, ending (70%)* Accounted for

*Degree of completion for conversion costs at the dates of the work-in-process inventories a 1,400 beginning inventory +12,000 –1,000 spoiled – 1,100 ending inventory = 11,300. b 6% (12,000 units started – 1,000 units spoiled) = 6% 11,000 = 660; beginning work-in-process inventory is excluded because it was already 20% complete at March 1 and past the inspection point. c 6% (13,400 units – 1,000 ) = 6% 12,400 = 744, because all units passed the 40% completion inspection point in March. d 6% 11,300 = 678, because 11,300 units are fully completed and inspected during March.


18-39 (30 35 min.) Weighted-average method, inspection at 80% completion (chapter appendix). The computation and allocation of spoilage is the most difficult part of this problem. The units in the ending inventory have passed inspection. Therefore, of the 100,000 units to account for (12,500 beginning + 87,500 started), 12,500 must have been spoiled in May [100,000 – (62,500 completed + 25,000 ending inventory)]. Normal spoilage is 8,750 [0.10 (62,500 + 25,000)]. The 3,750 remainder is abnormal spoilage (12,500 – 8,750). Solution Exhibit 18-39, Panel A, calculates the equivalent units of work done for each cost category. We comment on several points in this calculation: Ending work in process includes an element of normal spoilage since all the ending WIP have passed the point of inspection––inspection occurs when production is 80% complete, while the units in ending WIP are 95% complete. Spoilage includes no direct materials units because spoiled units are detected and removed from the finishing activity when inspection occurs at the time production is 80% complete. Direct materials are added only later when production is 90% complete. Direct materials units are included for ending work in process, which is 95% complete, but not for beginning work in process, which is 25% complete. The reason is that direct materials are added when production is 90% complete. The ending work in process, therefore, contains direct materials units; the beginning work in process does not. Solution Exhibit 18-39, Panel B, summarizes total costs to account for, computes the costs per equivalent unit for each cost category, and assigns costs to units completed (including normal spoilage), to abnormal spoilage, and to units in ending work in process using the weighted-average method. The cost of ending work in process includes the assignment of normal spoilage costs since these units have passed the point of inspection. The costs assigned to each cost category are as follows: Cost of good units completed and transferred out (including normal spoilage costs on good units) Abnormal spoilage Cost of ending work in process (including normal spoilage costs on ending work in process) Total costs assigned and accounted for

$2,346,687 84,638 917,675 $3,349,000


SOLUTION EXHIBIT 18-39 Weighted-Average Method of Process Costing with Spoilage; Finishing Department of the Kim Company for August. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units (Step 1)

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Good units completed and transferred out during current period: Normal spoilage on good units* 6,250 100%; 6,250 0%; 6,250 80% Work in process, ending‡ (given) 25,000 100%; 25,000 100%; 25,000 95% Normal spoilage on ending WIP** 2,500 100%; 2,500 0%; 2,500 80% Abnormal spoilage† 3,750 100%; 3,750 0%; 3,750 80% Accounted for Equivalent units of work done to date

Physical Units 12,500 87,500 100,000 62,500 6,250


62,500 6,250

62,500 0

62,500 5,000

25,000 25,000

25,000

23,750

2,500 2,500

0

2,000

3,750

0

3,000

3,750 100,000 100,000

87,500

96,250

*Normal spoilage is 10% of good units that pass inspection: 10% 62,500 = 6,250 units. Degree of completion of normal spoilage in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 80%. ‡ Degree of completion in this department: transferred-in costs, 100%; direct materials, 100%; conversion costs, 95%. **Normal spoilage is 10% of the good units in ending WIP that have passed the inspection point, 10% 25,000 = 2,500 units. Degree of completion of normal spoilage in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 80%. † Abnormal spoilage = Actual spoilage Normal spoilage = 12,500 8,750 = 3,750 units. Degree of completion of abnormal spoilage in this department: transferred-in costs, 100%; direct materials, 0%; conversion costs, 80%.


SOLUTION EXHIBIT 18-39 PANEL B: Steps 3, 4, and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process Total Production TransferredCosts in Costs (Step 3)

(Step 4)

Work in process, beginning (given) Costs added in current period (given) Total costs to account for Costs incurred to date Divided by equivalent units of work done to date Cost per equivalent unit

$ 156,125 3,192,875 $3,349,000

Direct Materials

$103,625 809,375 $913,000

9.13

819,000 $819,000

$

52,500 1,564,500 $1,617,000

$819,000 87,500

$1,617,000 96,250

$

$913,000 100,000 $

Conversion Costs

$

9.36

$

16.80

(Step 5)

Assignment of costs Good units completed and transferred out (62,500 units) 62,500# ($9.13 + $9.36 + $16.80) Costs before adding normal spoilage $2,205,625 (0# $9.36) + (5,000# $16.80) Normal spoilage (6,250 units) 141,063 (6,250# $9.13) + (A) Total costs of good units completed and transferred out 2,346,688 (0# $9.36) + (3,000# $16.80) (B) Abnormal spoilage (3,750 units) 84,638 (3,750# $9.13) + Work in process, ending (25,000 units) WIP ending, before normal spoilage 861,250 (25,000# $9.13) + (25,000# $9.36) + (23,750# $16.80) (0# $9.36) + (2,000# $16.80) Normal spoilage on ending WIP 56,425 (2,500# $9.13) + (C) Total costs of ending WIP 917,675 + $819,000 + $1,617,000 (A)+(B)+(C) Total costs accounted for $3,349,000 $913,000

#

Equivalent units of transferred-in costs, direct materials, and conversion costs calculated in Step 2 in Panel A.


18-40 (20 min.) Job costing, rework. 1.

2.

Manufacturing Overhead Control (rework costs) Materials Control ($12 50) Wages Payable ($9 50) Manufacturing Overhead Allocated ($15 50) Normal rework on 50 units, but not attributable to any specific XD1 job

1,800

Loss from Abnormal Rework ($36 30) Materials Control ($12 30) Wages Payable ($9 30) Manufacturing Overhead Allocated ($15 30) Total costs of abnormal rework on 30 units (Abnormal rework = Actual rework – Normal rework = 80 – 50 = 30 units) of XD1 chips.

1,080

600 450 750

360 270 450

Total rework costs for XD1 chips in August 2011 are as follows: Normal rework costs allocated to XD1 Abnormal rework costs for XD1 Total rework costs

$1,800 1,080 $2,880

3. Manufacturing costs of job #3879 before rework: 200 units ($60+$12+$38) $22,000 Add: Normal rework costs 1,800 Total cost of job #3879 $23,800 Unit cost of job (Total /200 units) $ 119 Work-in-Process Control (Job #3879) Materials Control ($60 200) Wages Payable ($12 200) Manufacturing Overhead Allocated ($38 200) Manufacturing costs for 200 units of XD1 on Job #3879 Work-in-Process Control (Job #3879) Materials Control ($12 50) Wages Payable ($9 50) Manufacturing Overhead Allocated ($15 50) Normal rework for 50 units of XD1 attributable to Job #3879

22,000 12,000 2,400 7,600

1,800 600 450 750


18-41 Physical units, inspection at various levels of completion, weighted average process costing report 1. Work in process, beginning (40%)* Started during November To account for

Inspection at 30% 20,000 100,000 120,000

Inspection at 60% 20,000 100,000 120,000

Inspection at 100% 20,000 100,000 120,000

75,000a 10,200b 4,800 30,000 120,000

75,000a 12,600c 2,400 30,000 120,000

75,000a 9,000d 6,000 30,000 120,000

Good units completed and transferred out Normal spoilage Abnormal spoilage (15,000 – normal spoilage) Work in process, ending (70%)* Accounted for

*Degree of completion for conversion costs at the dates of the work-in-process inventories a 20,000 beginning inventory +100,000 –15,000 spoiled – 30,000 ending inventory = 75,000. b 12% (100,000 units started – 15,000 units spoiled) = 12% 85,000 = 10,200; beginning work-in-process inventory is excluded because it was already 40% complete at Nov 1 and past the inspection point. c 12% (120,000 units – 15,000 ) = 12% 105,000 = 12,600, because all units passed the 60% completion inspection point in November. d 12% 75,000 = 9,000, because 75,000 units are fully completed and inspected during November.

2. There are different amounts of normal and abnormal spoilage because the spoilage is detected at different points in the process. At the 30% inspection point, the beginning work in process inventory has already passed inspection and consists entirely of good units. At the 60% inspection point, the beginning work in process as well as units started this period must pass through the inspection point in the month of November. At the 100% inspection point, only the finished units have been inspected. Those in ending work in process have not yet been inspected. The finished units that are transferred out are good, but the others have not been inspected yet. Of course in all three cases the total spoilage is 15,000 units (given in the problem.) 3. Solution Exhibit 18-41 summarizes total costs to account for, calculates the equivalent units of work done to date for each cost category, and assigns total costs to units completed (including normal spoilage), to abnormal spoilage, and to units in ending work in process using the weighted-average method.


SOLUTION EXHIBIT 18-41 Weighted-Average Method of Process Costing with Spoilage; Forging Department of Lester Company for November. PANEL A: Steps 1 and 2—Summarize Output in Physical Units and Compute Output in Equivalent Units (Step 1) Physical Units 20,000 100,000 120,000

Flow of Production Work in process, beginning (given) Started during current period (given) To account for Good units completed and transferred out during current period: Normal spoilage (at 60% inspection pt) 12,600 100%; 12,600 60% Abnormal spoilage (at 60% inspection pt) 2,400 100%; 2,400 60% Work in process, ending‡ (given) 30,000 100%; 30,000 70%a Accounted for Equivalent units of work done to date

a


75,000

75,000

75,000

12,600

12,600

7,560

2,400

2,400

1,440

30,000

30,000

21,000

120,000

120,000

105,000

Degree of completion in this department: direct materials, 100%; conversion costs, 70%.


SOLUTION EXHIBIT 18-41 PANEL B: Steps 3, 4, and 5— Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process Total Production Costs $ 166,500 1,200,000 $1,366,500

(Step 3)


(Step 4)


(Step 5)

(A) (B) (C)

Assignment of costs Good units completed and transferred out (75,000 units) Costs before adding normal spoilage Normal spoilage (12,600# units, 7560# units) Total costs of good units completed and transferred out Abnormal spoilage (2,400# units, 1,440# units) Work in process, ending (30,000# units, 21,000# units)



$264,000 120,000 2.20

$1,102,500 105,000 10.50

$

$

$ 952,500 (75,000 $2.20) + (75,000 10.50) 107,100 (12,600 2.20) + (7,560 10.50) 1,059,600 # 20,400 (2,400 2.20) + (1,440 10.50) 286,500 (30,000 2.20) + (21,000 10.50) $264,000 + $1,102,500 $1,366,500

(A)+(B)+(C) Total costs accounted for

#

Equivalent units of direct materials and conversion costs calculated in Step 2 in Panel A above.


CHAPTER 19 BALANCED SCORECARD: QUALITY, TIME, AND THE THEORY OF CONSTRAINTS 19-1 Quality costs (including the opportunity cost of lost sales because of poor quality) can be as much as 10% to 20% of sales revenues of many organizations. Quality-improvement programs can result in substantial cost savings and higher revenues and market share from increased customer satisfaction. 19-2 Design quality refers to how closely the characteristics of a product or service meet the needs and wants of customers. Conformance quality refers to the performance of a product or service relative to its design and product specifications. 19-3 Exhibit 19-1 of the text lists the following six line items in the prevention costs category: design engineering; process engineering; supplier evaluations; preventive equipment maintenance; quality training; and testing of new materials. 19-4 An internal failure cost differs from an external failure cost on the basis of when the nonconforming product is detected. Internal failure costs are costs incurred on a defective product before a product is shipped to a customer, whereas external failure costs are costs incurred on a defective product after a product is shipped to a customer. 19-5 Three methods that companies use to identify quality problems are: (a) a control chart which is a graph of a series of successive observations of a particular step, procedure, or operation taken at regular intervals of time; (b) a Pareto diagram, which is a chart that indicates how frequently each type of failure (defect) occurs, ordered from the most frequent to the least frequent; and (c) a cause-and-effect diagram, which helps identify potential causes of defects using a diagram that resembles the bone structure of a fish. 19-6 No, companies should emphasize financial as well as nonfinancial measures of quality, such as yield and defect rates. Nonfinancial measures are not directly linked to bottom-line performance but they indicate and direct attention to the specific areas that need improvement to improve the bottom line. Tracking nonfinancial measures over time directly reveals whether these areas have, in fact, improved over time. Nonfinancial measures are easy to quantify and easy to understand. 19-7 Examples of nonfinancial measures of customer satisfaction relating to quality include the following: 1. the number of defective units shipped to customers as a percentage of total units of product shipped; 2. the number of customer complaints; 3. delivery delays (the difference between the scheduled delivery date and date requested by customer); 4. on-time delivery rate (percentage of shipments made on or before the promised delivery date); 5. customer satisfaction with specific product features (to measure design quality); 6. market share; and 7. percentage of units of product that fail soon after delivery.


19-8 Examples of nonfinancial measures of internal-business-process quality: 1. the percentage of defective products; 2. percentage of reworked products; 3. manufacturing cycle time (the amount of time from when an order is received by production to when it becomes a finished good); and 4. number of product and process design changes 19-9 Customer-response time is how long it takes from the time a customer places an order for a product or a service to the time the product or service is delivered to the customer. Manufacturing cycle time is how long it takes from the time an order is received by manufacturing to the time a finished good is produced. Manufacturing cycle time is only one part of customer-response time. Delays in delivering an order for a product or service can also occur because of delays in receiving customer orders and delays in delivering a completed order to a customer. Customer Manufacturing response = Receipt + + Delivery cycle time time time time

19-10 No. There is a trade-off between customer-response time and on-time performance. Simply scheduling longer customer-response time makes achieving on-time performance easier. Companies should, however, attempt to reduce the uncertainty of the arrival of orders, manage bottlenecks, reduce setup and processing time, and run smaller batches. This would have the effect of reducing both customer-response time and improving on-time performance. 19-11 Two reasons why lines, queues, and delays occur is (1) uncertainty about when customers will order products or services––uncertainty causes a number of orders to be received at the same time, causing delays, and (2) limited capacity and bottlenecks––a bottleneck is an operation where the work to be performed approaches or exceeds the available capacity. 19-12 No. Adding a product when capacity is constrained and the timing of customer orders is uncertain causes delays in delivering all existing products. If the revenue losses from delays in delivering existing products and the increase in carrying costs of the existing products exceed the positive contribution earned by the product that was added, then it is not worthwhile to make and sell the new product, despite its positive contribution margin. The chapter describes the negative effects (negative externalities) that one product can have on others when products share common manufacturing facilities. 19-13 The three main measures used in the theory of constraints are the following: 1. throughput margin equal to revenues minus direct material cost of the goods sold; 2. investments equal to the sum of materials costs in direct materials, work-in-process and finished goods inventories, research and development costs, and costs of equipment and buildings; 3. operating costs equal to all costs of operations such as salaries and wages, rent, and utilities (other than direct materials) incurred to earn throughput contribution.


19-14 The four key steps in managing bottleneck resources are: Step 1: Recognize that the bottleneck operation determines throughput contribution of the entire system. Step 2: Search for, and identify the bottleneck operation. Step 3: Keep the bottleneck operation busy, and subordinate all nonbottleneck operations to the bottleneck operation. Step 4: Increase bottleneck efficiency and capacity. 19-15 The chapter describes several ways to improve the performance of a bottleneck operation. 1. Eliminate idle time at the bottleneck operation. 2. Process only those parts or products at the bottleneck operation that increase throughput margin, not parts or products that will remain in finished goods or spare parts inventories. 3. Shift products that do not have to be made on the bottleneck machine to nonbottleneck machines or to outside processing facilities. 4. Reduce setup time and processing time at bottleneck operations. 5. Improve the quality of parts or products manufactured at the bottleneck operation.


19-16 (30 min.) Costs of quality. 1.

The ratios of each COQ category to revenues and to total quality costs for each period are as follows: Costen, Inc.: Semi-annual Costs of Quality Report (in thousands) 6/30/2010

12/31/2010

6/30/2011

12/31/2011

% of Total % of Total % of Total % of Total % of Quality % of Quality % of Quality % of Quality Actual Revenues Costs Actual Revenues Costs Actual Revenues Costs Actual Revenues Costs (2) = (3) = (5) = (6) = (8) = (9) = (11) = (12) = (1) (1) ÷ $8,240 (1) ÷ $2,040 (4) (4) ÷ $9,080 (4) ÷ $2,159 (7) (7) ÷ $9,300 (7) ÷ $1,605 (10) (10) ÷ $9,020 (10) ÷ $1,271 Prevention costs Machine maintenance Supplier training Design reviews Total prevention costs Appraisal costs Incoming inspection Final testing Total appraisal costs Internal failure costs Rework Scrap Total internal failure costs External failure costs Warranty repairs Customer returns Total external failure costs Total quality costs Total production and revenues

$ 440 20 50 510 108 332 440 231 124 355 165 570 735 $2,040 $8,240

6.2%

5.3%

4.3%

8.9% 24.7%

25.0%

$ 440 100 214 754

21.6%

123 332 455

17.4%

202 116 318

36.0% 100.0%

85 547 632 $2,159 $9,080

8.3%

5.0%

3.5%

7.0% 23.8%

34.9%

$ 390 50 210 650

21.1%

90 293 383

14.7%

165 71 236

29.3% 100.0%

72 264 336 $1,605 $9,300

7.0%

4.1%

2.5%

3.6% 17.2%

40.5%

$ 330 40 200 570

6.3%

44.9%

23.9%

63 203 266

3.0%

20.9%

14.7%

112 67 179

2.0%

14.1%

2.8% 14.1%

20.1% 100.0%

20.9% 100.0%

68 188 256 $1,271 $9,020


2. From an analysis of the Cost of Quality Report, it would appear that Costen, Inc.’s program has been successful because: Total quality costs as a percentage of total revenues have declined from 24.7% to 14.1%. External failure costs, those costs signaling customer dissatisfaction, have declined from 8.9% of total revenues to 2.8% of total revenues and from 36% of all quality costs to 20.1% of all quality costs. These declines in warranty repairs and customer returns should translate into increased revenues in the future. Internal failure costs as a percentage of revenues have been halved from 4.3% to 2%. Appraisal costs have decreased from 5.3% to 3% of revenues. Preventing defects from occurring in the first place is reducing the demand for final testing. Quality costs have shifted to the area of prevention where problems are solved before production starts: total prevention costs (maintenance, supplier training, and design reviews) have risen from 25% to 44.9% of total quality costs. The $60,000 increase in these costs is more than offset by decreases in other quality costs. Because of improved designs, quality training, and additional pre-production inspections, scrap and rework costs have almost been halved while increasing sales by 9.5%. Production does not have to spend an inordinate amount of time with customer service since they are now making the product right the first time and warranty repairs and customer returns have decreased. 3. To estimate the opportunity cost of not implementing the quality program and to help her make her case, Jessica Tolmy could have assumed that: Sales and market share would continue to decline if the quality program was not implemented and then calculated the loss in revenue and contribution margin. The company would have to compete on price rather than quality and calculated the impact of having to lower product prices. Opportunity costs are not recorded in accounting systems because they represent the results of what might have happened if the company had not improved quality. Nevertheless, opportunity costs of poor quality can be significant. It is important for Costen to take these costs into account when making decisions about quality.


19-17 (20 min.) Costs of quality analysis. 1.

Appraisal cost = Inspection cost = $4 × 250,000 car seats = $1,000,000

2.

Internal failure cost = Rework cost = 9% × 250,000 × $0.75 = 22,500 × $0.75 = $16,875

3.

Out of pocket external failure cost = Shipping cost + Repair cost = 3% × 250,000 × ($7 + $0.75) = 7,500 × $7.75 = $58,125

4.

Opportunity cost of external failure = Lost future profits = (3% × 250,000) × 20% × $300 = 1,500 car seats × $300 = $450,000

5.

Total cost of quality control = $1,000,000 + $16,875 + $58,125 + $450,000 = $1,525,000

6.

Quality control costs under the alternative inspection technique: Appraisal cost = $1 × 250,000 = $250,000 Internal failure cost = 5% × 250,000 × $0.75 = $9,375 Out-of-pocket external failure cost = 7% × 250,000 × ($7 + $0.75) = 17,500 × $7.75 = $135,625 Opportunity cost of external failure = 17,500 car seats × 20% × $300 = 3,500 car seats × $300 = $1,050,000 Total cost of quality control = $250,000 + $9,375 + $135,625 + $1,050,000 = $1,445,000

7. In addition to the lower costs under the alternative inspection plan, Safe Rider should consider a number of other factors: a. There could easily be serious reputation effects if the percentage of external failures increases by 133% (from 3% to 7%). This rise in external failures may lead to costs greater than $300 per failure due to lost profits. b. Higher external failure rates may increase the probability of lawsuits. c. Government intervention is a concern, with the chances of government regulation increasing with the number of external failures.


19-18 (15 min.) Cost of quality analysis, ethical considerations (continuation of 19-17). 1. Cost of improving quality of plastic = $15 × 250,000 = $3,750,000 2. Total cost of lawsuits = 3 × $775,000 = $2,325,000 3. While economically this may seem like a good decision, qualitative factors should be more important than quantitative factors when it comes to protecting customers from harm and injury. If a product can cause a customer serious harm and injury, an ethical and moral company should take steps to prevent that harm and injury. The company’s code of ethics should guide this decision. 4. In addition to ethical considerations, the company should consider the societal cost of this decision, reputation effects if word of these problems leaks out at a later date, and governmental intervention and regulation.


19-19 (25 min.)

Nonfinancial measures of quality and time.

1.

2010 100 = 5% 2,000

2011 400 = 4% 10,000

150 = 7.5% 2,000

250 = 2.5% 10,000

Percentage of units reworked during production

120 = 6% 2,000

700 = 7% 10,000

Manufacturing cycle time as a percentage of total time from order to delivery

15 days = 50% 30 days

16 days = 57% 28 days

Percentage of defective units shipped Customer complaints as a percentage of units shipped

2. Quality has by and large improved. The percentage of defects has decreased by 1 percentage point and the number of customer complaints has decreased by 5 percentage points. The former indicates an increase in the quality of the cell phones being produced. The latter has positive implications for future sales. However, the percentage of units reworked has also increased. WCP should look into the reason for the increase. One possible explanation is the five-fold increase in production that may have resulted in a higher percentage of errors. WCP should do a root-cause analysis to identify reasons for the additional rework. Finally, the average time from order placement to order delivery has decreased. So customers are receiving their orders on a timelier basis. But manufacturing cycle time is a higher fraction of customer response time. WCP should seek ways to reduce manufacturing cycle time. For example, process improvements could reduce both rework and manufacturing cycle time. Any reduction in manufacturing cycle time would help to further reduce customer response time. 3. Manufacturing cycle time = wait time + manufacturing time. Producing 10,000 cell phones in 2011 may have required more waiting time for each order than the waiting time from producing 2,000 cell phones in 2010. Manufacturing cycle time may have increased as more time was spent on making products with fewer defects and reducing rework activities. Customer response time = receipt time + manufacturing cycle time + delivery time. Manufacturing cycle time is a subset of customer response time. Lower customer response time times is due to order processing efficiency and/or delivery efficiency and not manufacturing cycle time.


19-20 (25 min.) Quality improvement, relevant costs, and relevant revenues. 1.

Relevant costs over the next year of changing to the new component = $70 18,000 copiers = $1,260,000 Relevant Benefits over the Next Year of Choosing the New Component Costs of quality items Savings in rework costs $79 14,000 rework hours Savings in customer-support costs $35 850 customer-support hours Savings in transportation costs for parts $350 225 fewer loads Savings in warranty repair costs $89 8,000 repair-hours Opportunity costs Contribution margin from increased sales Cost savings and additional contribution margin

$1,106,000 29,750 78,750 712,000 1,680,000 $3,606,500

Because the expected relevant benefits of $3,606,500 exceed the expected relevant costs of the new component of $1,260,000, SpeedPrint should introduce the new component. Note that the opportunity cost benefits in the form of higher contribution margin from increased sales is an important component for justifying the investment in the new component. 2. The incremental cost of the new component of $1,260,000 is less than the incremental savings in rework and repair costs of $1,926,500 ($1,106,000 + $29,750 + $78,750 + $712,000). Thus, it is beneficial for SpeedPrint to invest in the new component even without making any additional sales.


19-21 (20 min.) Quality improvement, relevant costs, relevant revenues. 1. Budgeted variable cost per attendee: Customer support and service personnel Food and drink Conference materials Incidental products and services Total budgeted variable cost per attendee Total budgeted variable cost ($205 × 50,000 attendees) Budgeted fixed costs: Building and facilities Management salaries Total budgeted fixed costs Total budgeted costs Budgeted operating income Budgeted revenues Budgeted revenue per conference attendee ($18,750,000 ÷ 50,000)

$ 55 100 35 15 $205 $10,250,000 $3,600,000 1,400,000 5,000,000 15,250,000 3,500,000 $18,750,000 $375

The budgeted revenue per conference attendee is $375. 2. Quality improvements: additional menu items; additional incidental products and services; improved facilities. Budgeted variable cost per attendee: Customer support and service personnel ($55 + $3) Food and drink ($100 + $5) Conference materials ($35 + $0) Incidental products and services ($15 + $2) Total budgeted variable cost per attendee Budgeted revenues ($375 per attendee 70,000 attendees) Total budgeted variable costs ($215 70,000 attendees) Budgeted fixed costs: Building and facilities (3,500,000 1.50) Management salaries (1,500,000 1.50) Total budgeted fixed costs Total budgeted costs Budgeted operating income`

$ 58 105 35 17 $215 $26,250,000 15,050,000 $5,250,000 2,250,000 7,500,000 22,550,000 $ 3,700,000


The improvements above would increase operating income from $3,500,000 to $3,700,000. Moreover, improving the company’s meeting facilities could also lead to long-term growth. 3. Using information from requirement 2, Revenues Fixed costs Denote total variable costs by $x $26,250,000 – $x – $7,500,000 = $3,500,000 $x = $26,250,000 – $7,500,000 – $3,500,000 = $15,250,000 Total variable costs = $15,250,000

$26,250,000 $7,500,000

$15, 250, 000 = $217.86 70, 000 At a variable cost per conference attendee of $217.86, Flagstar would be indifferent between implementing and not implementing the proposed changes.

Variable cost per conference attendee =


19-22 (30 min.)

Waiting time, service industry.

1. If SMU’s advisors expect to see 300 students each day and it takes an average of 12 minutes to advise each student, then the average time that a student will wait can be calculated using the following formula: 2 Average number Time taken to advise a student of students per day Wait time = Maximum amount Average number Time taken to 2 advise a student of students per day of time available =

=

300

12

10 hours

2

2

10 advisors

60 minutes

2

43,200 = 9 minutes 6, 000 3, 600

300 12

2. At 420 students seen a day,

Average number of students per day

Wait time =

Average amount of students per day

Maximum amount of time available

2

420

=

=

Time taken to advise a student


2

12

10 hours

2

2

10 advisors

60 minutes

2

60,480 = 31.5 minutes 6, 000 5,040

420 12

3. If the average time to advise a student is reduced to 10 minutes, then the average wait time would be 2 Average number Time taken to advise a student of students per day =

2 =

=


Maximum amount of time available 420

2

10 advisors

2

42,000 6, 000 4, 200

10 hours

10


2

60 minutes

420 10

11.67 minutes


19-23 (25 min.) Waiting time, cost considerations, and customer satisfaction (continued from 19-24). 1.

i)

If SMU hires two more advisors then the average wait time will be:


=

=

420 2



2

12 advisors =

2


12

10 hours

2


2

60 minutes

420 12

60,480 = 14 minutes 7, 200 5, 040

ii) If SMU has its current employees work 6 days a week and has them advise 350 students a day then the average wait time will be:


=


2

=

350 2

10 advisors =

2

Average amount of students per day 12

10 hours

50,400 6, 000 4, 200


2


2

60 minutes

350 12

14 minutes

2. i) Cost if SMU hires 2 extra advisors for the registration period: Advisor salary cost = 12 advisors ×10 days × $100 = $12,000 ii) Cost if SMU has its 10 advisors work 6 days a week for the registration period: Advisor salary cost = 10 advisors × 10 days × $100 + 10 advisors × 2 days × $150 = $13,000 Alternative (i) is less costly for SMU. 3. Hiring two extra advisors has the same waiting time and a lower cost than extending the workweek to 6 days during the registration period. However, the quality of the advising may not be as high. The temporary advisors may not be as familiar with the requirements of the university. They may also be unaware of how to work within the system (i.e., they may not be aware of alternatives that may be available to help students). Therefore, from a student satisfaction standpoint, it would be better to have the regular advisors work an extra day in the week and pay them overtime. This will be more costly for SMU but is likely to result in better student advising. 19-13 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

19-24 (15 min.) Manufacturing cycle time, manufacturing cycle efficiency, non-financial measures of quality. 1, Manufacturing cycle time = Total time from receipt of an order by production until its completion. Manufacturing cycle time for 2010 = (8 + 6 + 2 + 4 + 2) days = 22 days Manufacturing cycle time for 2011 = (6 + 7 + 1 + 4 + 2) days = 20 days Manufacturing cycle efficiency (MCE) is defined as follows: MCE = Value-added manufacturing time ÷ Manufacturing cycle time MCE for Torrance Manufacturing for 2010 is: MCE = 4 days of processing time ÷ 22 days manufacturing cycle time = 0.18 MCE for Torrance Manufacturing for 2011 is: MCE = 4 days of processing time ÷ 20 days manufacturing cycle time = 0.20 Torrance has become more efficient in its value-added manufacturing time as a percentage of total manufacturing time during the last year. Torrance has also shortened its lead time, which means that customers had less time to wait between placing their order and receiving their shipment. This improvement in timeliness will likely lead to greater customer satisfaction. 2. Non-Financial Quality Measure Percentage of goods returned (as a percentage of units shipped) (385 14,240; 462 16,834) Defective units reworked as a percentage of units shipped (1,122 14,240; 834 16,834) Percentage of on-time deliveries (12,438 14,240; 14,990 16,834) Percentage of hours spent by each employee on quality training (32 2,000; 36 2,000)

2010

2011

2.70%

2.74%

7.88%

4.95%

87.35%

89.05%

1.60%

1.80%


3.

Torrance has become more efficient in its value-added manufacturing time as a percentage of manufacturing cycle time and has improved the company’s lead time. This improved efficiency should result in cost savings for the company as well as greater customer satisfaction. It is important to evaluate the other non-financial quality measures in relation to annual totals (total units shipped, etc.) rather than as absolute values. For example, the total number of on-time deliveries increased from 12,438 to 14,990 during 2011. This is an improvement in the timeliness of the company’s deliveries. As a percentage of total units delivered, the percentage of on-time deliveries increased from 87.35% to 89.05%.

Management also had two noteworthy areas of improvement related to the non-financial quality measures above. The first is the reduction in the total number of defective units reworked. This is a significant improvement over the prior year. However, it should be noted that a greater percentage of goods were returned in 2011 than in 2010. It is worth further investigation to analyze if the reduction in rework lead to more defective units being shipped to the end consumer. Secondly, the company spent an increased amount of time per employee on quality training. Because quality training programs are considered lead measures of performance, it is likely that the company will see improvements in the quality of its output in the future due to improved employee training.


19-25 (25 min.) Theory of constraints, throughput contribution, relevant costs. 1. Finishing is a bottleneck operation. Therefore, producing 1,000 more units will generate additional throughput margin and operating income. Increase in throughput margin ($72 – $32) 1,000 Incremental costs of the jigs and tools Increase in operating income investing in jigs and tools

$40,000 30,000 $10,000

Mayfield should invest in the modern jigs and tools because the benefit of higher throughput margin of $40,000 exceeds the cost of $30,000. 2. The Machining Department has excess capacity and is not a bottleneck operation. Increasing its capacity further will not increase throughput margin. There is, therefore, no benefit from spending $5,000 to increase the Machining Department's capacity by 10,000 units. Mayfield should not implement the change to do setups faster. 3. Finishing is a bottleneck operation. Therefore, getting an outside contractor to produce 12,000 units will increase throughput margin. Increase in throughput margin ($72 – $32) 12,000 Incremental contracting costs $10 12,000 Increase in operating income by contracting 12,000 units of finishing

$480,000 120,000 $360,000

Mayfield should contract with an outside contractor to do 12,000 units of finishing at $10 per unit because the benefit of higher throughput margin of $480,000 exceeds the cost of $120,000. The fact that the cost of $10 per unit is double Mayfield's finishing cost of $5 per unit is irrelevant. 4. Operating costs in the Machining Department of $640,000, or $8 per unit, are fixed costs. Mayfield will not save any of these costs by subcontracting machining of 4,000 units to Hunt Corporation. Total costs will be greater by $16,000 ($4 per unit 4,000 units) under the subcontracting alternative. Machining more filing cabinets will not increase throughput margin, which is constrained by the finishing capacity. Mayfield should not accept Hunt's offer. The fact that Hunt's costs of machining per unit are half of what it costs Mayfield in-house is irrelevant.


19-26 (15 min.) Theory of constraints, throughput contribution, quality. 1. Cost of defective unit at machining operation which is not a bottleneck operation is the loss in direct materials (variable costs) of $32 per unit. Producing 2,000 units of defectives does not result in loss of throughput margin. Despite the defective production, machining can produce and transfer 80,000 units to finishing. Therefore, cost of 2,000 defective units at the machining operation is $32 2,000 = $64,000. 2. A defective unit produced at the bottleneck finishing operation costs Mayfield materials costs plus the opportunity cost of lost throughput margin. Bottleneck capacity not wasted in producing defective units could be used to generate additional sales and throughput margin. Cost of 2,000 defective units at the finishing operation is: Loss of direct materials $32 2,000 Forgone throughput margin ($72 – $32) Total cost of 2,000 defective units

2,000

$ 64,000 80,000 $144,000

Alternatively, the cost of 2,000 defective units at the finishing operation can be calculated as the lost revenue of $72 2,000 = $144,000. This line of reasoning takes the position that direct materials costs of $32 2,000 = $64,000 and all fixed operating costs in the machining and finishing operations would be incurred anyway whether a defective or good unit is produced. The cost of producing a defective unit is the revenue lost of $144,000.


19-27 (30 min.) Quality improvement, relevant costs, and relevant revenues. One way to present the alternatives is via a decision tree, as shown below. Make T971 Implement new design

Do not make T971

Do not implement new design

The idea is to first evaluate the best action that Thomas should take if it implements the new design (that is, make or not make T971). Thomas can then compare the best mix of products to produce if it implements the new design against the status quo of not implementing the new design. 1. Thomas has capacity constraints. Demand for V262 valves (370,000 valves) exceeds production capacity of 330,000 valves (3 valves per hour 110,000 machine-hours). Since capacity is constrained, Thomas will choose to sell the product that maximizes contribution margin per machine-hour (the constrained resource). Contribution margin per = $8 per valve machine-hour for V262 Contribution margin per = $10 per valve machine-hour for T971

3 valves per hour = $24 2 valves per hour = $20.

Thomas should reject Jackson Corporation’s offer and continue to manufacture only V262 valves.


2. Now compare the alternatives of (a) not implementing the new design versus (b) implementing the new design. By implementing the new design, Thomas will save 10,000 machine-hours of rework time. This time can then be used to make and sell 30,000 (3 valves per hour 10,000 hours) additional V262 valves. The relevant costs and benefits of implementing the new design follow: The relevant costs of implementing the new design

$(315,000)

Relevant benefits: a (a) Savings in rework costs ($3 per V262 valve 30,000 valves) (b) Additional contribution margin from selling another 30,000 V262 valves (3 valves per hour 10,000 hours) because capacity previously used for rework is freed up ($8 per valve 30,000 units) Net relevant benefit

90,000

240,000 $

15,000

a

Note that the fixed rework costs of equipment rent and allocated overhead are irrelevant, because these costs will be incurred whether Thomas implements or does not implement the new design .

Thomas should implement the new design since the relevant benefits exceed the relevant costs by $15,000. 3. Thomas Corporation should also consider other benefits of improving quality. For example, the process of quality improvement will help Thomas's managers and workers gain expertise about the product and the manufacturing process that may lead to further cost reductions in the future. Improving quality within the plant is also likely to translate into delivering better quality products to customers. The increased reputation and customer goodwill may well lead to higher future revenues through greater unit sales and higher sales prices.


19-28 (30 min.) Quality improvement, relevant costs, and relevant revenues. 1. By implementing the new method, Tan would incur additional direct materials costs on all the 200,000 units started at the molding operation. Additional direct materials costs = $4 per lamp 200,000 lamps The relevant benefits of adding the new material are: Increased revenue from selling 30,000 more lamps $40 per lamp 30,000 lamps

$800,000

$1,200,000

Note that Tan Corporation continues to incur the same total variable costs of direct materials, direct manufacturing labor, setup labor and materials handling labor, and the same fixed costs of equipment, rent, and allocated overhead that it is currently incurring, even when it improves quality. Since these costs do not differ among the alternatives of adding the new material or not adding the new material, they are excluded from the analysis. The relevant benefit of adding the new material is the extra revenue that Tan would get from producing 30,000 good lamps. An alternative approach to analyzing the problem is to focus on scrap costs and the benefits of reducing scrap. The relevant benefits of adding the new material are: a. Cost savings from eliminating scrap: Variable cost per lamp, $19a 30,000 lamps b. Additional contribution margin from selling another 30,000 lamps because 30,000 lamps will no longer be scrapped: Unit contribution margin $21b 30,000 lamps Total benefits to Tan of adding new material to improve quality

$ 570,000

630,000 $1,200,000

a

Note that only the variable scrap costs of $19 per lamp (direct materials, $16 per lamp; direct manufacturing labor, setup labor, and materials handling labor, $3 per lamp) are relevant because improving quality will save these costs. Fixed scrap costs of equipment, rent, and other allocated overhead are irrelevant because these costs will be incurred whether Tan Corporation adds or does not add the new material. b

Contribution margin per unit Selling price Variable costs: Direct materials costs per lamp Molding department variable manufacturing costs per lamp (direct manufacturing labor, setup labor, and materials handling labor) Variable costs Unit contribution margin

$40.00 $16.00

3.00 (19.00) $21.00

On the basis of quantitative considerations alone, Tan should use the new material. Relevant benefits of $1,200,000 exceed the relevant costs of $800,000 by $400,000. 2. Other nonfinancial and qualitative factors that Tan should consider in making a decision include the effects of quality improvement on: a. gaining manufacturing expertise that could lead to further cost reductions in the future; b. enhanced reputation and increased customer goodwill which could lead to higher future revenues through greater unit sales and higher sales prices; and c. higher employee morale as a result of higher quality. 19-20 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

19-29

(30–40 min.) Statistical quality control.

1. The + 2 rule will trigger a decision to investigate when mean weight per production run is outside the control limit: Double Bran Bits: Honey Wheat Squares: Sugar King Pops:

Mean + 2 Mean + 2 Mean + 2

= 17.97 + (2 0.28) or 17.41 to 18.53 oz. = 14 + (2 0.16) or 13.68 to 14.32 oz. = 16.02 + (2 0.21) or 15.60 to 16.44 oz.

Any weight less than the lower control limit or greater than the upper control limit will trigger an investigation by management. The only cereal weights outside the specified Pops on production runs #6 and #10. 2.

+ 2 control limit were the Sugar King

Solution Exhibit 19-29 presents the SQC charts for each of the three breakfast cereals.

Double Bran Bits had no observations outside the control limits. Each of the production runs is considered to be in conformance with quality standards. However, there is an apparent trend from the SQC that the mean of each of the later production runs gets nearer to the lower control limit. Even though this product has not violated the quality requirements, management should investigate the trend to learn if there is faulty equipment or flawed processes that are causing subsequent runs to result in less cereal per box on average. Honey Wheat Squares also has no observations outside of the control limits. In fact, this product seems to be following the quality specifications most closely. Also, variations appear random in nature and no trends are apparent from the SQC that warrant further investigation by management. Sugar King Pops has two observations outside the control limits. One falls below the lower control limit and one above the upper control limit. These two production runs would not be in conformance with quality standards. The wide fluctuation in weight variances should be investigated further by management to determine the failure to comply with quality standards.


3.

The costs of quality include (1) Prevention costs—Costs of designing the process, maintaining equipment, and employee training to operate the production line. (2) Appraisal costs—Costs of inspection to check the weight of cereal boxes. (3) Internal failure costs—Costs of refilling cereal boxes that do not meet specifications; costs to identify causes of failure such as machine calibration, material variability, or human error; costs of reconfiguring manufacturing processes to prevent errors in filling cereal boxes. (4) External failure costs—Costs of customer ill-will if they discover that cereal boxes are underfilled, costs of returning and replacing incorrectly filled boxes.

Six sigma quality is a standard of excellence that requires a strict understanding of both customer expectations and reasons for manufacturing defects to improve current quality performance. The statistical term six sigma translates to 3.4 defects per 1 million incidents, or near perfection in quality variability. Key aspects of Six Sigma are to Define, Measure, Analyze, Improve and Control processes. Keltrex Cereals could employ Six Sigma programs to reduce variability in box weights. The company would first need to 1) define the quality problem (i.e. variability in weight per cereal box) 2) measure the incidents of defect using statistical quality control tools 3) analyze potential reasons for variability in the weight per cereal box (machine calibration, material variability, human error, etc.) 4) Assuming the variability is due to machines the company may choose to better calibrate the existing machines, purchase new machines that are more precise, or investigate other engineering alternatives 5) Finally, once improvements have been made to the existing machines, the company needs to monitor the improvements to ensure that the variability problem has been resolved.


SOLUTION EXHIBIT 19-29 Plots of Mean Weight per Production Run for Keltrex Cereals

Weight

Double Bran Bits 18.56 18.42 18.28 18.14 18.00 17.86 17.72 17.58 17.44 17.30

Mean + 2

Mean – 2 0

1

2

3

4

5

6

7

8

9

10

9

10

9

10

Production Run

Weight

Honey Wheat Squares 14.32 14.24 14.16 14.08 14.00 13.92 13.84 13.76 13.68 13.60

Mean+2

Mean–2 0

1

2

3

4

5

6

7

8

Production Run

Weight

Sugar King Pops 16.70 16.56 16.42 16.28 16.14 16.00 15.86 15.72 15.58 15.44

Mean–2

Mean–2 0

1

2

3

4

5

6

7

8

Production Run


19-30 (30–40 min.) Compensation linked with profitability, waiting time, and quality measures. 1. Philadelphia Add: Profitability 0.75% of operating income Add: Average waiting time $40,000 if < 10 minutes Deduct: Patient satisfaction $40,000 if < 65 Total: Bonus paid

Jan.-June

Baltimore Add: Profitability 0.75% of operating income Add: Average waiting time $40,000 if < 10 minutes Deduct: Patient satisfaction $40,000 if < 65 Total: Bonus paid 2.

July-Dec.

$83,625

$78,750

0

0

0 $83,625

0 $78,750

$71,250

$44,063

0

40,000

(40,000) $31,250

0 $84,063

Operating income as a measure of profitability

Operating income captures revenue and cost-related factors. However, there is no recognition of investment differences between the two groups. If one group is substantially bigger than the other, differences in size alone give the president of the larger group the opportunity to earn a bigger bonus. An alternative approach would be to use return on investment (perhaps relative to the budgeted ROI). 10 minute benchmark as a measure of patient response time This measure reflects the ability of East Coast Healthcare to meet a benchmark for patient response time. Several concerns arise with this specific measure: a. It is a yes-or-no cut-off. A 12-minute waiting time earns no bonus, but neither does a two hour wait. Moreover, no extra bonus is paid for additional waiting time reductions below 10 minutes. An alternative is to have the bonus that increases with greater waiting time improvements. b. It can be manipulated. Doctors might quickly make initial contact with a patient to meet the benchmark, but then leave the patient sitting in the examination room for a more detailed examination or procedure to take place. c. It reflects performance relative only to the initial waiting time. It does not consider other time-related issues such as the wait for an appointment or the time needed to fill out forms.


Problems in (b) and (c) can be overcome by measuring total patient response time (such as how long it takes from the time a patient makes an appointment to the time the actual appointment is concluded), in addition to average waiting time to meet the doctor. Patient satisfaction as a measure of quality This measure represents a common method for assessing quality. However, there are several concerns with its use: a. Patient satisfaction is likely to be influenced by a number of factors that are outside the groups’ control, such as how sick the patients are when coming in or the extent to which they follow doctors’ orders. b. It is influenced by the questions asked in the survey and the survey methodology. As a result, is likely to be ―noisy‖ or very sensitive to assumptions. c. Patient satisfaction is not the same as patient health outcomes, an important measure of healthcare quality. A combination of measures may work well as a composite measure of quality. 3. Most companies use both financial and nonfinancial measures to evaluate performance, sometimes presented in a single report such as a balanced scorecard. Using multiple measures of performance enables top management to evaluate whether lower-level managers have improved one area at the expense of others. For example, did the better average waiting time (and patient satisfaction) between July and December in the Baltimore group result from significantly higher expenditures that contributed to the dramatic reduction in operating income? An important issue is the relative importance to place on the different measures. If waiting time is not used for performance evaluation, managers will concentrate on increasing operating income and give less attention to waiting time, even if waiting time has a significant influence on whether customers choose East Coast Healthcare or another healthcare provider when given the choice. However, the president of the Baltimore group received a larger bonus in the second half of the year due in part to lower average waiting time, even though operating profits dropped by nearly 40%. Companies must understand the relative importance of different financial and nonfinancial objectives when using multiple measures for performance evaluation.


19-31 (25–30 min.) Waiting times, manufacturing cycle times. 1a.

Average waiting time for an order of Z39

Annual average number of orders of Z39 2 x Annual machine capacity

[50 (80)2 ] 2 [5, 000 (50 80)]

Manufacturing time per order of Z39

Annual average number of orders of Z39

(50 6, 400) 2 (5, 000 4, 000)

2


320, 000 160 hours per order (2 1, 000)

1b. Average manufacturing Average order Order manufacturing cycle time per order for Z39 = waiting time + time for Z39

= 160 hours + 80 hours = 240 hours per order 2a.

Average waiting time for Z39 and Y28

Annual average number of orders of Z39 2

Annual machine capacity


Annual average number of orders of Z39

Annual average number of orders of Y28


[50 (80)2 ] [25 (20)2 ] 2 [5,000 (50 80) (25 20)] 330,000 1,000

2

Manufacturing time per order of Y28

Annual average number of orders of Y28

[(50 6, 400) (25 400)] 2 [5,000 4,000 500]

2

Manufacturing time per order of Y28

(320,000 10,000) 2

330 hours

2b. Average manufacturing Average order = waiting time + Order manufacturing cycle time for Z39 time for Z39 = 330 hours + 80 hours = 410 hours Average manufacturing Average order = waiting time + Order manufacturing cycle time for Y28 time for Y28 = 330 hours + 20 hours = 350 hours


19-32 (60 min.) Waiting times, relevant revenues, and relevant costs (continuation of 19-31). 1.

The direct approach is to look at incremental revenues and incremental costs. Selling price per order of Y28, which has an average manufacturing lead time of 350 hours Variable cost per order Additional contribution per order of Y28 Multiply by expected number of orders Increase in expected contribution from Y28

$ 8,000 5,000 3,000 × 25 $75,000

Expected loss in revenues and increase in costs from introducing Y28

Product (1) Z39 Y28 Total

Expected Loss in Revenues from Increasing Average Manufacturing Cycle Times for All Products (2) $25,000.00a – $25,000.00

Expected Increase in Expected Loss in Carrying Costs from Revenues Plus Increasing Average Expected Increases Manufacturing Cycle in Carrying Costs of Times for All Products Introducing Y28 (3) (4) = (2) + (3) b $6,375.00 $31,375.00 c 2,187.50 2,187.50 $8,562.50 $33,562.50

a

50 orders × ($27,000 – $26,500) (410 hours – 240 hours) × $0.75 × 50 orders c (350 hours – 0) × $0.25 × 25 b

Increase in expected contribution from Y28 of $75,000 is greater than increase in expected costs of $33,562.50 by $41,437.50. Therefore, Seawall should introduce Y28. Alternative calculations of incremental revenues and incremental costs of introducing Y28:

Alternative 1: Introduce Y28 (1) Expected revenues $1,525,000.00a Expected variable costs 875,000.00c Expected inv. carrying costs 17,562.50e Expected total costs 892,562.50 Expected revenues minus expected costs $ 632,437.50 a

b

c

d

(50 × $26,500) + (25 × $8,000) (50 × $15,000) + (25 × $5,000) e (50 × $0.75 × 410) + (25 × $0.25 × 350)

Alternative 2: Do Not Introduce Y28 (2) $1,350,000.00b 750,000.00d 9,000.00f 759,000.00

Relevant Revenues and Relevant Costs (3) = (1) – (2) $175,000.00 125,000.00 8,562.50 133,562.50

$ 591,000.00

$ 41,437.50

50 × $27,000 50 × $15,000 f 50 × $0.75 × 240


2.

Selling price per order of Y28, which has an average manufacturing lead time of more than 320 hours Variable cost per order Additional contribution per order of Y28 Multiply by expected number of orders Increase in expected contribution from Y28

$ 6,000 5,000 $ 1,000 × 25 $25,000

Expected loss in revenues and increase in costs from introducing Y28:

Product (1) Z39 Y28 Total

Expected Loss in Revenues from Increasing Average Manufacturing Cycle Times for All Products (2) $25,000.00a – $25,000.00

Expected Increase in Expected Loss in Carrying Costs from Revenues Plus Increasing Average Expected Increases Manufacturing Cycle in Carrying Costs of Times for All Products Introducing Y28 (3) (4) = (2) + (3) $6,375.00b $31,375.00 c 2,187.50 2,187.50 $8,562.50 $33,562.50

a

50 orders × ($27,000 – $26,500) (410 hours – 240 hours) × $0.75 × 50 orders c (350 hours – 0) × $0.25 × 25 b

Increase in expected contribution from Y28 of $25,000 is less than increase in expected costs of $33,562.50 by $8,562.50. Therefore, Seawall should not introduce Y28.


19-33 (40 45 min.) Manufacturing lead times, relevant revenues, and relevant costs. 1a.

Average waiting time for an order of B7 if Brandt manufactures only B7

Average number of orders of B7

=

2


Manufactur ing time for B7

2

Average number Manufactur ing of orders of B7 time for B7

[125 (40) 2 ] (125 1,600 ) 200,000 = = = 100 hours 2 [6,000 (125 40)] 2 (6,000 5,000 ) (2 1,000)

=

Average manufacturing = Average order wait ing + Order manufactur ing time cycle time for B7 time for B7 for B7

= 100 hours + 40 hours = 140 hours 1b.

Average waiting time for an order of B7 and A3 if Brandt manufactures both B7 and A3. Average number of orders of B7

2


Manufacturing time for B7 Average number of orders of B7

2

Average number of orders of A3 Manufacturing time for B7

Manufacturing time for A3

Average number of orders of A3

2

Manufacturing time for A3

[125 (40)2 ] [10 (50) 2 ] = 2 [6, 000 (125 40) (10 50)]

=

[(125 1, 600) (10 2,500)] (200, 000 25, 000) = 2 [6, 000 5, 000 500] 2 500

=

225, 000 1, 000

225 hours

Average manufacturing = cycle time for B7

Average order waiting time

+

Order manufacturing time for B7

= 225 hours + 40 hours = 265 hours Average manufacturing = cycle time for A3

Average order waiting time

+

Order manufacturing time for A3

= 225 hours + 50 hours = 275 hours


2.

The direct approach is to look at incremental revenues and incremental costs of manufacturing and selling A3. Selling price per order for A3, which has average operating throughput time of 275 hours Variable cost per order Additional contribution per order from A3 Multiply by expected number of orders Increase in expected contribution from A3

$12,960 9,000 3,960 10 $39,600

Expected loss in revenues and increase in costs from introducing A3:

Product (1) B7 A3 Total

Expected Loss in Revenues from Increasing Average Manufacturing Cycle Times for All Products (2) $75,000.00a — $75,000.00

Expected Increase in Carrying Costs from Increasing Average Manufacturing Cycle Times for All Products (3) $7,812.50b 1,237.50c $9,050.00

Expected Loss in Revenues Plus Expected Increases in Carrying Costs of Introducing A3 (4) = (2) + (3) $82,812.50 1,237.50 $84,050.00

a

125 orders ($15,000 $14,400) (265 hours – 140 hours) $0.50 125 orders c (275 hours – 0) $0.45 10 orders b

Increase in expected contribution from A3 of $39,600 is less than increase in expected costs of $84,050 by $44,450. Therefore, Brandt should not introduce A3; instead, it should sell only B7. Alternative calculations of incremental revenues and incremental costs of introducing A3 follow. Alternative 1: Introduce A3 (1) $1,929,600a 1,340,000c 17,800e 1,357,800 $ 571,800

Expected revenues Expected variable costs Expected inventory carrying costs Expected total costs Expected revenues minus expected costs a

(125 (125 e (125 c

$14,400) + (10 $12,960) $10,000) + (10 $9,000) $0.50 265) + (10 $0.45

Alternative 2: Do Not Introduce A3 (2) $1,875,000b 1,250,000d 8,750f 1,258,750 $ 616,250

Relevant Revenues and Relevant Costs (3) = (1) – (2) $ 54,600 90,000 9,050 99,050 $(44,450)

b

125 $15,000 125 $10,000 f 125 $0.50 140 d

275)


3. Delays occur in the processing of B7 and A3 because of (a) uncertainty about how many orders Brandt will actually receive (Brandt expects to receive 125 orders of B7 and 10 orders of A3), and (b) uncertainty about the actual dates when Brandt will receive the orders. The uncertainty (randomness) about the quantity and timing of customer orders means that Brandt may receive customer orders while another order is still being processed. Orders received while the machine is actually processing another order must wait in queue for the machine to be free. As average capacity utilization of the machine increases, there is less slack and a greater chance that a machine will be busy when another order arrives. Delays can be reduced if the uncertainties facing the firm can be reduced, perhaps by negotiating fixed schedules with customers in advance. Brandt should explore these alternatives before deciding on whether to manufacture and sell A3. A3 may be a strategically important product for Brandt in the future. For example, it may help Brandt to develop a customer relationship with Airbus Industries that could be helpful in the future. Even though manufacturing A3 is costly in the short run, it may be beneficial to Brandt in the long term. If Brandt could reduce manufacturing time for A3 (and B7), it could find it profitable to manufacture both harnesses. Brandt may also want to try to negotiate a higher price for A3 that would make manufacturing both B7 and A3 profitable.


19-34 (20 min.) Theory of constraints, throughput contribution, relevant costs. It will cost Nevada $60 per unit to reduce manufacturing time. But manufacturing is not a bottleneck operation; installation is. Therefore, manufacturing more equipment will not increase sales and throughput margin. Nevada Industries should not implement the new manufacturing method. 1.

2.

Increase in throughput margin, $25,000 0 units, Additional relevant costs of new direct materials, $3,000 Increase/(Decrease) in operating income

280 units,

$ 750,000 840,000 $ (90,000)

The additional incremental costs exceed the benefits from higher throughput margin by $90,000, so Nevada Industries should not implement the new design. Alternatively, compare throughput margin under each alternative. With the modification, throughput margin is $22,000 Current throughput margin is $25,000 250 Increase/(Decrease) in operating income

$

$6,160,000 6,250,000 (90,000)

The current throughput margin is greater than the throughput margin resulting from the proposed change in direct materials. Therefore, Nevada Industries should not implement the new design. 3.

Increase in throughput margin, $25,000 Increase in relevant costs Increase in operating income

units

$ 175,000 45,000 $ 130,000

The additional throughput margin exceeds incremental costs by $130,000, so Nevada Industries should implement the new installation technique. 4. Motivating installation workers to increase productivity is worthwhile because installation is a bottleneck operation, and any increase in productivity at the bottleneck will increase throughput margin. On the other hand, motivating workers in the manufacturing department to increase productivity is not worthwhile. Manufacturing is not a bottleneck operation, so any increase in output will result only in extra inventory of equipment. Nevada Industries should encourage manufacturing to produce only as much equipment as the installation department needs, not to produce as much as it can. Under these circumstances, it would not be a good idea to evaluate and compensate manufacturing workers on the basis of their productivity.


19-35 (30–40 min.) Theory of constraints, throughput contribution, quality, relevant costs. 1.

Direct materials costs to produce 390,000 tablets, $156,000 $156 ,000 Direct materials costs per tablet = = $0.40 per tablet 390 ,000 Selling price per tablet = $1.00 = Selling price – Unit direct materials costs = $1.00 – $0.40 = $0.60 per tablet

Unit throughput margin

Tablet-making is a bottleneck operation. Therefore, producing 19,500 more tablets will generate additional operating income. Additional operating income per contractor-made tablet

Unit throughput – margin = $0.60 – $0.12 = $0.48

=

Increase in operating income, $0.48 the outside contractor's offer.

Additional operating costs per tablet

19,500 = $9,360. Therefore, Aardee should accept

2. Operating costs for the mixing department are a fixed cost. Contracting out the mixing activity will not reduce mixing department costs but will cost an additional $0.07 per gram of mixture. Mixing more direct materials will have no effect on throughput margin, since tablet making is the bottleneck operation. Therefore, Aardee should reject the company's offer. 3. The benefit of improved quality is $10,000. Aardee is using the same quantity of direct materials as before, so it incurs no extra direct materials costs. Additional revenue from selling 10,000 extra tablets ($1 10,000) $10,000 Incremental costs to improve quality 7,000 Increase in operating income $ 3,000 Aardee should implement the new method. 4.

Cost per gram of mixture =

$156 ,000 = $0.78 per gram 200 ,000

Cost of 10,000 grams of mixture = $0.78 Benefit from better mixing quality Cost of improving the mixing operation Increase/(Decrease) in operating income

10,000 = $7,800 $ 7,800 9,000 $ (1,200)

Since the costs exceed the benefits by $1,200 per month, Aardee should not adopt the proposed quality improvement plan. 5. Compare the answers to requirements 3 and 4. The benefit of improving quality at the mixing operation is the savings in materials costs. The benefit of improving quality of the tabletmaking department (the bottleneck operation) is the savings in materials costs plus the additional throughput margin from higher sales equal to the total revenues that result from relieving the bottleneck constraint.


19-36 (30-35 min.) Theory of constraints, contribution margin, sensitivity analysis. 1. Assuming only one type of doll is produced, the maximum production in each department given their resource constraints is:

Chatty Chelsey Talking Tanya

Molding Department 30,000 lbs = 20,000 1.5 lbs 30,000 lbs = 15,000 2lbs

Assembly Department 8,500 hours = 25,500 1/3 hours 8,500 hours = 17,000 1/2hours

Contribution Margin $39 − 1.5 × $12 – 1/3 × $18 = $15 $51 − 2 × $12 − ½ × $18 = $18

For both types of dolls, the constraining resource is the availability of material since this constraint causes the lowest maximum production. If only Chatty Chelsey is produced, FTT can produce 20,000 dolls with a contribution margin of 20,000 × $15 = $300,000 If only Talking Tanya is produced, FTT can produce 15,000 dolls with a contribution margin of 15,000 × $18 = $270,000. FTT should produce Chatty Chelseys. 2. As shown in Requirement 1, available material in the Molding department is the limiting constraint. If FTT sells two Chatty Chelseys for each Talking Tanya, then the maximum number of Talking Tanya dolls the Molding Department can produce (where the number of Talking Tanya dolls is denoted as T) is: (T × 2 lbs.) + ([2 × T] × 1.5 lbs.) = 30,000 lbs. 2T + 3T = 30,000 5T = 30,000 T = 6,000 The Molding Department can produce 6,000 Talking Tanya dolls, and 2 × 6,000 (or 12,000) Chatty Chelsey dolls.

Since FTT can only produce 6,000 Talking Tanyas and 12,000 Chatty Chelseys before it runs out of ingredients, the maximum contribution margin (CM) is:

Contribution margin from Chatty Chelsey

+

Contribution margin from Talking Tanya

= 12,000 × $15 + 6,000 × $18 = $180,000 + 108,000 = $288,000


3. With 15 more pounds of materials, FTT would produce more dolls. Using the same technique as in Requirement 2, the increase in production is: (T × 2 lbs.) + ([2 × T] × 1.5 lbs.) = 15 lbs. 2T + 3T = 15 T= 3 FTT would produce 3 extra Talking Tanya dolls and 6 extra Chatty Chelsey dolls. Contribution margin would increase by Contribution margin from Chatty Chelsey

+

Contribution margin from Talking Tanya

=6

$15 + 3

$18 = $90 + $54 = $144

4. With 10 more labor hours, production would not change. The limiting constraint is pounds of material, not labor hours. FTT already has more labor hours available than it needs.


19-37 (25 min.) Quality improvement, Pareto diagram, cause-and-effect diagram. 1. Solution Exhibit 19-37A presents a Pareto diagram for the quality incidents observed by Pauli’s Pizza. SOLUTION EXHIBIT 19-37A Quality improvement, Pareto diagram, cause-and-effect diagram

Number of Times Incident Observed

Pauli's Pizza Quality Incidents First Quarter 2012 60 50 50 40 30 18

20

12

8

10

5

0 Late delivery

Failure to deliver incidental items with order (drinks, side items, etc.)

Incorrect order delivered

Service complaints Damaged or by customer of spoiled product delivery personnel delivered

Type of Incident Observed

2.

Prevention activities that could reduce failures in Pauli’s Pizza deliveries could include a. better staff training b. improved technology for order processing c. additional time for delivery personnel to review orders prior to pick-up c. additional procedure checks to ensure all order items are included and that delivery pick-up matches order d. incentives offered to staff and delivery personnel for lower rates of quality failure to avoid delivery of damaged or spoiled products and to reduce service complaints by customers.


3. Solution Exhibit 19-37B presents a cause-and-effect or fishbone diagram for the problem of ―late deliveries.‖ SOLUTION EXHIBIT 19-37B Cause-and-Effect Diagram for incidents of ―late delivery‖ to customer at Pauli’s Pizza: Methods and Design Factors

Human Factor Poor staff training on quality standards

Poor system for order processing

Order misplaced by staff

Poor system for organizing delivery queue

Delivery driver falls behind schedule

Late Delivery to customer

Raw food materials failed to cook properly due to defects – product must be remade Spoiled raw food materials delays processing

Mechanical difficulties with delivery vehicle Ovens not working properly – product must be remade

Machine related Factors

Materials Factors


19-38 (30–35 min.) Ethics and quality. Total Revenue

$3,400,000

Costs of Quality Prevention Costs Testing of purchased materials Quality control training for production staff Quality design engineering

Cost

Appraisal Costs Product inspection

Internal Failure Costs Materials scrap Rework of failed parts Engineering redesign of failed parts

External Failure Costs Customer support Warranty repairs Total costs of quality

Percentage of Total Revenue

$ 32,000 5,000 48,000 85,000

2.50%

102,000 102,000

3.00%

12,000 18,000 21,000 51,000

1.50%

37,000 82,000 119,000 $357,000

3.50% 10.50%

The total costs of quality are currently more than 10% of revenue. 2. Option 1: Equipment

Purchase

of

New

Manufacturing

Prevention costs ($32,000 + $5,000 + $48,000 + $75,000) Appraisal costs ($102,000 × 0.75) Internal failure costs ($12,000 + $21,000 + $18,000) External failure costs [($82,000 + $37,000) × 0.60] Total costs of quality Percentage of quality costs to total revenue Costs of quality increase/(decrease) over current budget ($358,900 – $357,000; $283,900 – $357,000) Total two-year increase/(decrease) over current budget

Year One $160,000 76,500 51,000 71,400 $358,900 10.56%

Year Two* $ 85,000 76,500 51,000 71,400 $283,900 8.35%

$ 1,900 $ (71,200)

$ (73,100)

*Reengineering cost of $75,000 is a one-time cost and is not reflected in year two costs.


Option 2: Increase Quality Control Training by $15,000 per Year Year One Prevention costs ($32,000 + $20,000 + $48,000) $100,000 Appraisal costs ($102,000 × 0.9) 91,800 Internal failure costs ($12,000 + $21,000 + $18,000) 51,000 External failure costs [($82,000 + $37,000) × 0.80] 95,200 Total costs of quality $338,000 Percentage of quality costs to total revenue 9.94% Costs of quality increase/(decrease) over current budget ($338,000 – $357,000) $ (19,000) Total two-year increase/(decrease) over current budget $ (38,000)

Year Two* $100,000 91,800 51,000 95,200 $338,000 9.94% $ (19,000)

*Reengineering cost is a one-time cost and is not reflected in year two costs. 3. Nancy faces a difficult situation. On the one hand, she could argue that she is following corporate guidelines in choosing what to report and so only reports options that satisfy it. On the other hand, the guideline does not appear to be so strict that Nancy or Chris would not be able to seek an exception, particularly because quality costs are only slightly greater than 10% of revenues in the first year because of the one-time reengineering costs. Taking this second view, according to the IMA Statement of Ethical Professional Practice, Nancy should disclose both alternatives to Chris Sheldon, the General Manager; even though option (b) is the only alternative that meets all three of the corporate objectives. Competence Competence states that each practitioner has a responsibility to provide decision support information and recommendations that are accurate, clear, concise and timely. If Nancy knows of an alternative that could improve the overall corporate position and fails to raise it in a timely manner, she would be in violation of this standard. Credibility The management accountant's standards of ethical conduct require that information should be fairly and objectively communicated and that all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations be disclosed. From a management accountant's standpoint, failing to disclose option (a) to the General Manager, Chris Sheldon would be a violation of this standard. Even though this alternative does not meet the corporate objective of reducing quality costs to less than 10% of revenues for the period, it provides a significantly better cost savings over option (b) over a two-year period. Chris Sheldon has the right to know that this alternative exists. He may choose to pitch the idea to corporate management as a better long-term quality improvement option, even though it violates short-term corporate objectives. The instructor should indicate to students that ethical questions are rarely clear-cut. Even though on balance it appears that the ethical response is for Naney to present both options, the opposing view of following corporate guidelines is a reasonable position for a student to take.


19-39 (45–50 min.) Quality improvement, theory of constraints. 1. Consider the incremental revenues and incremental costs to Wellesley Corporation of purchasing additional grey cloth from outside suppliers. Incremental revenues, $1,250 × (5,000 rolls × 0.90) Incremental costs: Cost of grey cloth, $900 × 5,000 rolls $4,500,000 Direct materials variable costs at printing operation, $100 × 5,000 rolls 500,000 Incremental costs Excess of incremental revenues over incremental costs

$5,625,000

5,000,000 $ 625,000

Note that, because the printing department has surplus capacity equal to 5,500 (15,000 – 9,500) rolls per month, purchasing grey cloth from outside entails zero opportunity costs. Yes, the Printing Department should buy the grey cloth from the outside supplier. 2. By producing a defective roll in the Weaving Department, Wellesley Corporation is worse off by the entire amount of revenue forgone of $1,250 per roll. Note that, since the weaving operation is a constraint, any rolls received by the Printing Department that are defective and disposed of at zero net disposal value result in lost revenue to the firm. An alternative approach to analyzing the problem is to focus on the costs of defective units and the benefits of reducing defective units. The relevant costs of defective units in the Printing Department are: a. Direct materials variable costs in the Weaving Department b. Direct materials variable costs in the Printing Department c. Contribution margin forgone from not selling one roll $1,250 – $500 – $100 Amount by which Wellesley Corporation is worse off as a result of a defective unit in the Printing Department

$ 500 100 650 $1,250

Note that only the variable costs of defective units of $600 per roll (direct materials in the Weaving Department, $500 per roll: direct materials in the Printing Department, $100 per roll) are relevant because improving quality will save these costs. Fixed costs of producing defective units, attributable to other operating costs, are irrelevant because these costs will be incurred whether Wellesley Corporation reduces defective units in the Printing Department or not. Wellesley Corporation should make the proposed modifications in the Printing Department because the incremental benefits exceed the incremental costs by $125,000 per month: Incremental benefits of reducing defective units in the Printing Department by 4% (from 10% to 6%) 4% × 9,500 rolls × $1,250 per roll (computed above) $475,000 Incremental costs of the modification 350,000 Excess of incremental benefits over incremental costs $125,000 19-40 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

3. To determine how much Wellesley Corporation is worse off by producing a defective roll in the Weaving Department, consider the payoff to Wellesley from not having a defective roll produced in the Weaving Department. The good roll produced in the Weaving Department will be sent for further processing in the Printing Department. The relevant costs and benefits of printing and selling this roll follow: Additional direct materials variable costs incurred in the Printing Department Expected revenue from selling the finished product, $1,250 × 0.9 (since 10% of the Printing Department output will be defective and will earn zero revenue) Net expected benefit of producing a good roll in the Weaving Department

$ (100)

1,125 $1,025

By producing a defective roll in the Weaving Department, Wellesley Corporation is worse off by $1,025 per roll. Note that, since the weaving operation is a constraint, any rolls that are defective will result in lost revenue to the firm. An alternative approach to analyzing the problem is to focus on the costs and benefits of reducing defective units. The relevant costs of defective units in the Weaving Department are: a. Direct materials variable costs in the Weaving Department b. Expected unit contribution margin forgone from not selling one roll, ($1,250 × 0.9) – $500 – $100 Amount by which Wellesley Corporation is worse off as a result of producing a defective unit in the Weaving Department

$ 500 525 $1,025

Note that only the variable scrap costs of $500 per roll (direct materials in the Weaving Department) are relevant because improving quality will save these costs. All fixed costs of producing defective units attributable to other operating costs are irrelevant because these costs will be incurred whether Wellesley Corporation reduces defective units in the Weaving Department or not. Wellesley Corporation should make the improvements proposed by the design engineering team because the incremental benefits exceed the incremental costs by $30,000 per month: Incremental benefits of reducing defective units in the Weaving Department by 2% (from 5% to 3%) 2% × 10,000 rolls × $1,025 per roll (computed above) $205,000 Incremental costs of improvements 175,000 Excess of incremental benefits over incremental costs $ 30,000


CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS 20-1 Cost of goods sold (in retail organizations) or direct materials costs (in organizations with a manufacturing function) as a percentage of sales frequently exceeds net income as a percentage of sales by many orders of magnitude. In the Kroger grocery store example cited in the text, cost of goods sold to sales is 76.8%, and net income to sales is 0.1%. Thus, a 10% reduction in the ratio of cost of goods sold to sales (76.8 to 69.1% equal to 7.7%) without any other changes can result in a 7800% increase in net income to sales (0.1% plus 7.7% equal to 7.8%). 20-2 Six cost categories important in managing goods for sale in a retail organization are the following: 1. purchasing costs; 2. ordering costs; 3. carrying costs; 4. stockout costs; 5. costs of quality; and 6. shrinkage costs 20-3 1. 2. 3. 4. 5.

Five assumptions made when using the simplest version of the EOQ model are: The same quantity is ordered at each reorder point. Demand, ordering costs, carrying costs, and the purchase-order lead time are certain. Purchasing cost per unit is unaffected by the quantity ordered. No stockouts occur. Costs of quality and shrinkage costs are considered only to the extent that these costs affect ordering costs or carrying costs.

20-4 Costs included in the carrying costs of inventory are incremental costs for such items as insurance, rent, obsolescence, spoilage, and breakage plus the opportunity cost of capital (or required return on investment). 20-5 Examples of opportunity costs relevant to the EOQ decision model but typically not recorded in accounting systems are the following: 1. the return forgone by investing capital in inventory; 2. lost contribution margin on existing sales when a stockout occurs; and 3. lost contribution margin on potential future sales that will not be made to disgruntled customers. 20-6 The steps in computing the costs of a prediction error when using the EOQ decision model are: Step 1: Compute the monetary outcome from the best action that could be taken, given the actual amount of the cost input. Step 2: Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost input. Step 3: Compute the difference between the monetary outcomes from Steps 1 and 2.


20-7 Goal congruence issues arise when there is an inconsistency between the EOQ decision model and the model used for evaluating the performance of the person implementing the model. For example, if opportunity costs are ignored in performance evaluation, the manager may be induced to purchase in a quantity larger than the EOQ model indicates is optimal. 20-8 Just-in-time (JIT) purchasing is the purchase of materials (or goods) so that they are delivered just as needed for production (or sales). Benefits include lower inventory holdings (reduced warehouse space required and less money tied up in inventory) and less risk of inventory obsolescence and spoilage. 20-9

Factors causing reductions in the cost to place purchase orders of materials are: Companies are establishing long-run purchasing agreements that define price and quality terms over an extended period. Companies are using electronic links, such as the Internet, to place purchase orders. Companies are increasing the use of purchase-order cards.

20-10 Disagree. Choosing the supplier who offers the lowest price will not necessarily result in the lowest total purchase cost to the buyer. This is because the price or purchase cost of the goods is only one—and perhaps, most obvious—element of cost associated with purchasing and managing inventories. Other relevant cost items are ordering costs, carrying costs, stockout costs, quality costs, and shrinkage costs. A low-cost supplier may well impose conditions on the buyer—such as poor quality, or frequent stockouts, or excessively high inventories—that result in high total costs of purchase. Buyers must examine all the elements of costs relevant to inventory management, not just the purchase price. 20-11 Supply-chain analysis describes the flow of goods, services, and information from the initial sources of materials and services to the delivery of products to consumers, regardless of whether those activities occur in the same company or in other companies. Sharing of information across companies enables a reduction in inventory levels at all stages, fewer stockouts at the retail level, reduced manufacture of product not subsequently demanded by retailers, and a reduction in expedited manufacturing orders. 20-12 Just-in-time (JIT) production is a ―demand-pull‖ manufacturing system that has the following features: Organize production in manufacturing cells, Hire and retain workers who are multi-skilled, Aggressively pursue total quality management (TQM) to eliminate defects, Place emphasis on reducing both setup time and manufacturing cycle time, and Carefully select suppliers who are capable of delivering quality materials in a timely manner. 20-13 Traditional normal and standard costing systems use sequential tracking, in which journal entries are recorded in the same order as actual purchases and progress in production, typically at four different trigger points in the process. Backflush costing omits recording some of the journal entries relating to the cycle from purchase of direct materials to sale of finished goods, i.e., it has fewer trigger points at which journal entries are made. When journal entries for one or more stages in the cycle are omitted, 20-2 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

the journal entries for a subsequent stage use normal or standard costs to work backward to ―flush out‖ the costs in the cycle for which journal entries were not made. 20-14 Versions of backflush costing differ in the number and placement of trigger points at which journal entries are made in the accounting system:

Version 1

Number of Journal Entry Trigger Points 3

Version 2

2

Stage A. Purchase of direct materials and incurring of conversion costs Stage D. Sale of finished goods

Version 3

2

Stage C. Completion of good finished units of product Stage D. Sale of finished goods

Location in Cycle Where Journal Entries Made Stage A. Purchase of direct materials and incurring of conversion costs Stage C. Completion of good finished units of product Stage D. Sale of finished goods

20-15 Traditional accounting systems cost individual products, and separate product costs from selling, general, and administrative costs. Lean accounting costs the entire value stream instead of individual products. Rework costs, unused capacity costs, and common costs that cannot be reasonably assigned to value streams are excluded from value stream costs. In addition, many lean accounting systems expense material costs the period they are purchased, rather than storing them on the balance sheet until the products using the material are sold. 20-16 (20 min.) Economic order quantity for retailer. 1.

D = 10,000 jerseys per year, P = $200, C = $7 per jersey per year

EOQ

2 DP C

2 10,000 $200 = 755.93 7

756 jerseys

10,000 D = = 13.22 EOQ 756

2.

Number of orders per year =

3.

Demand each working day

=

Purchase lead time

= 7 days

Reorder point

= 27.40

14 orders

D 10,000 = = 27.40 jerseys per day Number of working days 365

= 191.80

7 192 jerseys 20-3


20-17 (20 min.) Economic order quantity, effect of parameter changes (continuation of 20-16). 1. D = 10,000 jerseys per year, P = $30, C = $7 per jersey per year

EOQ

2 DP C

2 10,000 $30 = 292.77 jerseys 7

293 jerseys

The sizable reduction in ordering cost (from $200 to $30 per purchase order) has reduced the EOQ from 756 to 293. 2. The AT proposal has both upsides and downsides. The upside is potentially higher sales. FB customers may purchase more online than if they have to physically visit a store. FB would also have lower administrative costs and lower inventory holding costs with the proposal. The downside is that AT could capture FB’s customers. Repeat customers to the AT web site need not be classified as FB customers. FB would have to establish enforceable rules to make sure it captures ongoing revenues from customers it directs to the AP web site. There is insufficient information to determine whether FB should accept AT’s proposal. Much depends on whether FB views AT as a credible, ―honest‖ partner.

20-18 (15 min.) EOQ for a retailer. 1.

D = 26,400 yards per year, P = $165, C = 20% EOQ

2 DP C

2 26, 400 $165 $1.80

2.

Number of orders per year:

3.

Demand each working day

D EOQ

$9 = $1.80 per yard per year

2, 200 yards

26, 400 2, 200

12 orders per year

= Error! 26, 400 = 250 = 105.60 yards per day = 528 yards per week (105.60 × 5 days per week)

Purchasing lead time = 2 weeks Reorder point = 528 yards per week

2 weeks = 1,056 yards


20-19 (20 min.) EOQ for manufacturer. 1.

Relevant carrying costs per part per year: Required annual return on investment 15% $60 = Relevant insurance, materials handling, breakage, etc. costs per year Relevant carrying costs per part per year

$ 9 6 $15

With D = 18,000 parts per year; P = $150; C = $15 per part per year, EOQ for manufacturer is: 2DP 2 18,000 $150 EOQ= 600 units C $15 2.

Relevant annual ordering costs =

D Q

P

18,000 $150 600 = $4,500 where Q = 600 units, the EOQ. =

3. At the EOQ, total relevant ordering costs and total relevant carrying costs will be exactly equal. Therefore, total relevant carrying costs at the EOQ = $4,500 (from requirement 2). We can also confirm this with a direct calculation: Q Relevant annual carrying costs = C 2 600 = $15 2 = $4,500 where Q = 600 units, the EOQ. 4.

Purchase order lead time is half a month. Monthly demand is 18,000 units ÷ 12 months = 1,500 units per month. Demand in half a month is Error! 1,500 units or 750 units. Lakeland should reorder when the inventory of rotor blades falls to 750 units.


20-20 (20 min.) Sensitivity of EOQ to changes in relevant ordering and carrying costs. 1. A straightforward approach to the requirement is to construct the following table for EOQ at relevant carrying and ordering costs. Annual demand is 10,000 units. The formula for the EOQ model is: 2DP DP QC and for Relevant Total Costs (RTC) = EOQ = C Q 2 where D = demand in units per year P = relevant ordering costs per purchase order C = relevant carrying costs of one unit in stock for the time period used for D (one year in this problem.

Relevant Carrying Costs per Unit per Year (C)

Relevant Ordering Costs per Purchase Order (P)

$10

$400

EOQ =

2 10, 000 $400 $10

895, RTC=

$20

$200

EOQ =

2 10, 000 $200 $20

$40

$100

EOQ =

2 10, 000 $100 $40

10,000 $400 895

895 $10 2

$8, 944

447, RTC=

10,000 $200 447

$47 $20 2

$8, 944

224, RTC=

10,000 $100 224

224 $40 2

$8, 944

2. For a given demand level, as relevant carrying costs increase and relevant ordering costs decrease, EOQ becomes smaller. The change in EOQ results in relevant total costs (RTC) being the same across all three cases. That is, the EOQ offsets the effect on total costs of the increase in carrying costs and the decrease in ordering costs. 3.

If Alpha estimates C = $10 per unit per year and P = $400 per order, then from requirement 1, EOQ = 224 units and Relevant Total Cost (RTC) = $8,944 For EOQ = 224 units, C = $20 per unit per year and P = $200 per order, DP QC Relevant total costs (RTC) = Q 2 10, 000 $200 224 $20 224 2 = $8,929 + $2,240 = $11,169

The prediction error equals $11,169 – $8,944 = $2,225 which is 25% ($2,225 ÷ $8,944) of the relevant total cost had there been no prediction error. The error in prediction results is a significantly higher cost but is still limited, given that the estimate of the carrying cost was half the actual amount and the estimate of the ordering cost was twice the actual amount. The square root function dampens the effect of the errors. 20-6 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

20-21 (15 min.)

Inventory management and the balanced scorecard.

1. The incremental increase in operating profits from employee cross-training (ignoring the cost of the training) is: Increased revenue from higher customer satisfaction ($5,000,000 × 2% × 5) $500,000 Reduced inventory-related costs 100,000 Incremental increase in operating profits (ignoring training costs) $600,000 2. At a cost of $600,000, DSC will be indifferent between current expenditures and increasing employee cross-training by 5%. Consequently, the most DSC would be willing to pay for this cross-training is the $600,000 benefit received. 3. Besides increasing short-term operating profits, additional employee cross-training can improve employee satisfaction because their jobs can have more variety, potentially leading to unanticipated productivity improvements and lower employee turnover. Multi-skilled employees can also understand the production process better and can suggest potential improvements. Each of these may lead to additional cost reductions.


20-22 (20 min.) JIT production, relevant benefits, relevant costs. 1. Solution Exhibit 20-22 presents the annual net benefit of $315,000 to Champion Hardware Company of implementing a JIT production system. 2. Other nonfinancial and qualitative factors that Champion should consider in deciding whether it should implement a JIT system include: a. The possibility of developing and implementing a detailed system for integrating the sequential operations of the manufacturing process. Direct materials must arrive when needed for each subassembly so that the production process functions smoothly. b. The ability to design products that use standardized parts and reduce manufacturing time. c. The ease of obtaining reliable vendors who can deliver quality direct materials on time with minimum lead time. d. Willingness of suppliers to deliver smaller and more frequent orders. e. The confidence of being able to deliver quality products on time. Failure to do so would result in customer dissatisfaction. f. The skill levels of workers to perform multiple tasks such as minor repairs, maintenance, quality testing and inspection. SOLUTION EXHIBIT 20-22 Annual Relevant Costs of Current Production System and JIT Production System for Champion Hardware Company Relevant Relevant Costs under Costs under Current JIT Production Production Relevant Items System System Annual tooling costs – $100,000 Required return on investment: 15% per year $1,000,000 of average inventory per year $150,000 30,000 15% per year $200,000a of average inventory per year Insurance, space, materials handling, and setup costs 300,000 225,000b Rework costs 200,000 140,000c Incremental revenues from higher selling prices – (160,000)d Total net incremental costs $650,000 $335,000 Annual difference in favor of JIT production $315,000 a

$1,000,000 (1 – 80%) = $200,000 $300,000 (1 – 0.25) = $225,000 c $200,000 (1 – 0.30) = $140,000 d $4 × 40,000 units = $160,000 b


3. Personal observation by production line workers and managers is more effective in JIT plants than in traditional plants. A JIT plant’s production process layout is streamlined. Operations are not obscured by piles of inventory or rework. As a result, such plants are easier to evaluate by personal observation than cluttered plants where the flow of production is not logically laid out. Besides personal observation, nonfinancial performance measures are the dominant methods of control. Nonfinancial performance measures provide most timely and easy to understand measures of plant performance. Examples of nonfinancial performance measures of time, inventory, and quality include: Manufacturing lead time Units produced per hour Machine setup time ÷ manufacturing time Number of defective units ÷ number of units completed In addition to personal observation and nonfinancial performance measures, financial performance measures are also used. Examples of financial performance measures include: Cost of rework Ordering costs Stockout costs Inventory turnover (cost of goods sold average inventory) The success of a JIT system depends on the speed of information flows from customers to manufacturers to suppliers. The Enterprise Resource Planning (ERP) system has a single database, and gives lower-level managers, workers, customers, and suppliers access to operating information. This benefit, accompanied by tight coordination across business functions, enables the ERP system to rapidly transmit information in response to changes in supply and demand so that manufacturing and distribution plans may be revised accordingly.


20-23 (30 min.) Backflush costing and JIT production. 1. (a) Record purchases of direct materials (b) Record conversion costs incurred

Materials and In-Process Inventory Control Accounts Payable Control Conversion Costs Control Various Accounts (such as Wages Payable Control) Finished Goods Controla Materials and In-Process Inventory Controla Conversion Costs Allocateda Cost of Goods Soldb Finished Goods Control

(c) Record cost of good finished units completed

(d) Record cost of finished goods sold a

2,754,000 2,754,000 723,600 723,600 3,484,000 2,733,600 750,400 3,432,000 3,432,000

26,800 × ($102 + $28) = $3,484,000; 26,800 × $102 = $2,733,600; 26,800 × $28 = $750,400 26,400 × ($102 + $28) = $3,432,000

b

2. Materials and In-Process Inventory Control (a) 2,754,000

Direct Materials

(c) 2,733,600

Bal. 20,400

Finished Goods Control (c) 3,484,000

(d) 3,432,000

Cost of Goods Sold (d) 3,432,000

Bal. 52,000

Conversion Costs Allocated (c)

750,400

Conversion Costs Conversion Costs Control (b) 723,600

3. Under an ideal JIT production system, there would be zero inventories at the end of each day. Entry (c) would be $3,432,000 finished goods production, not $3,484,000. Also, there would be no inventory of direct materials instead of $2,754,000 – $2,733,600 = $20,400.


20-24

(20 min.)

Backflush costing, two trigger points, materials purchase and sale (continuation of 20-23).

1. (a). Record purchases of direct materials (b) Record conversion costs incurred (c) Record cost of good finished units completed (d) Record cost of finished goods sold (e) Record underallocated or overallocated conversion costs a

Inventory Control Accounts Payable Control Conversion Costs Control Various Accounts (such as Wages Payable Control) No entry

2,754,000

Cost of Goods Solda Inventory Controla Conversion Costs Allocateda Conversion Costs Allocated Costs of Goods Sold Conversion Costs Control

3,432,000

2,754,000 723,600 723,600

2,692,800 739,200 739,200 15,600 723,600

26,400 × ($102 + $28) = $3,432,000; 26,400 × $102 = $2,692,800; 26,400 × $28 = $739,200

2. Inventory Control

Direct Materials

(a) 2,754,000

Cost of Goods Sold

(d) 2,692,800

Bal. 61,200

(d) 3,432,000

(e)

15,600

Bal. 52,000

Conversion Costs Allocated (e) 739,200

(d) 739,200

Conversion Costs Conversion Costs Control (b)

723,600

(e)

723,600


20-25 (20 min.)

Backflush costing, two trigger points, completion of production and sale (continuation of 20-23).

1. (a). Record purchases of direct materials (b) Record conversion costs incurred

No Entry Conversion Costs Control Various Accounts (such as Wages Payable Control) Finished Goods Controla Accounts Payable Controla Conversion Costs Allocateda Cost of Goods Soldb Finished Goods Control Conversion Costs Allocated Costs of Goods Sold Conversion Costs Control

(c) Record cost of good finished units completed (d) Record cost of finished goods sold (e) Record underallocated or overallocated conversion costs a

723,600 723,600 3,484,000 2,733,600 750,400 3,432,000 3,432,000 750,400 26,800 723,600

26,800 × ($102 + $28) = $3,484,000; 26,800 × $102 = $2,733,600; 26,800 × $28 = $750,400 26,400 × ($102 + $28) = $3,432,000

b

2. Finished Goods Control

Direct Materials

(a) 3,484,000

Cost of Goods Sold

(d) 3,432,800

(d) 3,432,000

(e)

26,800

Bal. 52,000


(d) 750,400


(e)

723,600


20-26 (30 min.) Effect of different order quantities on ordering costs and carrying costs, EOQ. 1. Demand (units) (D) Cost per purchase order (P) Annual carrying cost per package (C) Order quantity per purchase order (units) (Q) Number of purchase orders per year (D Q)

1 380,000 $ 57.00 $ 12.00 760 500

2 380,000 $ 57.00 $ 12.00 1,000 380

Scenario 3 380,000 $ 57.00 $ 12.00 1,900 200

4 380,000 $ 57.00 $ 12.00 3,800 100

5 380,000 $ 57.00 $ 12.00 4,750 80

Annual ordering costs (D Q) P Annual carrying costs (QC 2) Total relevant costs of ordering and carrying inventory

$28,500 $ 4,560 $33,060

$21,660 $ 6,000 $27,660

$11,400 $11,400 $22,800

$ 5,700 $22,800 $28,500

$ 4,560 $28,500 $33,060

The economic order quantity is 1,900 packages. It is the order quantity at which carrying costs equal ordering costs and total relevant ordering and carrying costs are minimized. We can also confirm this from direct calculation. Using D = 380,000; P = $57 and C = $12 2 380, 000 $57 EOQ = 1,900 packages $12 It is interesting to note that Soothing Meadow faces a situation where total relevant ordering and carrying costs do not vary very much even though order quantities vary greatly from 760 packages to 4,750 packages. The square root in the EOQ model dampens the effect of the variations in order quantity by making the incorrect numbers smaller. 2.

When the ordering cost per purchase order is reduced to $30: 2 380, 000 $30 1,378.4 packages (or 1,378 packages) EOQ = $12 The EOQ drops from 1,900 packages to 1,378 packages when Soothing Meadow’s ordering cost per purchase order decreases from $57 to $30. D 380, 000 P = $30 = $8,272 And the new relevant costs of ordering inventory = Q 1,378

Q 1,378 C = $12 = $8,268 2 2 The total new relevant costs of ordering and carrying inventory = $8,272 + $8,268 = $16,540. The slight difference in relevant ordering costs ($8,272) and relevant carrying costs ($8,268) is because of rounding down the number of packages from 1,378.4 in the EOQ formula to 1,378. and the new relevant costs or carrying inventory =

3. As summarized below, the new Mona Lisa web-based ordering system, by lowering the EOQ to 1,378 packages, will lower the carrying and ordering costs by $6,260. Soothing Meadow will spend $2,150 to train its purchasing assistants on the new system. Overall, Soothing Meadow will still save $4,110 in the first year alone. Total relevant costs at EOQ (from Requirement 2) Annual cost benefit over old system ($22,800 – $16,540) Training costs Net benefit in first year alone

$16,540 $ 6,260 2,150 $ 4,110


20-27 (30 min.) EOQ, uncertainty, safety stock, reorder point. 1. EOQ

2 DP C

2 120,000 $250 $2.40

= 5,000 pairs of shoes 2.

Weekly demand = Monthly demand ÷ 4 = 10,000 ÷ 4 = 2,500 pairs of shoes per week Purchasing lead time = 1 week Reorder point = 2,500 pairs of shoes per week × 1 week = 2,500 pairs of shoes

3. Solution Exhibit 20-27 presents the safety stock computations for Warehouse OR2 when the reorder point excluding safety stock is 2,500 pairs of shoes. The exhibit shows that annual relevant total stockout and carrying costs are the lowest ($1,080) when a safety stock of 250 pairs of shoes is maintained. Therefore, Warehouse OR2 should hold a safety stock of 250 pairs. As a result, Reorder point with safety stock = 2,500 pairs + 250 pairs = 2,750 pairs. Reorder quantity is unaffected by the holding of safety stock and remains the same as calculated in requirement 1. Reorder quantity = 5,000 pairs Warehouse OR2 should order 5,000 pairs of shoes each time its inventory of shoes falls to 2,750 pairs.

SOLUTION EXHIBIT 20-27 Computation of Safety Stock for Warehouse OR2 When Reorder Point is 2,500 Units Safety Stock Level in Units (1)

Demand Levels Resulting in Stockouts (2)

Stockout in Unitsa (3)= (2)–2,500–(1)

Probability of Stockouts (4)

Relevant Stockout Costsb (5)=(3)×$2

Number of Orders per Yearc (6)

0

2,750 3,000

250 500

0.20 0.04

$ 500 1,000

24 24

250 500

3,000 --

250 --

0.04 --

500 --

24 --

Expected Stockout Costsd (7)(4)×(5)×(6) $2,400 960 $3,360 $ 480 $ 0f

Relevant Carrying Costse (8)= (1)×$2.40

Relevant Total Costs (9)=(7)+(8)

$ 0 $ 600 $1,200

$3,360 $1,080 $1,200

a

Demand level resulting in stockouts – Inventory available during lead time (excluding safety stock), 2,500 units – Safety stock. b Stockout in units × Relevant stockout costs of $2.00 per unit. c Annual demand, 120,000 ÷ 5,000 EOQ = 24 orders per year. d Probability of stockout × Relevant stockout costs × Number of orders per year. e Safety stock × Annual relevant carrying costs of $2.40 per unit (assumes that safety stock is on hand at all times and that there is no overstocking caused by decreases in expected usage). f At a safety stock level of 500 units, no stockout will occur and, hence, expected stockout costs = $0.


20-28 (25 min.) MRP, EOQ, and JIT. 1. Under a MRP system: Annual cost of producing and carrying J-Pods in inventory = Variable production cost + Setup cost + Carrying cost = $54 × 48,000 + ($10,000 × 12 months) + [$17 × (4,000 ÷ 2)] = $2,592,000 + $120,000 + $34,000 = $2,746,000 2. Using an EOQ model to determine batch size: EOQ

2 DP C

2 48, 000 $10, 000 $17

= 7,515 J-Pods per batch Production of 48,000 per year divided by a batch size of 7,515 would imply J-Pods would be produced in 6.4 batches per year. Rounding this up to the nearest whole number yields 7 batches per year, which means a production size of 48,000 ÷ 7 or 6,857 J-Pods per batch. Annual Cost of producing and carrying J-Pods in inventory = Variable production cost + Setup cost + Carrying cost = $54 × 48,000 + ($10,000 × 7) + [$17 × (6,857 ÷ 2)] = $2,592,000 + $70,000 + $58,285 = $2,720,285 The costs of producing and carrying J-Pods in inventory decrease but not by a lot. The square root in the EOQ formula reduces the effect of errors in computing optimal batch size. 3. Under a JIT system Annual Cost of producing and carrying J-Pods in inventory = Variable production cost + Setup cost + Carrying cost = $54 × 48,000 + ($500 × 80 a) + [$17 × (600 ÷ 2)] = $2,592,000 + $40,000 + $5,100 = $2,637,100 a

Production of 48,000 per year divided by a batch size of 600 would imply 80 setups per year. 4. The JIT model resulted in the lowest costs because set up and carrying costs were lower than for the EOQ model. The EOQ model also limits production to almost once every two months. This would not allow managers to react quickly to changing market demand or economic conditions. The JIT model provides management with much more flexibility. JIT systems might also lead managers to improve processes, reduce costs and increase quality.


20-29 (30 min.) Effect of management evaluation criteria on EOQ model. 1. EOQ

2 DP C

2 500,000 $800 $50

= 4,000 computers 2. Number of orders per year =

Total relevant ordering costs =

D Q

Total relevant carrying costs =

Q 2

D EOQ

500,000 = 125 orders 4,000

500,000 4,000

P =

C =

$800 = $100,000

4,000 2

$50 = $100,000

Relevant total costs = $100,000 + $100,000 = $200,000

3. EOQ

2 DP C

2 500,000 $800 $30

= 5,164 computers D Total relevant = ordering costs Q

Q Total relevant carrying costs = 2

P =

C =

500,000 5,164

$800 = $77,459

5,164 2

$50 = $129,100

Relevant total costs = $77,459 + $129,100 = $206,559 4. Since managers will choose to order 5,164 computers instead of 4,000, the cost to the company will be $6, 559 ($206,559 – $200,000) higher than it would be if managers were evaluated based upon all carrying costs. The EOQ quantity and relevant total costs are higher if the company ignores holding costs when evaluating managers, but only by about 3% ($6,559 ÷ $200,000). The square root in the EOQ model reduces the sensitivity of the ordering decision to errors in parameter estimates. Computers 4 U probably does not include the opportunity costs of carrying inventory because it is not tracked by the financial accounting system. The company could change the evaluation model to include a cost of investment in inventory. Even though this would involve an additional calculation, it would encourage managers to make optimal decisions, more congruent with the goal of reducing total inventory costs.


20-30 (30 min.) JIT purchasing, relevant benefits, relevant costs. 1. Solution Exhibit 20-30 presents the $37,500 cash savings that would result if Margro Corporation adopted the just-in-time inventory system in 2011. 2. Conditions that should exist in order for a company to successfully adopt just-in-time purchasing include the following: •

Top management must be committed and provide the necessary leadership support to ensure a company-wide, coordinated effort.

•

A detailed system for integrating the sequential operations of the manufacturing process needs to be developed and implemented. Direct materials must arrive when needed for each subassembly so that the production process functions smoothly.

•

Accurate sales forecasts must be available for effective finished goods planning and production scheduling.

•

Products should be designed to maximize use of standardized parts to reduce manufacturing time and costs.

•

Reliable vendors who can deliver quality direct materials on time with minimum lead time must be obtained.


SOLUTION EXHIBIT 20-30 Annual Relevant Costs of Current Purchasing Policy and JIT Purchasing Policy for Margro Corporation Relevant Relevant Costs under Costs under Current JIT Purchasing Purchasing Policy Policy Required return on investment 20% per year $600,000 of average inventory per year $120,000 20% per year $0 inventory per year $ 0 Annual insurance and property tax costs 14,000 0 Warehouse rent 60,000 (13,500)a Overtime costs No overtime 0 Overtime premium 40,000 Stockout costs No stockouts 0 $6.50b contribution margin per unit 20,000 units 130,000 Total incremental costs $194,000 $156,500 Difference in favor of JIT purchasing $37,500 a

$(13,500) = Warehouse rental revenues, [(75% 12,000) Calculation of unit contribution margin Selling price ($10,800,000 ÷ 900,000 units) Variable costs per unit: Variable manufacturing cost per unit ($4,050,000 ÷ 900,000 units) Variable marketing and distribution cost per unit ($900,000 ÷ 900,000 units) Total variable costs per unit Contribution margin per unit

$1.50].

b

$12.00

$4.50 1.00 5.50 $ 6.50

Note that the incremental costs of $40,000 in overtime premiums to make the additional 15,000 units are less than the contribution margin from losing these sales equal to $97,500 ($6.50 15,000). Margro would rather incur overtime than lose 15,000 units of sales.


20-31 (25 min.) Supply chain effects on total relevant inventory costs. 1.

The relevant costs of purchasing from Maji and Induk are:

Cost Category Purchase costs 10,000 boards × $93 per board 10,000 boards × $90 per board Ordering costs 50 orders × $10 per order 50 orders × $8 per order Inspection costs 10,000 boards × 5% × $5 per board 10,000 boards × 25% × $5 per board Required annual return on investment 100 boards × $93 per board × 10% 100 boards × $90 per board × 10% Stockout costs 100 boards × $5 per board 300 boards × $8 per board Return costs 50 boards × $25 per board 500 boards × $25 per board Other carrying costs 100 boards × $2.50 per board per year 100 boards × $2.50 per board per year Total Cost

Maji

Induk

$930,000 900,000 500 400 2,500 12,500 930 900 500 2,400 1,250 12,500 250 $935,930

250 $928,950

2. While Induk will save Cow Spot $6,980 ($935,930 − $928,950), Cow Spot may still choose to use Maji for the following reasons: a. The savings are less than 1% of the total cost of the mother boards. b. With ten times the number of returns, Induk will probably have a negative effect on Cow Spot’s reputation. c. With Induk’s higher stockouts, Cow Spot’s reputation for availability and on time delivery will be effected. d. The increased number of inspections may necessitate the hiring of additional personnel and the need for additional factory space and equipment.


20-32 (20 min.) Blackflush costing and JIT production. 1. (a) Record purchases of direct materials (b) Record conversion costs incurred (c) Record cost of good finished units completed

(d) Record cost of finished goods sold a

Materials and In-Process Inventory Control Accounts Payable Control Conversion Costs Control Various Accounts (such as Wages Payable Control) Finished Goods Controla Materials and In-Process Inventory Controla Conversion Costs Allocateda Cost of Goods Soldb Finished Goods Control

546,000 546,000 399,000 399,000 900,000 520,000 380,000 855,000 855,000

20,000 × ($26 + $19) = $900,000; 20,000 × $26 = $520,000; 20,000 × $19 = $380,000 19,000 × ($26 + $19) = $855,000

b

2. Materials and In-Process Inventory Control (a) 546,000

Direct Materials

(c) 520,000

Bal. 26,000

Finished Goods Control (c) 900,000

(d) 855,000

Cost of Goods Sold (d) 855,000

Bal. 45,000

Conversion Costs Allocated (c)

380,00



20-33 (20 min.) Backflush, two trigger points, materials purchase and sale (continuation of 20-32). 1. (a) Record purchases of direct materials (b) Record conversion costs incurred (c) Record cost of good finished units completed (d) Record cost of finished goods sold (e) Record underallocated or overallocated conversion costs a

Inventory Control Accounts Payable Control Conversion Costs Control Various Accounts (such as Wages Payable Control) No entry

546,000

Cost of Goods Solda Inventory Controla Conversion Costs Allocateda Conversion Costs Allocated Cost of Goods Sold Conversion Costs Control

855,000

546,000 399,000 399,000

494,000 361,000 361,000 38,000 399,000

19,000 × ($26 + $19) = $855,000; 19,000 × $26 = $494,000; 19,000 × $19 = $361,000

2. Inventory Control

Direct Materials

(a) 546,000

Cost of Goods Sold

(d) 494,000

(d) 855,000

Bal. 52,000


(d) 361,000

(e) 38,000 Conversion Costs Conversion Costs Control (b) 399,000

(e)

399,000


20-34 (20 min.) Backflush, two trigger points, completion of production and sale (continuation of 20-32). 1. (a) Record purchases of direct materials (b) Record conversion costs incurred (c) Record cost of good finished units completed (d) Record cost of finished goods sold (e) Record underallocated or overallocated conversion costs a

No Entry Conversion Costs Control Various Accounts (such as Wages Payable Control) Finished Goods Controla Accounts Payable Controla Conversion Costs Allocateda Cost of Goods Sold Finished Goods Control Conversion Costs Allocated Cost of Goods Sold Conversion Costs Control

399,000 399,000 900,000 520,000 380,000 855,000 855,000 380,000 19,000 399,000

20,000 × ($26 + $19) = $900,000; 20,000 × $26 = $520,000; 20,000 × $19 = $380,000 19,000 × ($26 + $19) = $855,000

b

2. Finished Goods Control

Cost of Goods Sold

Direct Materials

(c) 900,000

(d) 855,000

(d) 855,000

Bal. 45,000


(c) 380,000

(e) 19,000 Conversion Costs Conversion Costs Control (b) 399,000

(e) 399,000


20-35 (20 min.) Lean accounting. 1. The cost object in lean accounting is the value stream, not the individual product. FSD has identified two distinct value streams: Mechanical Devices and Electronic Devices. All direct costs are traced to the value streams. However, not all plant-level overhead costs are allocated to the value streams when computing operating income. Value streams are only charged for the percentage of space they actually use, only 90% of the $200,000 plant facility costs are charged to the two value streams. The remaining 10%, or $20,000, is not used to compute value stream profits, nor are other corporate-level overhead costs. 2.

Operating income under lean accounting are the following (in thousands of dollars):

Sales ($700 + $500; $900 + $450) Costs Direct materials purchased ($210 + $120; $250 + $90) Direct manufacturing labor ($150 + $75; $200 + $60) Equipment costs ($90 + $120; $200 + $95) Design and marketing costs ($95 + $50; $105 + $42) Plant facility costs ($200,000 × 40%) ($200,000 × 50%) Value stream operating income

Mechanical Devices $1,200

Electronic Devices $1,350

330

340

225

260

210

295

145

147

80 $ 210

100 $ 208

In addition to the differences discussed in Requirement 1, FSD’s lean accounting system accounts for direct materials as expenses in the period the materials are purchased. The following factors explain the differences between traditional operating income and lean accounting income for the two value streams (in thousands of dollars):

Traditional operating income ($100 + $105; $45 + $140) Additional cost of direct materials purchased over direct materials used ($330 − $200 – $100; $340 − $250 – $75) Decrease in allocated plant-level overhead ($50 + $40 – $80; $80 + $30 – $100) Add back allocated corporate overhead costs ($15 + $10; $20 + $8) Value stream operating income

Mechanical Devices

Electronic Devices

$205

$185

(30)

(15)

10

10

25 $210

28 $208


20-36 (20 min.)

JIT production, relevant benefits, relevant costs, ethics.

1. Solution Exhibit 20-37 presents the annual net benefit of $105,000 to Parson Container Corporation of implementing a JIT production system. 2. As part of the IMA’s Standards of Ethical Professional Practice, Sue Winston, the company controller has an obligation under the competence standard to ―provide decision support information and recommendations that are accurate, clear, concise and timely‖. Therefore, Sue must provide the cost benefit analysis to Parson’s senior management in a timely fashion, even if it could result in layoffs for some employees. The credibility standard also requires Sue to disclose any relevant information that could expect to influence an intended user’s decision. This would indicate that Sue has an ethical obligation to disclose the potential cost/benefits of the new JIT system to management. 3. It is understandable that Jim Ingram the company’s operations manager would be concerned about potential layoffs in his department and the resulting morale issues. However, recommendations could include 1) fully engage the production staff in the upcoming changes to minimize negative morale issues 2) retrain existing staff to manage the new JIT production and purchasing system, so as to avoid as many potential layoffs, as possible 3) relocate existing staff to other production and or administrative positions wherever possible to minimize layoffs. As for Jim’s other concerns, the new system will be costly to implement and maintain and there is a likelihood for additional stockouts, but the financial benefits clearly outweigh the costs. SOLUTION EXHIBIT 20-37 Annual Relevant Costs and Benefits of new JIT Production System for Parson Container Corporation Relevant Relevant Benefits Costs under JIT under JIT Production Production Relevant Items System System Annual additional costs for JIT system implementation and management $220,000 125,000 Additional expected stockout costs 10,000 5% $250 Required return on investment: 10% per year $2,000,000 75% of average inventory $150,000 210,000 Insurance, and warehousing costs 60% per year $350,000 Reduction in payroll expense for current inventory management staff 15% per year $600,000 90,000 Incremental revenues from higher selling prices --Total net incremental benefits/costs $450,000 $345,000 Annual difference in favor of JIT production $105,000


CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS 21-1 No. Capital budgeting focuses on an individual investment project throughout its life, recognizing the time value of money. The life of a project is often longer than a year. Accrual accounting focuses on a particular accounting period, often a year, with an emphasis on income determination. 21-2 The five stages in capital budgeting are the following: 1. An identification stage to determine which types of capital investments are available to accomplish organization objectives and strategies. 2. An information-acquisition stage to gather data from all parts of the value chain in order to evaluate alternative capital investments. 3. A forecasting stage to project the future cash flows attributable to the various capital projects. 4. An evaluation stage where capital budgeting methods are used to choose the best alternative for the firm. 5. A financing, implementation and control stage to fund projects, get them under way and monitor their performance. 21-3 In essence, the discounted cash-flow method calculates the expected cash inflows and outflows of a project as if they occurred at a single point in time so that they can be aggregated (added, subtracted, etc.) in an appropriate way. This enables comparison with cash flows from other projects that might occur over different time periods. 21-4 No. Only quantitative outcomes are formally analyzed in capital budgeting decisions. Many effects of capital budgeting decisions, however, are difficult to quantify in financial terms. These nonfinancial or qualitative factors (for example, the number of accidents in a manufacturing plant or employee morale) are important to consider in making capital budgeting decisions. 21-5 Sensitivity analysis can be incorporated into DCF analysis by examining how the DCF of each project changes with changes in the inputs used. These could include changes in revenue assumptions, cost assumptions, tax rate assumptions, and discount rates. 21-6 The payback method measures the time it will take to recoup, in the form of expected future net cash inflows, the net initial investment in a project. The payback method is simple and easy to understand. It is a handy method when screening many proposals and particularly when predicted cash flows in later years are highly uncertain. The main weaknesses of the payback method are its neglect of the time value of money and of the cash flows after the payback period. The first drawback, but not the second, can be addressed by using the discounted payback method. 21-7 The accrual accounting rate-of-return (AARR) method divides an accrual accounting measure of average annual income of a project by an accrual accounting measure of investment. The strengths of the accrual accounting rate of return method are that it is simple, easy to understand, and considers profitability. Its weaknesses are that it ignores the time value of money and does not consider the cash flows for a project.


21-8 No. The discounted cash-flow techniques implicitly consider depreciation in rate of return computations; the compound interest tables automatically allow for recovery of investment. The net initial investment of an asset is usually regarded as a lump-sum outflow at time zero. Where taxes are included in the DCF analysis, depreciation costs are included in the computation of the taxable income number that is used to compute the tax payment cash flow. 21-9 A point of agreement is that an exclusive attachment to the mechanisms of any single method examining only quantitative data is likely to result in overlooking important aspects of a decision. Two points of disagreement are (1) DCF can incorporate those strategic considerations that can be expressed in financial terms, and (2) ―Practical considerations of strategy‖ not expressed in financial terms can be incorporated into decisions after DCF analysis. 21-10 All overhead costs are not relevant in NPV analysis. Overhead costs are relevant only if the capital investment results in a change in total overhead cash flows. Overhead costs are not relevant if total overhead cash flows remain the same but the overhead allocated to the particular capital investment changes. 21-11 The Division Y manager should consider why the Division X project was accepted and the Division Y project rejected by the president. Possible explanations are: a. The president considers qualitative factors not incorporated into the IRR computation and this leads to the acceptance of the X project and rejection of the Y project. b. The president believes that Division Y has a history of overstating cash inflows and understating cash outflows. c. The president has a preference for the manager of Division X over the manager of Division Y—this is a corporate politics issue. Factor a. means qualitative factors should be emphasized more in proposals. Factor b. means Division Y needs to document whether its past projections have been relatively accurate. Factor c. means the manager of Division Y has to play the corporate politics game better. 21-12 The categories of cash flow that should be considered in an equipment-replacement decision are: 1a. Initial machine investment, b. Initial working-capital investment, c. After-tax cash flow from current disposal of old machine, 2a. Annual after-tax cash flow from operations (excluding the depreciation effect), b. Income tax cash savings from annual depreciation deductions, 3a. After-tax cash flow from terminal disposal of machines, and b. After-tax cash flow from terminal recovery of working-capital investment. 21-13 Income taxes can affect the cash inflows or outflows in a motor vehicle replacement decision as follows: a. Tax is payable on gain or loss on disposal of the existing motor vehicle, b. Tax is payable on any change in the operating costs of the new vehicle vis-à-vis the existing vehicle, and c. Tax is payable on gain or loss on the sale of the new vehicle at the project termination date. d. Additional depreciation deductions for the new vehicle result in tax cash savings.


21-14 A cellular telephone company manager responsible for retaining customers needs to consider the expected future revenues and the expected future costs of ―different investments‖ to retain customers. One such investment could be a special price discount. An alternative investment is offering loyalty club benefits to long-time customers. 21-15 These two rates of return differ in their elements: Real-rate of return 1. Risk-free element 2. Business-risk element

Nominal rate of return 1. Risk-free element 2. Business-risk element 3. Inflation element

The inflation element is the premium above the real rate of return that is demanded for the anticipated decline in the general purchasing power of the monetary unit. 21-16 Exercises in compound interest, no income taxes. The answers to these exercises are printed after the last problem, at the end of the chapter. (Please alert students that in some printed versions of the book there is a typographical error in the solution to part 5. The interest rate is 8%, not 6%.) 21-17 (20–25 min.) Capital budget methods, no income taxes. 1a.

The table for the present value of annuities (Appendix A, Table 4) shows: 8 periods at 8% = 5.747 Net present value

= $67,000 (5.747) – $250,000 = $385,049 – $250,000 = $135,049

1b. Payback period 1c.

Discounted Payback Period

Period

0 1 2 3 4 5

= $250,000 ÷ $67,000 = 3.73 years

Cash Savings

$67,000 $67,000 $67,000 $67,000 $67,000

Discount Factor (8%)

.926 .857 .794 .735 .681

Discounted Cash Savings

$62,042 $57,419 $53,198 $49,245 $45,627

Cumulative Discounted Cash Savings $62,042 $119,461 $172,659 $221,904 $267,531

Unrecovered Investment -$250,000 -$187,958 -$130,539 -$77,341 -$28,096

$28,096/$45,627 = .6158 Discounted Payback period = 4.62 years


1d.

Internal rate of return: $250,000 = Present value of annuity of $67,000 at R% for 8 years, or what factor (F) in the table of present values of an annuity (Appendix A, Table 4) will satisfy the following equation. $250,000 = $67,000F F = 250000/67000= 3.73

On the 8-year line in the table for the present value of annuities (Appendix A, Table 4), find the column closest to 3.73; it is between a rate of return of 20% and 22%. Interpolation is necessary: 20% IRR rate 22% Difference Internal rate of return

Present Value Factors 3.837 3.837 – 3.730 3.619 –– 0.218 0.107 = 20% + (.107/.218) * (2%) = 20% + .4908 (2%) = 20.98%

1d.

Accrual accounting rate of return based on net initial investment: Net initial investment = $250,000 Estimated useful life = 8 years Annual straight-line depreciation = $250,000 ÷ 8 = $31,250 Accrual accounting = Increase in expected average annual operating income rate of return Net initial investment

= ($67,000 – $31,250) / $250,000 = $35,750 / $250,000 = 14.3% Note how the accrual accounting rate of return can produce results that differ markedly from the internal rate of return. 2.

Other than the NPV, rate of return and the payback period on the new computer system, factors that Riverbend should consider are: Issues related to the financing the project, and the availability of capital to pay for the system. The effect of the system on employee morale, particularly those displaced by the system. Salesperson expertise and real-time help from experienced employees is key to the success of a hardware store. The benefits of the new system for customers (faster checkout, fewer errors). The upheaval of installing a new computer system. Its useful life is estimated to be 8 years. This means that Riverbend could face this upheaval again in 8 years. Also,


ensure that the costs of training and other ―hidden‖ start-up costs are included in the estimated $250,000 cost of the new computer system.


21-18 (25 min.) Capital budgeting methods, no income taxes. The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% = 5.216 Net present value

= $28,000 (5.216) – $110,000 = $146,048 – $110,000 = $36,048

b.

Payback period

=

c.

For a $110,000 initial outflow, the project generates $28,000 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 21.96%.

d.

Accrual accounting rate of return based on net initial investment: Net initial investment = $110,000 Estimated useful life = 10 years Annual straight-line depreciation = $110,000 ÷ 10 = $11,000 $28,000 $11,000 Accrual accounting rate of return = $110 ,000 $17,000 = = 15.45% $110 ,000

1a.

$110 ,000 = 3.93 years $28,000

e. Accrual accounting rate of return based on average investment: Average investment = ($110,000 + $0) / 2 = $55,000 Accrual accounting rate of return

=

$28,000 $11,000 = 30.91%. $55,000

2. Factors City Hospital should consider include: a. Quantitative financial aspects. b. Qualitative factors, such as the benefits to its customers of a better eye-testing machine and the employee-morale advantages of having up-to-date equipment. c. Financing factors, such as the availability of cash to purchase the new equipment.


21-19 (35 min.) Capital budgeting, income taxes.

1a.

Net after-tax initial investment = $110,000

Annual after-tax cash flow from operations (excluding the depreciation effect): Annual cash flow from operation with new machine Deduct income tax payments (30% of $28,000) Annual after-tax cash flow from operations

$28,000 8,400 $19,600

Income tax cash savings from annual depreciation deductions 30% $11,000

$3,300

These three amounts can be combined to determine the NPV: Net initial investment; $110,000 1.00 10-year annuity of annual after-tax cash flows from operations; $19,600 5.216 10-year annuity of income tax cash savings from annual depreciation deductions; $3,300 5.216 Net present value

b.

$(110,000) 102,234

$

Payback period =

$110 ,000 ($19,600 + $3,300 )

=

$110 ,000 $22,900

= 4.80 years


17,213 9,447

c.

For a $110,000 initial outflow, the project now generates $22,900 in after-tax cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 16.17%.

d.

Accrual accounting rate of return based on net initial investment: AARR =

$22,900 $11,000 $11,900 = $110 ,000 $110,000

= 10.82% e.

Accrual accounting rate of return based on average investment: AARR =

$22,900 $11, 000 $11,900 = $55, 000 $55, 000

= 21.64% 2a. Increase in NPV. To get a sense for the magnitude, note that from Table 2, the present value factor for 10 periods at 14% is 0.270. Therefore, the $10,000 terminal disposal price at the end of 10 years would have an after-tax NPV of: $10,000 b. 10.

(1

0.30)

0.270 = $1,890

No change in the payback period of 4.80 years. The cash inflow occurs at the end of year

c. Increase in internal rate of return. The $10,000 terminal disposal price would raise the IRR because of the additional inflow. (The new IRR is 16.54%.) d. The AARR on net initial investment would increase because accrual accounting income in year 10 would increase by the $7,000 ($10,000 gain from disposal, less 30% $10,000) aftertax gain on disposal of equipment. This increase in year 10 income would result in higher average annual accounting income in the numerator of the AARR formula. e. The AARR on average investment would also increase, for the same reasons given in the previous answer. Note that the denominator is unaffected because the investment is still depreciated down to zero terminal disposal value, and so the average investment remains $55,000.


21-20 (25 min.) Capital budgeting with uneven cash flows, no income taxes. 1. Present value of savings in cash operating costs: $10,000 × 0.862 8,000 × 0.743 6,000 × 0.641 5,000 × 0.552 Present value of savings in cash operating costs Net initial investment Net present value 2.

$ 8,620 5,944 3,846 2,760 21,170 (23,000) $ (1,830)

Payback period: Year 0 1 2 3

Cash Savings – $10,000 8,000 6,000

Payback period

=

Cumulative Cash Savings – $10,000 18,000 24,000

2 years +

Initial Investment Yet to Be Recovered at End of Year $23,000 13,000 5,000 –

$5,000 = 2.83 years $6,000

3. Discounted Payback Period Period

0 1 2 3 4

Cash Savings

$10,000 $8,000 $6,000 $5,000

Disc Factor Discounted Cumulative Unrecovered (16%) Cash Savings Discounted. Investment Cash Savings -$23,000 .862 $8,620 $8,620 -$14,380 .743 $5,944 $14,564 -$8,436 .641 $3,846 $18,410 -$4,590 .552 $2,760 $21,170 -$1,830

At a 16% rate of return, this project does not save enough to make it worthwhile using the discounted payback method. 4. From requirement 1, the net present value is negative with a 16% required rate of return. Therefore, the internal rate of return must be less than 16%.

Year (1) 1 2 3 4

Cash Savings (2) $10,000 8,000 6,000 5,000

P.V. Factor at 14% (3) 0.877 0.769 0.675 0.592

P.V. at 14% (4) = (2) × (3) $ 8,770 6,152 4,050 2,960 $21,932

P.V. Factor at 12% (5) 0.893 0.797 0.712 0.636

P.V. at 12% (6) = (2) × (5) $ 8,930 6,376 4,272 3,180 $22,758

P.V. Factor at 10% (7) 0.909 0.826 0.751 0.683

P.V. at 10% (8) = (2) × (7) $ 9,090 6,608 4,506 3,415 $23,619


Net present value at 14% = $21,932 – $23,000 = $(1,068) Net present value at 12% = $22,758 – $23,000 = $(242) Net present value at 10% = $23,619 – $23,000 = $619 Internal rate of return

5.

619 (2%) 619 242

=

10% +

=

10% + (0.719) (2%) = 11.44%

Accrual accounting rate of return based on net initial investment: Average annual savings in cash operating costs =

$29,000 = $7,250 4 years

Annual straight-line depreciation =

$23,000 = $5,750 4 years

Accrual accounting rate of return =

$7,250 $5,750 $23,000

=

$1,500 = 6.52% $23,000


21-21 (30 min.) Comparison of projects, no income taxes. 1. Total Present Value Plan I $ (100,000) (3,778,950) $(3,878,950)

Present Value Discount Factors at 10%

Year 0

1.000 0.826

$ (100,000)

Plan II $(1,550,000) (1,408,950) (1,280,300) $(4,239,250)

1.000 0.909 0.826

$(1,550,000)

Plan III $ (200,000) (1,340,775) (1,218,350) (1,107,725) $(3,866,850)

1.000 0.909 0.826 0.751

$ (200,000)

1

2

3

$(4,575,000)

$(1,550,000) $(1,550,000)

$(1,475,000) $(1,475,000) $(1,475,000)

2.

Plan III has the lowest net present value cost, and is therefore preferable on financial criteria.

3.

Factors to consider, in addition to NPV, are: a. Financial factors including: Competing demands for cash. Availability of financing for project. b. Nonfinancial factors including: Risk of building contractor not remaining solvent. Plan II exposes New Bio most if the contractor becomes bankrupt before completion because it requires more of the cash to be paid earlier. Ability to have leverage over the contractor if quality problems arise or delays in construction occur. Plans I and III give New Bio more negotiation strength by being able to withhold sizable payment amounts if, say, quality problems arise in Year 1. Investment alternatives available. If New Bio has capital constraints, the new building project will have to compete with other projects for the limited capital available.


21-22 (30 min.) Payback and NPV methods, no income taxes. 1a. Payback measures the time it will take to recoup, in the form of expected future cash flows, the net initial investment in a project. Payback emphasizes the early recovery of cash as a key aspect of project ranking. Some managers argue that this emphasis on early recovery of cash is appropriate if there is a high level of uncertainty about future cash flows. Projects with shorter paybacks give the organization more flexibility because funds for other projects become available sooner. Strengths Easy to understand One way to capture uncertainty about expected cash flows in later years of a project (although sensitivity analysis is a more systematic way) Weaknesses Fails to incorporate the time value of money, unless discounted payback is used Does not consider a project’s cash flows after the payback period 1b. Project A Outflow, $3,000,000 Inflow, $1,000,000 (Year 1) + $1,000,000 (Year 2) + $1,000,000 (Year 3) + $1,000,000 (Year 4) Payback = 3 years Project B Outflow, $1,500,000 Inflow, $400,000 (Year 1) + $900,000 (Year 2) + $800,000 (Year 3) Payback = 2 years +

($1,500 ,000 $400 ,000 $900 ,000 ) = 2.25 years $800 ,000


Project C Outflow, $4,000,000 Inflow, $2,000,000 (Year 1) + $2,000,000 (Year 2) + $200,000 (Year 3) + $100,000 (Year 4) Payback = 2 years Payback Period 2 years 2.25 years 3 years

1. Project C 2. Project B 3. Project A

If payback period is the deciding factor, Andrews will choose Project C (payback period = 2 years; investment = $4,000,000) and Project B (payback period = 2.25 years; investment = $1,500,000), for a total capital investment of $5,500,000. Assuming that each of the projects is an all-or-nothing investment, Andrews will have $500,000 left over in the capital budget, not enough to make the $3,000,000 investment in Project A. 2.

Solution Exhibit 21-22 shows the following ranking: NPV $ 207,800 $ 169,000 $(311,500)

1. Project B 2. Project A 3. Project C

3. Using NPV rankings, Projects B and A, which require a total investment of $3,000,000 + $1,500,000 = $4,500,000, which is less than the $6,000,000 capital budget, should be funded. This does not match the rankings based on payback period because Projects B and A have substantial cash flows after the payback period, cash flows that the payback period ignores. Nonfinancial qualitative factors should also be considered. For example, are there differential worker safety issues across the projects? Are there differences in the extent of learning that can benefit other projects? Are there differences in the customer relationships established with different projects that can benefit Andrews Construction in future projects?



Total Present Value PROJECT A Net initial invest.

$(3,000,000) 1.000

Annual cash inflow

Net present value PROJECT B Net initial invest.


$

909,000 826,000 751,000 683,000 169,000

$

PROJECT C Net initial invest.

$(4,000,000) 1.000

Net present value

1,818,000 1,652,000 150,200 68,300 $ (311,500)

0.909 0.826 0.751 0.683

1

2

3

4

$(3,000,000) $1,000,000 $1,000,000 $1,000,000 $1,000,000

$(1,500,000)

363,600 0.909 743,400 0.826 600,800 0.751 207,800

Net present value

Annual cash inflow

0

0.909 0.826 0.751 0.683

$(1,500,000) 1.000

Annual cash inflow

Sketch of Relevant Cash Flows

$ 400,000 $ 900,000 $ 800,000

$(4,000,000) $2,000,000 $2,000,000 $ 200,000


$ 100,000

21-23 (22–30 min.) DCF, accrual accounting rate of return, working capital, evaluation of performance, no income taxes. 1. Present value of annuity of savings in cash operating costs ($31,250 per year for 8 years at 14%): $31,250 4.639 Present value of $37,500 terminal disposal price of machine at end of year 8: $37,500 0.351 Present value of $10,000 recovery of working capital at end of year 8: $10,000 0.351 Gross present value Deduct net initial investment: Centrifuge machine, initial investment Additional working capital investment Net present value

$144,969 13,163 3,510 161,642 $137,500 10,000

147,500 $ 14,142

2. The sequence of cash flows from the project is: For a $147,500 initial outflow, the project now generates $31,250 in cash flows at the end of each of years one through seven and $78,750 (= $31,250 + $37,500) at the end of year 8. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 16.51%. 3.

Accrual accounting rate of return based on net initial investment: Net initial investment = $137,500 + $10,000 = $147,500 Annual depreciation ($137,500 – $37,500) ÷ 8 years = $12,500 Accrual accounting rate of return

4.

=

$31,250 $12,500 = 12.71%. $147,500

Accrual accounting rate of return based on average investment: Net terminal cash flow

= $37,500 terminal disposal price + $10,000 working capital recovery = $47,500

Average investment

= ($147,500 + $47,500) / 2 = $97,500

Accrual accounting rate of return

=

$31,250 $12,500 = 19.23%. $97,500

5. If your decision is based on the DCF model, the purchase would be made because the net present value is positive, and the 16.51% internal rate of return exceeds the 14% required rate of return. However, you may believe that your performance may actually be measured using


accrual accounting. This approach would show a 12.71% return on the initial investment, which is below the required rate. Your reluctance to make a ―buy‖ decision would be quite natural unless you are assured of reasonable consistency between the decision model and the performance evaluation method.


21-24 (40 min.) New equipment purchase, income taxes. 1.

The after-tax cash inflow per year is $29,600 ($21,600 + $8,000), as shown below: Annual cash flow from operations Deduct income tax payments (0.40 × $36,000) Annual after-tax cash flow from operations

$ 36,000 14,400 $ 21,600

Annual depreciation on machine [($88,000 – $8,000) ÷ 4]

$ 20,000

Income tax cash savings from annual depreciation deductions (0.40 × $20,000)

$8,000

a. Solution Exhibit 21-24 shows the NPV computation. NPV = $7,013 b. Payback = $88,000 ÷ ($21,600 + $8,000) = 2.97 years c. For a $88,000 initial outflow, the project now generates $29,600 in after-tax cash flows at the end of each of years one through four and an additional $8,000 at the end of year 4. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 15.59%.

2.

Accrual accounting rate of return based on net initial investment: Net initial investment = $88,000 Annual after-tax operating income

= $29,600 - $20,000 depreciation = $9,600

Accrual accounting rate of return

=

$9, 600 = 10.91%.. $88,000



Total Present Value 1a. Initial machine investment $(88,000) 1b. Initial working capital investment 0 2a. Annual after-tax cash flow from operations (excl. depr.) Year 1 19,289 Year 2 17,215 Year 3 15,379 Year 4 13,738 2b. Income tax cash savings from annual depreciation deductions Year 1 7,144 Year 2 6,376 Year 3 5,696 Year 4 5,088 3. After-tax cash flow from: a. Terminal disposal of machine 5,088 b. Recovery of working capital 0 Net present value if new machine is purchased $ 7,013

Present Value Discount Factor at 12%

1.000

Sketch of Relevant After-Tax Cash Flows 0 1 2 3 4 $(88,000)

1.000

$0

0.893 0.797 0.712 0.636

$21,600

0.893 0.797 0.712 0.636

$8,000

$21,600 $21,600 $21,600

$8,000 $8,000 $8,000

0.636

$8,000

0.636

$0


21-25 1.

a.

(40 min.) New equipment purchase, income taxes. The after-tax cash inflow per year is $21,500 ($16,250 + $5,250), as shown below: Annual cash flow from operations Deduct income tax payments (0.35 $25,000) Annual after-tax cash flow from operations

$25,000 8,750 $16,250

Annual depreciation on motor ($75,000 5 years) Income tax cash savings from annual depreciation deductions (0.35 $15,000)

$15,000

Solution Exhibit 21-25 shows the NPV computation. NPV= $6,486 An alternative approach: Present value of 5-year annuity of $21,500 at 10% $21,500 3.791 Present value of cash outlays, $75,000 1.000 Net present value*

*

$ 5,250

$ 81,507 75,000 $ 6,507

Minor dfference from solution exhibit 21-25 due to rounding.

b.

Payback = $75,000 ÷ $21,500 = 3.49 years

c. Discounted Payback Period Period

Cash Savings

Disc Factor (10%)

Discounted Cash Savings

Cumulative Disc Cash Savings

0 1 2 3 4 5

$21,500 $21,500 $21,500 $21,500 $21,500

.909 .826 .751 .683 .621

$19,543.50 $17,759.00 $16,146.50 $14,684.50 $13,351.50

$19,543.50 $37,302.50 $53,449.00 $68,133.50 $81,485.00

Unrecovered Investment -$75,000.00 -$55,456.50 -$37,697.50 -$21,551.00 -$6,866.50

$6,866.50/$13,351.50 = .51 Discounted Payback Period = 4.51 years d. For a $75,000 initial outflow, the project now generates $21,500 in after-tax cash flows at the end of each of years one through five. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 13.34%.


2. Both the net present value and internal rate of return methods use the discounted cash flow approach in which all expected future cash inflows and outflows of a project are measured as if they occurred at a single point in time. The net present value approach computes the surplus generated by the project in today’s dollars while the internal rate of return attempts to measure its effective return on investment earned by the project. The payback method, by contrast, considers nominal cash flows (without discounting) and measures the time at which the project’s expected future cash inflows recoup the net initial investment in a project. The payback method thus ignores the profitability of the project’s entire stream of future cash flows. The discounted payback method shares this last defect, but looks at the time taken to recoup the initial investment based on the discounted present value of cash inflows. The two payback methods are becoming increasingly important in the global economy. When the local environment in an international location is unstable and therefore highly risky for a potential investment, a company would likely pay close attention to the payback period for making its investment decision. In general, the more unstable the environment, the shorter the payback period desired.


SOLUTION EXHIBIT 21-25 Total Present Value

Present Value Discount Factors At 10% 0

1a. Initial motor investment 1b. Initial working capital investment 2a. Annual aftertax cash flow from operations (excl. depr.) Year 1 Year 2 Year 3 Year 4 Year 5 2b Income tax cash savings from annual deprec. Deductions Year 1 Year 2 Year 3 Year 4 Year 5 3. After-tax cash flow from: a. Terminal disposal of motor b. Recovery of working capital Net present value if new motor is purchased

$(75,000)

1

Sketch of Relevant After-Tax Cash Flows 2 3 4

5

1.000

$(75,000)

0

1.000

$0

14,771 13,423 12,204 11,099 10,091

0.909 0.826 0.751 0.683 0.621

$16,250

4,772 4,337 3,943

0.909 0.826 0.751

$5 250

3,586 3,260

0.683 0.621

0

0.621

$0

0

0.621

$0

$16,250 $16,250 $16,250 $16,250

$5 250 $5 250 $5 250

$ 6,486


$5 250

21-26 (60 min.) Selling a plant, income taxes. 1.

Option 1 Current disposal price Deduct current book value Gain on disposal Deduct 35% tax payments Net present value

$450,000 0 450,000 157,500 $292,500

Option 2 Crossroad receives three sources of cash inflows: a. Rent. Four annual payments of $110,000. The after-tax cash inflow is: $110,000 × (1 – 0.35) = $71,500 per year b. Discount on material purchases, payable at year-end for each of the four years: $20,000 The after-tax cash inflow is: $20,000 × (1 – 0.35) = $13,000 c. Sale of plant at year-end 2012. The after-tax cash inflow is: $75,000 × (1 – 0.35) = $48,750 Total Present Value

1. Rent `


Sketch of Relevant After-Tax Cash Flows 0 1 2 3

$ 64,994 59,059 53,697 48,835

0.909 0.826 0.751 0.683

$71,500

$11,817 10,738 9,763 8,879

0.909 0.826 0.751 0.683

$13,000

3. Sale of plant

$ 33,296

0.683

Net present value

$301,078

2. Discount on Purchases

4

$71,500 $71.500 $71,500

$13,000 $13,000 $13,000 $48,750


Option 3 Contribution margin per jacket: Selling price Variable costs Contribution margin

Contribution margin $12.00 × 9,000; 13,000; 15,000; 5,000 Fixed overhead (cash) costs Annual cash flow from operations Income tax payments (35%) After-tax cash flow from operations (excl. depcn.)

$55.00 43.00 $ 12.00 2012

2013

2014

2015

$108,000 10,000 98,000 34,300

$156,000 10,000 146,000 51,100

$180,000 10,000 170,000 59,500

$60,000 10,000 50,000 17,500

$63,700

$ 94,900

$ 110,500

$32,500

Depreciation: $80,000 ÷ 4 = $20,000 per year Income tax cash savings from depreciation deduction: $20,000 × 0.35 = $7,000 per year Sale of plant at end of 2015: $135,000 × (1 – 0.35) = $87,750 Solution Exhibit 21-26 presents the NPV calculations: NPV = $243,590


SOLUTION EXHIBIT 21-26 Total Present Value

Present Value Discount Factors at 10% 2011

1a. Initial plant equipment upgrade investment 1b. Initial working capital investment 2a. Annual after-tax cash flow from operations (excluding depreciation effects) Year 1 Year 2 Year 3 Year 4 2b. Income tax cash savings from annual depreciation deductions Year 1 Year 2 Year 3 Year 4 3. After-tax cash flow From a. Terminal disposal of plant b. Recovery of working capital Net present value

$(80,000)

1.000

Sketch of Relevant After-Tax Cash Flows 2012 2013 2014

2015

$80,000

0

1.000

$0

57,903 78,387 82,986 22,198

0.909 0.826 0.751 0.683

$63,700

6,363 5,782 5,257 4,781

0.909 0.826 0.751 0.683

$7,000

59,933

0.683

$87,750

0 $243,590

0.683

$0

$94,900 $110,500 $32,500

$7,000 $7,000 $7,000

Option 2 has the highest NPV: NPV $292,500 $301,078 $243,590

Option 1 Option 2 Option 3 2.

Nonfinancial factors that Crossroad should consider include the following: Option 1 gives Crossroad immediate liquidity which it can use for other projects. Option 2 has the advantage of Crossroad having a closer relationship with the supplier. However, it limits Crossroad’s flexibility if Austin Corporation’s quality is not comparable to competitors. Option 3 has Crossroad entering a new line of business. If this line of business is successful, it could be expanded to cover souvenir jackets for other major events. The risks of selling the predicted number of jackets should also be considered.


21-27 (60 min.) Equipment replacement, no income taxes. 1.

Cash flows for modernizing alternative:

Year (1) Jan. 1, 2012 Dec. 31, 2012 Dec. 31, 2013 Dec. 31, 2014 Dec. 31, 2015 Dec. 31, 2016 Dec. 31, 2017 Dec. 31, 2018 a

Net Cash Units Sold Contributions (2) (3) = (2) × $18,000a –– 552 612 672 732 792 852 912

–– $ 9,936 000 11,016 000 12,096 000 13,176 000 14,256 000 15,336 000 16,416 000

Sale of Equip. at Termination (5)

$(33,600,000)

––

$6 000 000

$80 000 – $62 000 = $18 000 cash contribution per prototype.

Cash flows for replacement alternative: Net Cash Year Units Sold Contributions (1) (2) (3) = (2) × $24,000b Jan. 1, 2012 Dec. 31, 2012 Dec. 31, 2013 Dec. 31, 2014 Dec. 31, 2015 Dec. 31, 2016 Dec. 31, 2017 Dec. 31, 2018 b

Initial Investments (4)

–– 552 612 672 732 792 852 912

–– $13,248 000 14,688 000 16,128 000 17,568 000 19,008 000 20,448 000 21,888 000

Initial Investments (4)

Sale of Equip.

$(58,800,000)

$3 600 000

(5)

$14 400 000

$80 000 – $56 000 = $24 000 cash contribution per prototype.


2.

Payback period calculations for modernizing alternative:

Year (1) Jan. 1, 2012 Dec. 31, 2012 Dec. 31, 2013 Dec. 31, 2014 Dec. 31, 2015

Cash Inflow (2) –– $ 9,936 000 11,016 000 12,096 000 13,176 000

Cumulative Cash Inflow (3) –– $ 9,936 000 20,952 000 33,048 000

Net Initial Investment Unrecovered at End of Year (4) $33,600,000 23,664 000 12,648 000 552 000

Payback = 3 + ($552,000 ÷ $13,176,000) = 3.04 years Payback period calculations for replace alternative:

Year (1) Jan. 1, 2012 Dec. 31, 2013 Dec. 31, 2014 Dec. 31, 2015 Dec. 31, 2016

Cash Inflow (2) –– $13,248 000 14,688 000 16,128 000 17,568 000

Cumulative Cash Inflow (3) –– $13,248 000 27,936 000 44,064 000

Net Initial Investment Unrecovered at End of Year (4) $55,200,000 41,952 000 27,264 000 11,136 000

Payback = 3 + ($11,136,000 ÷ $17,568,000) = 3.63 years


3.

Modernizing alternative:

Year Jan. 1, 2012 Dec. 31, 2012 Dec. 31, 2013 Dec. 31, 2014 Dec. 31, 2015 Dec. 31, 2016 Dec. 31, 2017 Dec. 31, 2018 Total

Present Value Discount Factors At 12% 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452

Net Cash Flow $(33,600 000) 9,936 000 11,016 000 12,096 000 13,176 000 14,256 000 15,336 000 22,416 000

Present Value $(33,600,000) 8,872 848 8,779,752 8,612,352 8,379,936 8,083,152 7,775,352 10,132,032 $27,035,424

Net Cash Flow $(55,200 000) 13,248 000 14,688 000 16,128 000 17,568 000 19,008 000 20,448 000 36,288,000

Present Value $(55,200,000) 11,830,464 11,706,336 11,483,136 11,173,248 10,777,536 10,367,136 16,402,176 $28,540,032

Replace Alternative:

Year Jan. 1, 2012 Dec. 31, 2012 Dec. 31, 2013 Dec. 31, 2014 Dec. 31, 2015 Dec. 31, 2016 Dec. 31, 2017 Dec. 31, 2018 Total

Present Value Discount Factors At 12% 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452

4. Using the payback period, the modernize alternative is preferred to the replace alternative. On the other hand, the replace alternative has a higher NPV than the modernize alternative and so should be preferred. However, the NPV amounts are based on best estimates. Pro Chips should examine the sensitivity of the NPV amounts to variations in the estimates. Nonfinancial qualitative factors should be considered. These could include the quality of the prototypes produced by the modernize and replace alternatives. These alternatives may differ in capacity and their ability to meet surges in demand beyond the estimated amounts. The alternatives may also differ in how workers increase their shop floor-capabilities. Such differences could provide labor force externalities that can be the source of future benefits to Pro Chips.


21-28 (40 min.) Equipment replacement, income taxes (continuation of 21-27). 1. & 2. Income tax rate = 30% Modernize Alternative Annual depreciation: $33,600 000 7 years = $4 800 000 a year. Income tax cash savings from annual depreciation deductions: $4 800 000 0.30 = $1 440 000 a year. Terminal disposal of equipment = $6 000 000. After-tax cash flow from terminal disposal of equipment: $6 000 000 0.70 = $4,200 000. The NPV components are: a. Initial investment: Jan. 1, 2012

$(33,600 000)

b. Annual after-tax cash flow from operations (excluding depreciation): Dec. 31, 2012 9,936 000 0.70 2013 11,016 000 0.70 2014 12,096,000 0.70 2015 13,176 000 0.70 2016 14,256 000 0.70 2017 15,336 000 0.70 2018 16,416 000 0.70

1.000

NPV $(33,600 000)

0.893 0.797 0.712 0.636 0.567 0.507 0.452

6,210,994 6,145,826 6,028,646 5,865,955 5,658,206 5,442,746 5,194,022

c. Income tax cash savings from annual depreciation deductions ($1,440,000 each year for 7 years): $1,440,000 4.564

6,572,160

d. After-tax cash flow from terminal sale of equipment: $4,200,000 0.452

1,898,400

Net present value of modernize alternative

$ 15,416,955


Replace alternative Initial machine replacement = $58,800,000 Sale on Jan. 1, 2012, of equipment = $3,600,000 After-tax cash flow from sale of old equipment: $3,600,000

0.70 = $2,520,000

Net initial investment: $58,800,000

$2,520,000 = $56,280,000

Annual depreciation: $58,800,000

7 years = $8,400,000 a year

Income-tax cash savings from annual depreciation deductions: $8,400,000 After-tax cash flow from terminal disposal of equipment: $14,400,000

0.30 = $2,520,000

0.70 = $10,080,000

The NPV components of the replace alternative are: a. Net initial investment Jan. 1, 2012 $(56,280,000)

$(56,280,000) 1.000

b. Annual after-tax cash flow from operations (excluding depreciation) Dec. 31, 2012 $13,248,000 0.70 0.893 2013 14,688,000 0.70 0.797 2014 16,128,000 0.70 0.712 2015 17,568,000 0.70 0.636 2016 19,008,000 0.70 0.567 2017 20,448,000 0.70 0.507 2018 21,888,000 0.70 0.452

8,281,325 8,194,435 8,038,195 7,821,274 7,544,275 7,256,995 6,925,363

c. Income tax cash savings from annual depreciation deductions ($2,520,000 each year for 7 years) $2,520,000 4.564 d. After-tax cash flow from terminal sale of equipment, $10,080,000 Net present value of replace alternative

11,501,280 4,556,160

0.452

$13,839,302

On the basis of NPV, Pro Chips should modernize rather than replace the equipment. Note that absent taxes, the replace alternative had a higher NPV than the modernize alternative. In making decisions, companies should always consider after-tax amounts. 3.

Pro Chips would prefer to: a. have lower tax rates, b. have revenue exempt from taxation, c. recognize taxable revenues in later years rather than earlier years, d. recognize taxable cost deductions greater than actual outlay costs, and e. recognize cost deductions in earlier years rather than later years (including accelerated amounts in earlier years).


21-29 (20 min.) DCF, sensitivity analysis, no income taxes. 1.

2a.

b.

Revenues, $100 × 900,000 Variable cash costs, $50 × 900,000 Cash contribution margin Fixed cash costs Cash inflow from operations

$90,000,000 45,000,000 45,000,000 9,000,000 $36,000,000

Net present value: Cash inflow from operations: $36,000,000 × 4.868 Cash outflow for initial investment Net present value

$175,248,000 (120,000,000) $ 55,248,000

20% reduction in selling prices: Revenues, $80 × 900,000 Variable cash costs, $50 × 900,000 Cash contribution margin Fixed cash costs Cash inflow from operation

$72,000,000 45,000,000 27,000,000 9,000,000 $18,000,000


$87,624,000 (120,000,000) $(32,376,000)

20% increase in the variable cost per unit: Revenues, $100 × 900,000 Variable cash costs, $60 × 900,000 Cash contribution margin Fixed cash costs Cash inflow from operations

$90,000,000 54,000,000 36,000,000 9,000,000 $27,000,000


$131,436,000 (120,000,000) $ 11,436,000

3. Sensitivity analysis enables management to see those assumptions for which input variations have sizable impact on NPV. Extra resources could be devoted to getting more informed estimates of those inputs with the greatest impact on NPV. Sensitivity analysis also enables management to have contingency plans in place if assumptions are not met. For example, if a 20% reduction in selling price is viewed as occurring with a reasonable probability, management may wish to line up bank loan facilities.


21-30 (45 min.) NPV, IRR and sensitivity analysis. 1. Net Present Value of project: Period 1 – 10 $28,000 (18,000) $ 10,000

0 Cash inflows Cash outflows Net cash flows

$(62,000) $(62,000)

Annual net cash inflows $ 10,000 Present value factor for annuity, 10 periods, 8% × 6.71 Present value of net cash inflows $67,100 Initial investment (62,000) Net present value $ 5,100 For a $62,000 initial outflow, the project now generates $10,000 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 9.79%. 2. If revenues are 10% higher, the new Net Present Value will be:

Period 0 Cash inflows Cash outflows Net cash inflows

$(62,000) $(62,000)

1 – 10 $30,800 (18,000) $12,800

Annual net cash inflows

$12,800

Present value factor for annuity, 10 periods, 8% Present value of net cash inflows Initial investment Net present value

× 6.71 $85,888 (62,000) $23,888

For a $62,000 initial outflow, the project now generates $12,800 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 15.94%.


If revenues are 10% lower, the new net present value will be:

Period 1 – 10 $25,200 (18,000) $ 7,200

0 Cash inflows Cash outflows Net cash inflows

$(62,000) $(62,000)

Annual net cash inflows Present value factor for annuity, 10 periods, 6% Present value of net cash inflows Initial investment Net present value

$ 7,200 x 6.71 $ 48,312 (62,000) $ (13,688)


3. If both revenues and costs are higher, the new Net Present Value will be: Period 0 Cash inflows Cash outflows Net cash inflows

$(62,000) $(62,000)


1 – 10 $30,800 (19,260) $11,540 $ 11,540 × 6.71 $77,433 (62,000) $15,433



If both revenues and costs are lower, the new Net Present Value will be: Period 0 1 – 10 $25,200 Cash inflows (16,200) Cash outflows $(62,000) $ 9,000 Net cash inflows $(62,000) Annual net cash inflows Present value factor for annuity, 10 periods, 8% Present value of net cash inflows Initial investment Net present value

$ 9,000 × 6.71 $60,390 (62,000) $ (1,610)

For a $62,000 initial outflow, the project now generates $9,000 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 7.42%. 4. To find the NPV with a different rate of return, use the same cash flows but with a different discount rate, this time for ten periods at 10%. Annual net cash inflows Present value factor for annuity, 10 periods, 10% Present value of net cash inflows Initial investment Net present value

$ 10,000 × 6.145 $61,450 (62,000) $ (550)

5. The sensitivity analysis shows that the return on the project is sensitive to changes in the projected revenues and costs. With the cost of capital (8%) as the discount rate, the NPV is positive and the IRR exceeds the required rate of return in most cases. The exceptions occur when the sales revenues are 10% lower than in the benchmark case, regardless of whether costs decline proportionately. Further, if Crumbly seeks to earn returns that exceed its cost of capital by 2%, then even the baseline scenario is unprofitable and should be rejected. Overall, the project appears to be a good one for Crumbly Cookie, provided that it is satisfied with earning its cost of capital, and if the likelihood of the scenario where revenues decline substantially is not too great.


21-31 (30 min.) Payback, even and uneven cash flows. Payback problem:

1. Annual revenue Annual costs Fixed Variable Net annual cash inflow

$140,000 $96,000 14,000

Payback period = Investment

110,000 $ 30,000

net cash inflows = $159,000 ÷ $30,000 = 5.30 years

Discounted Payback Period with even cash flows: PerioYear Cash Fixed Revenues Costs 0 1 2 3 4 5 6 7 8 9

$140,000 $140,000 $140,000 $140,000 $140,000 $140,000 $140,000 $140,000 $140,000

$96,000 $96,000 $96,000 $96,000 $96,000 $96,000 $96,000 $96,000 $96,000

Variable Net Costs Cash Inflows $14,000 $14,000 $14,000 $14,000 $14,000 $14,000 $14,000 $14,000 $14,000

$30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000

Disc Discounted Cumulative Unrecovered Factor Cash Disc. Cash Investment (12%) Savings Savings .893 .797 .712 .636 .567 .507 .452 .404 .361

$26,790 $23,910 $21,360 $19,080 $17,010 $15,210 $13,560 $12,120 $10,830

$ 26,790 $ 50,700 $ 72,060 $ 91,140 $108,150 $123,360 $136,920 $149,040 $159,870

$159,000 $132,210 $108,300 $ 86,940 $ 67,860 $ 50,850 $ 35,640 $ 22,080 $ 9,960

$9,960/$10,830 = .92 Discounted Payback Period = 8.92 years


2.

Year 1 2 3 4 5 6 7 8 9

Revenue (1) $ 90,000 115,000 130,000 155,000 170,000 180,000 140,000 125,000 110,000

Cash Fixed Costs (2) $ 96,000 96,000 96,000 96,000 96,000 96,000 96,000 96,000 96,000

Cash Variable Costs (3) $ 9,000 11,500 13,000 15,500 17,000 18,000 14,000 12,500 11,000

Net Cash Inflows (4) = (1) − (2) − (3) $(15,000) 7,500 21,000 43,500 57,000 66,000 30,000 16,500 3,000

Cumulative Amounts $(15,000) (7,500) 13,500 57,000 114,000 180,000 210,000 226,500 229,500

The cumulative amount exceeds the initial $159,000 investment for the first time at the end of year 6. So, payback happens in year 6. Using linear interpolation, a more precise measure is that payback happens at: $159,000 - $114,000 5.68 years. 5 years + $66,000 Discounted Payback Period with uneven cash flows: Year

0 1 2 3 4 5 6 7 8 9

Cash Revenues

$ 90,000 $115,000 $130,000 $155,000 $170,000 $180,000 $140,000 $125,000 $110,000

Fixed Costs

$96,000 $96,000 $96,000 $96,000 $96,000 $96,000 $96,000 $96,000 $96,000

Variable Costs

$ 9,000 $11,500 $13,000 $15,500 $17,000 $18,000 $14,000 $12,500 $11,000

Net Cash Inflows

$(15,000) $ 7,500 $ 21,000 $ 43,500 $ 57,000 $ 66,000 $ 30,000 $ 16,500 $ 3,000

Disc Factor (12%) .893 .797 .712 .636 .567 .507 .452 .404 .361

Discounted Cash Savings ($13,395) $ 5,978 $14,952 $27,666 $32,319 $33,462 $13,560 $ 6,666 $ 1,083

Cumulative Unrecovered Disc. Cash Investment Savings ($13,395) ($ 7,417) $ 7,535 $ 35,201 $ 67,520 $100,982 $114,542 $121,208 $122,291

$159,000 $172,395 $166,417 $151,465 $123,799 $ 91,480 $ 58,018 $ 44,458 $ 37,792 $ 36,709

At a 12% rate of return, this project does not generate sufficient cash flows to ever recoup the investment under the discounted payback method.


21-32 (40 min.) Replacement of a machine, income taxes, sensitivity. 1a. Original cost of old machine: Depreciation taken during the first 3 years {[($150,000 – $20,000) ÷ 8] 3} Book value Current disposal price: Loss on disposal Tax rate Tax savings in cash from loss on current disposal of old machine

$150,000 48,750 101,250 68,000 $ 33,250 × 0.36 $ 11,970

1b. Difference in recurring after-tax variable cash-operating savings, with 36% tax rate: ($0.25 – $0.19) (475,000) (1– 0.36) = $18,240 (in favor of new machine) Difference in after-tax fixed cost savings, with 36% tax rate: ($25,000 – $24,000) (1 – 0.36) = $640 (in favor of new machine) 1c. Initial machine investment Terminal disposal price at end of useful life Depreciable base Annual depreciation using straight-line (8-year life) Annual depreciation using straight-line (5-year life):

Old Machine $150,000 20,000 $130,000

New Machine $190,000 25,000 $165,000

$ 16,250 $ 33,000

Annual income tax cash savings from difference in depreciation deduction: ($33,000 - $16,250) 0.36 = $6,030 (in favor of new machine)


1d. Old Machine $150,000

Original cost

Total depreciation 130,000 Book value of machines on Dec. 31, 2015 20,000 Terminal disposal price of machines on Dec. 31, 2015 12,000 Loss on disposal of machines 8,000 Add tax savings on loss (36% of $8,000; 36% of $3,000) 2,880 After-tax cash flow from terminal disposal of machines ($12,000 + $2,880; $22,000 + $1,080) $ 14,880

New Machine $190,000 165,000 25,000 22,000 3,000 1,080 $ 23,080

Difference in after-tax cash flow from terminal disposal of machines: $23,080 – $14,880 = $8,200 (in favor of new machine) 2. The Smacker Company should retain the old equipment because the net present value of the incremental cash flows from the new machine is negative. The computations, using the results of requirement 1, are presented below. In this format the present value factors appear at the bottom. All cash flows, year by year, are then converted into present values. 2010a $(190,000) 68,000

After-Tax Cash Flows 2012 2013 2014

2011 Initial machine investment Current disposal price of old machine Tax savings from loss on disposal of old machine 11,970 Recurring after-tax cash-operating savings Variable $18,240 $18,240 $18,240 $18,240 Fixed 640 640 640 640 Income tax cash savings from difference in depreciation deductions 6,030 6,030 6,030 6,030 Additional after-tax cash flow from terminal disposal of new machine over old machine _________ _______ _______ _______ _______ Net after-tax cash flows $(110,030) $24,910 $24,910 $24,910 $24,910 Present value discount factors (at 14%) _ 1.000 0.877 0.769 0.675 0.592 Present value $(110,030) $21,846 $19,156 $16,814 $14,747 Net present value $ (20,283) a

More precisely, January 1, 2011

3.

Let $X be the additional recurring after-tax cash operating savings required each year to make NPV = $0. The present value of an annuity of $1 per year for 5 years discounted at 14% = 3.433 (Appendix A, Table 4) To make NPV = 0, Smacker needs to generate cash savings with NPV of $20,283. That is $X (3.433) = $20,283 X = 20,283 ÷ 3.433 = $5,908.24 Smacker must generate additional annual after-tax cash operating savings of $5,908.24.


2015

$18,240 640 6,030

_ 8,200 $33,110 0.519 $17,184

21-33 (30–35 min.) NPV and AARR, goal-congruence issues. 1. Annual cash flow from operations Income tax payments (35%) After-tax cash flow from operations (excl. deprn.)

$125,000 43,750 $ 81,250

Depreciation: $420,000 ÷ 7 = $60,000 per year Income-tax cash savings from depreciation deduction: $60,000 × 0.35 = $21,000 per year

Initial investment Initial working capital investment After-tax cash flow from operations (exl. deprcn.) Income-tax cash savings from annual depreciation deductions After-tax cash flow from recovery of working capital Total after-tax cash flows Times discount factor at 14% Present value Net present value

= =

0 $(420,000) (2,500)

_________ $(422,500) × 1.000 $(422,500)

1

2

Year 3

4

5

6

7

$81,250

$81,250

$81,250

$81,250

$81,250

$81,250

$81,250

21,000

21,000

21,000

21,000

21,000

21,000

21,000

_______ $102,250 × 0.877 $89,673

_______ $102,250 × 0.769 $78,630

_______ $102,250 × 0.675 $69,019

_______ $102,250 × 0.592 $60,532

_______ $102,250 × 0.519 $53,068

_______ $102,250 × 0.456 $46,626

2,500 $104,750 × 0.400 $41,900

$(422,500) + $89,673+$78,630 + $69,019 +$60,532 + $53,068 + $46,626 + $41,900 $16,948

2. Accrual accounting rate of return (AARR): The accrual accounting rate of return takes the annual accrual net income after tax and divides by the initial investment to get a return. Incremental net operating income excluding depreciation Less: Depreciation expense ($420,000 ÷ 7) Income before tax Income tax expense (at 35%) Net income per period

$125,000 60,000 65,000 22,750 $ 42,250

AARR = $42,250 ÷ $422,500 = 10%. 3. Jack will not accept the project if he is being evaluated on the basis of accrual accounting rate of return, because the project does not meet the 14% threshold above which Jack earns a bonus. Jack should accept the project if he wants to act in the firm’s best interest because the NPV is positive, implying that, based on the cash flows generated, the project exceeds the firm’s required 14% rate of return. Thus, Jack will turn down an acceptable long-run project to avoid a poor evaluation based on the measure used to evaluate his performance. To remedy this, the firm could evaluate Jack instead on a project-by-project basis, by looking at how well he achieves the cash flows forecasted when he chose to accept the project.


21-34 (35 min.) Recognizing cash flows for capital investment projects. 1.

Partitioning relevant cash flows into categories: (1) Net initial investment cash flows: - The $98,000 cost of the new Flab-Buster 3000 - The disposal value of the old machine, $5,000, is a cash inflow - The book value of the old machine $4,000 ($50,000 − $46,000), relative to the disposal value of $5,000, yields a taxable gain of $1,000 ($5,000 − $4,000) that leads to a cash outflow for taxes of $1,000 Tax Rate (2) Cash flow savings from operations: - The 30% savings in utilities cost per year of $4,320 (30% × $1,200 per month × 12 months) results in cash inflow from operations after tax of $4,320 (1 − Tax Rate) - The savings of half the maintenance costs per year of $5,000 (50% × $10,000) results in a cash inflow from operations after tax of $5,000 (1 − Tax Rate) - Annual depreciation of ($98,000 − $10,000) ÷ 10 years = $8,800 on Flab-Buster 3000, relative to the ($4,000 − $0) ÷ 10 years = $400 depreciation on current Fit-OMatic leads to additional tax savings of $8,400 × Tax Rate (3) Cash flows from terminal disposal of investment: - The $10,000 salvage value of Flab-Buster 3000 minus the $0 salvage value of the old Fit-O-Matic is a terminal cash flow at the end of Year 10. There are no tax effects because both machines are planned to be disposed of at book value. (4) Data not relevant to the capital budgeting decision: - The $10 charge for customers, since it would not change whether or not Ludmilla got the new machine - The $50,000 original cost of the Fit-O-Matic machine


2.

Net present value of the investment:

Net initial investment Initial investment in Flab-Buster 3000 Current disposal value of Fit-O-Matic Tax on gain on sale of Fit-O-Matic, 40% × $1,000 Net initial investment Annual after-tax cash flow from operations (excl. deprn. effects) After-tax savings in utilities costs, $4,320 × (1−0.40) After-tax savings in maintenance costs, $5,000 × (1−0.40) Annual after-tax cash flow from operations Income-tax cash savings from annual additional depreciation deductions ($8,800 − $400) × 40% After-tax cash flow from terminal disposal of machines

$(98,000) 5,000 (400) $(93,400)

$ $

2,592 3,000 5,592

$

3,360

$ 10,000

These four amounts can be combined to determine the NPV at an 8% discount rate. Present value of net initial investment, $(93,400) × 1.000 Present value of 10-year annuity of annual after-tax cash flow from operations (excl. deprcn. effects), $5,592 × 6.710 Present value of 10-year annuity of income-tax cash savings from annual depreciation deductions, $3,360 × 6.710 Present value of after-tax cash flow from terminal disposal of machines, $10,000 × 0.463 Net present value

$(93,400) 37,522 22,546 4,630 $(28,702)

At the required rate of return of 8%, the net present value of the investment in the Flab-Buster 3000 is substantially negative. Ludmilla should therefore not make the investment.


21-35 (40-45 min.) Recognizing cash flows for capital investment projects, NPV. 1. Net initial investment Initial equipment investment Initial working-capital investment Net initial investment

$(2,575,000) (25,000) $(2,600,000)

Cash flow from operations Annual after-tax cash flow from operations (excl. deprn. effects) Cash revenues Material cash costs Direct labor cash costs (0.25 x 3,550,000) Increase in cash overhead costs Annual cash flow from operations with new equipment Deduct income-tax payments (0.35 × $795,000) Annual after-tax cash flow from operations

$3,372,500 (1,300,000) (887,500) (390,000) (795,000) (278,250) $516,750

Income-tax cash savings from annual depreciation deductions (0.35×$315,000)1 Total cash flow from operations (after-tax)

110,250 $627,000

Cash flow from terminal disposal of investment Cash flow from terminal disposal of machine (net of tax of $0) Cash flow from terminal recovery of working capital After-tax cash flow from terminal disposal of investment

$370,000 25,000 $395,000

1

Depreciation deductions = ($2,575,000 - $370,000) / 7 = $315,000

Cash flows not relevant to the capital budgeting problem -The revenues and investment in the furniture parts division are not relevant to the project -The costs of the furniture parts division are not relevant except as the basis for estimation of labor costs for the project -The CFO salary is irrelevant since it is not affected by the project 2. These three amounts can be combined to determine the NPV at a 14% discount rate: Present value of net initial investment, $(2,600,000) × 1.000 Present value of 7-year annuity of annual after-tax cash flow from operations ($627,000 × 4.288) Present value of after-tax cash flow from terminal disposal of investment ($395,000 × 0.400) Net present value

$(2,600,000) 2,688,576 158,000 $246,576

Since the net present value is positive, this is clearly a good investment for a firm that requires a 14% rate of return. Unbreakable should expand into bicycle parts.


21-36 (25 min.) NPV, inflation and taxes. 1.Without inflation or taxes this is a simple net present value problem using an 8% discount rate Present value of initial investment, $(749,700) × 1.000 Present value of 7-year annuity of annual cash savings: $160,000 × 5.206 Net present value

$(749,700) 832,960 $ 83,260

2. With inflation, we adjust each year’s cash flow for the inflation rate to get nominal cash flows and then discount each cash flow separately using the nominal discount rate. Nominal rate = (1 + real rate) × (1 + inflation rate) − 1 Nominal rate = (1.08) × (1.055) − 1 = 1.1394 – 1 = .1394 or 14% (approx.) Cash Flow Cumulative Cash Inflows Period (Real Dollars) Inflation Rate (Nominal Dollars) (1) (2) (3) = (1) × (2) 1 $160,000 1.055 $168,800 1 2 160,000 1.113 178,080 3 160,000 1.174 187,840 4 160,000 1.239 198,240 5 160,000 1.307 209,120 6 160,000 1.379 220,640 7 160,000 1.455 232,800 Total present value of annual net cash inflows in nominal dollars Present value of initial investment, $(749,700) × 1.000 Net present value 1

Present Value Factor, 14% Present Value (4) (5) = (3) × (4) 0.877 $148,038 0.769 136,944 0.675 126,792 0.592 117,358 0.519 108,533 0.456 100,612 0.400 _93,120 831,397 (749,700) $ 81,697

1.113 = (1.055)2

3. Both the unadjusted and adjusted NPV are positive. Based on financial considerations alone, Cost-Less should buy the new cash registers. However, the effect of taxes should also be considered, as well as any pertinent non-financial issues, such as potential improvements in customer response time from moving to the new cash registers.


4. Initial equipment investment

$(749,700)

Annual cash flow from operations (excl. deprn. effects) Deduct income tax payments (0.30 × $160,000) Annual after-tax cash flow from operations (excl. deprn. effects) Income tax cash savings from annual depreciation deductions (0.30 × $107,100)1 1 Depreciation deductions = ($749,700 – $0) / 7 = $107,100

$160,000 48,000 $ 112,000

$ 32,130

The terminal disposal price of the equipment is equal to the book value at disposal = $0, so these three amounts can be combined to determine the NPV at a 8% discount rate. Present value of net initial investment, $(749,700) × 1.000 Present value of 7-year annuity annual after-tax cash flow from operations, $112,000 × 5.206 Present value of 7-year annuity of income tax cash savings from annual depreciation deductions, $32,130 × 5.206 Net present value

$(749,700) 583,072 167,269 $ 641

5. As in the previous section, with inflation, we adjust each year’s cash flow for the inflation rate to get nominal cash flows and then discount each cash flow separately using the nominal discount rate. Nominal rate = (1 + real rate) × (1 + inflation rate) −1 Nominal rate = (1.08)(1.055) −1 = 1.1394 – 1 = .1394 or 14% (approx.) After Tax Cash Flow Cumulative Cash Inflows Cash Present Value Period (Real Dollars) Inflation Rate (Nominal Dollars) Flows Factor, 14% Present Value (1) (2) (3) = (1) × (2) (4) = 0.7 × (3) (5) (6) = (4) × (5) 1 $160,000 1.055 $168,800 0.877 $118,160 $103,626 2 160,000 1.113 178,080 0.769 124,656 95,860 3 160,000 1.174 187,840 0.675 131,488 88,754 4 160,000 1.239 198,240 0.592 138,768 82,151 5 160,000 1.307 209,120 0.519 146,384 75,973 6 160,000 1.379 220,640 0.456 154,448 70,428 7 160,000 1.455 232,800 0.400 162,960 65,184 Total present value of annual net cash inflows (excl. depreciation. effects) $581,976 Present value of 7-year annuity of income-tax cash savings from annual depreciation deductions, $32,100 × 5.206 167,269 Present value of initial investment $(749,700) × 1.000 (749,700) Net present value

$


(455)

6. Without inflation, we obtain a positive NPV; however, with inflation NPV is negative, and Best-Cost Foods would be better off not purchasing the new registers. Negative NPV is obtained with an inflation estimate of 5.5%. If a careful review of this forecasted inflation rate results in a lower rate of inflation, Best-Cost should recalculate the NPV to determine whether the purchase of the registers is in its best interest. 21-37 (45 min.) Net present value, Internal Rate of Return, Sensitivity Analysis. 1. Given the annual operating cash outflows of $165,000 and the payment of 10% of revenues (10% × $280,000 = $28,000), the net cash inflows for each period are as follows: Period 0 Cash inflows Cash outflows Net cash inflows

1 - 10 $280,000 (193,000) $ 87,000

$(500,000) $(500,000)

The NPV of the investment is: Annual net cash inflows Present value factor for annuity, 10 periods, 10% Present value of net cash inflows Initial investment Net present value

$ 87,000 × 6.145 $534,615 (500,000) $ 34,615

For a $500,000 initial outflow, the project now generates $87,000 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 11.59%. 2. For revenues of $260,000, the cash flows and NPV computation are given below. Period 0 Cash inflows Cash outflows Net cash inflows

$(500,000) $(500,000)

Annual net cash inflows Present value factor for annuity, 10 periods, 10% Present value of net cash inflows Initial investment

1 – 10 $260,000 (191,000) $ 69,000

$ 69,000 × 6.145 $424,005 (500,000)


$ (75,995)

Net present value

For a $500,000 initial outflow, the project now generates $69,000 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 6.33%. For revenues of $240,000: Period 1 – 10 $240,000 (189,000) $ 51,000


$(500,000) $(500,000)


$ 51,000 × 6.145 $ 313,395 (500,000) $(186,605)

For a $500,000 initial outflow, the project now generates $51,000 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 0.36%. 3. For revenues of $260,000, with proportional lower expenses: The annual cash outflows now equal payment of 10% of revenues (10% × $260,000 = $26,000), plus operating expenses of 165,000 × ($260,000/$280,000) = $153,214. Period 0 Cash inflows Cash outflows Net cash inflows

$(500,000) $(500,000)


1 – 10 $260,000 (179,214) $ 80,786 $ 80,786 × 6.145 $496,430 (500,000) $ (3,570)

For a $500,000 initial outflow, the project now generates $80,786 in cash flows at the end of each of years one through ten. 21-45 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 9.83%. For revenues of $240,000, with proportional lower expenses: The annual cash outflows now equal payment of 10% of revenues (10% × $240,000 = $24,000), plus operating expenses of 165,000 × ($240,000/$280,000) = $141,429. Period 1 – 10 $240,000 (165,429) $ 74,571


$(500,000) $(500,000)


$ 74,571 × 6.145 $458,239 (500,000) $ (41,761)

For a $500,000 initial outflow, the project now generates $74,571 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 8.02%. 4. For revenues of $260,000, with proportional lower expenses and fees of 8%: The annual cash outflows now equal payment of 8% of revenues (8% × $260,000 = $20,800), plus operating expenses of 165,000 × ($260,000/$280,000) = $153,214.

Period 0 Cash inflows Cash outflows Net cash inflows

$(500,000) $(500,000)


1 – 10 $260,000 (174,014) $ 85,986 $ 85,986 × 6.145 $528,384 (500,000) $ 28,384

For a $500,000 initial outflow, the project now generates $85,986 in cash flows at the end of each of years one through ten.


Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 11.30%. For revenues of $240,000, with proportional lower expenses and fees of 8%: The annual cash outflows now equal payment of 8% of revenues (8% × $240,000 = $19,200), plus operating expenses of 165,000 × ($240,000/$280,000) = $141,429. Period 0 Cash inflows Cash outflows Net cash inflows

$(500,000) $(500,000)


1 – 10 $240,000 (160,629) $ 79,371 $ 79,371 × 6.145 $487,735 (500,000) $ (12,265)

For a $500,000 initial outflow, the project now generates $79,371 in cash flows at the end of each of years one through ten. Using either a calculator or Excel, the internal rate of return for this stream of cash flows is found to be 9.42%. 5. Sally learns from this sensitivity analysis that the profitability of her investment depends critically on a variety of factors, including the expected annual revenue, the nature of cost behavior, and the franchise fee that she has to pay. If there is a high probability that revenues will equal $280,000, then Sally should buy a Burgers-N-Fries franchise. If revenues are more likely to be $260,000, then she should buy the franchise only if she is certain that costs will decline proportional to revenues and Sally is able to negotiate an 8% franchise fee. Finally, if revenues are expected to drop to $240,000, then Sally should not buy a franchise in any circumstance.


Collaborative Learning Problem 21-38 (45 min.) NPV, Relevant costs, Income taxes 1. Alternatives

As Is

Outsource

Annual cash outflows: Cost of out-sourcing Non-ICI direct material Direct labor Salary for other manager Department overhead Warehouse rent Total annual cash flows

$( 0) $(120,000) $(220,000) $( 85,000) $( 65,000) $( 27,000) $(517,000)

$( 700,000) $( 0) $( 0) $( 0) $( 0) $( 0) $( 700,000)

Total after-tax annual cash outflows (60% of above totals)

$(310,200)

$(420,000)

$

24,000

$

One-time cash inflows at t = 0: Sale of ICI ($0; $3,800 x 40) Tax savings on sale of ICI Sale of machinery Tax savings on sale of machinery

$ $ $ $

0 0 0 0

$ 152,000 $ 3,200 $ 280,000 $ 12,000

Total one-time cash inflows at t = 0

$

0

$ 447,200

One-time cash inflows at end of year 5: Terminal disposal of machine

$ 10,000

$

0

Cash flows associated with ICI: t = 1: Tax shield from use of ICI t = 2: Tax shield from use of ICI t = 3: Purchase and use of ICI t = 4: Purchase and use of ICI t = 5: Purchase and use of ICI

$ $ $( $( $(

$ $ $ $ $

0 0 0 0 0

Annual cash inflows: Tax shield from depreciation of machinery [$60,000 x 0.40; $0]

See Note A See Note B

0

See Note C See Note D

See Note E 32,000 32,000 54,000) 54,000) 54,000)


Notes: A. The manager of the packaging department is retained in both cases, so his salary of $85,000 is irrelevant for the analysis. However, if Patrick Scott decides to keep the packaging department as is, the Phish Corporation has to recruit another manager externally for the other position that it is seeking to fill. Since that position is ―similar,‖ the salary is likely approximately the same as the that of the current packaging department manager. B. The allocated rent of $15,000 and the allocated general administrative overhead of $70,000 are not relevant since the firm as a whole incurs those costs regardless of the decision on outsourcing.. If the outsourcing alternative is chosen though, the rent currently being paid for the secondary warehouse ($27,000) is no longer required. This manager of the packaging department is retained in both cases, so his salary of $85,000 is irrelevant for the analysis. However, if Patrick Scott decides to keep the packaging department as is, the Phish Corporation has to recruit another manager externally for the other position that it is seeking to fill. Since that position is ―similar,‖ the salary is likely approximately the same as the that of the current packaging department manager. C. Original cost of 100 tons of ICI (100 $4,000) Amount of ICI consumed in previous three years {20 tons per year 3 years $4,000} Book value of remaining inventory (40 tons) Current disposal price: (40 tons $3,800) Loss on disposal Tax rate Tax savings from loss on disposal of ICI D. Original cost of old machine: Depreciation taken during the first 2 years {[($430,000 – $10,000) ÷ 7] 2} Book value Current disposal price: Loss on disposal Tax rate Tax savings from loss on current disposal of old machine

$400,000 240,000 160,000 152,000 $ 8,000 × 0.40 $ 3,200 $430,000 120,000 310,000 280,000 $ 30,000 × 0.40 $ 12,000

E. For the first two years, Phish uses up the remaining inventory of ICI. This results in an expense of $80,000 each year, thereby providing a tax savings of $80,000 0.40 = $32,000. There is no cash outflow since the ICI was purchased earlier and that outflow is a sunk cost. From year 3 onwards, Phish has to purchase 20 tons of ICI each year at $4,500 per ton. This represents a cash outflow of 20,000 $4,500 = $90,000. The ICI is then consumed and expensed, thereby providing a tax savings of $90,000 0.40 = $36,000. Therefore, the net cash outflow in each of years 3, 4, and 5 is $90,000 - $36,000 = $54,000.


2.

Suppose that the annual cash flows occur at the end of the year. Then, using the cash flows derived in requirement 1, and applying the present value and annuity factors from Tables 2 and 4 of Appendix A, the net present value of the two alternatives can be calculated as follows:

As Is Option:

($24,000 – $310,200)

3.791 + ($10,000

0.621)

+ ($32,000

0.909) + ($32,000

0.826)

- ($54,000

0.751) - ($54,000

0.683) - ($54,000

0.621)

= $(1,134,224) Outsourcing:

$447,200 - ($420,000

3.791)

= $(1,145,020) The ―As Is‖ alternative has a higher net present value and so is the preferred choice based purely on quantitative considerations. 3.

Other issues that are relevant to the choice between the alternatives faced by Phish are: a) b) c) d) e) f)

The effect on employee morale from closing a department The ability to ensure quality control when packaging is outsourced The potential loss of internal expertise and technology in packaging Transfer of legal liability for any defects in packaging to the new supplier firm Ability of the vendor to accommodate sudden shifts in demand Future costs (after the five-year period) of potentially reopening the internal department if the decision to outsource is taken now

Given the uncertainties related to the outsourcing option, the firm is likely better off, even on qualitative grounds, keeping the internal packaging department going.


CHAPTER 22 MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING, AND MULTINATIONAL CONSIDERATIONS 22-1 A management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout an organization and to guide the behavior of its managers and employees. The goal of the system is to improve the collective decisions within an organization. 22-2 To be effective, management control systems should be (a) closely aligned to an organization's strategies and goals, (b) designed to support the organizational responsibilities of individual managers, and (c) able to motivate managers and employees to put in effort to attain selected goals desired by top management. 22-3 Motivation combines goal congruence and effort. Motivation is the desire to attain a selected goal specified by top management (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort aspect). 22-4 1. 2. 3. 4. 5.

The chapter cites five benefits of decentralization: Creates greater responsiveness to local needs Leads to gains from faster decision making Increases motivation of subunit managers Assists management development and learning Sharpens the focus of subunit managers

The chapter cites four costs of decentralization: 1. Leads to suboptimal decision making 2. Focuses managers’ attention on the subunit rather than the company as a whole 3. Increases costs of gathering information 4. Results in duplication of activities 22-5 No. Organizations typically compare the benefits and costs of decentralization on a function-by-function basis. For example, companies with highly decentralized operating divisions frequently have centralized income tax strategies. 22-6 No. A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. The two segments can be cost centers, profit centers, or investment centers. For example, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an example of transfer pricing. 22-7 The three general methods for determining transfer prices are: 1. Market-based transfer prices 2. Cost-based transfer prices 3. Hybrid transfer prices


22-8 1. 2. 3. 4.

Transfer prices should have the following properties. They should promote goal congruence, be useful for evaluating subunit performance, motivate management effort, and preserve a high level of subunit autonomy in decision making.

22-9 No, the chapter illustration demonstrates how division operating incomes differ dramatically under the variable-cost, full-cost, and market-price methods of transfer pricing. 22-10 Transferring products or services at market prices generally leads to optimal decisions when (a) the market for the intermediate product market is perfectly competitive, (b) interdependencies of subunits are minimal, and (c) there are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally. 22-11 One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal decisions for the company as a whole. An example of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally. This situation often arises where full-cost-based transfer prices are used. This situation can make the fixed costs of the supplying division appear to be variable costs of the purchasing division. Another limitation is that the supplying division may not have sufficient incentives to control costs if the full-cost-based transfer price uses actual costs rather than standard costs. The purchasing division sources externally if market prices are lower than full costs. From the viewpoint of the company as a whole, the purchasing division should source from outside only if market prices are less than variable costs of production, not full costs of production. 22-12 Reasons why a dual-pricing approach to transfer pricing is not widely used in practice include: 1. In this approach, the manager of the supplying division uses a cost-based method to record revenues and does not have sufficient incentives to control costs. 2. This approach does not provide clear signals to division managers about the level of decentralization top management wants. 3. This approach tends to insulate managers from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division. 4. It leads to problems in computing the taxable income of subunits located in different tax jurisdictions. 22-13 Disagree. Cost and price information are often useful starting points in the negotiation process. Costs, particularly variable costs of the selling division, serve as a ―floor‖ below which the selling division would be unwilling to sell. Prices that the buying division would pay to purchase products from the outside market serves as a ―ceiling‖ above which the buying division would be unwilling to buy. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices. But the negotiated price will generally fall between the variable costs-based floor and the market price-based ceiling.


22-14 Yes. The general transfer-pricing guideline specifies that the minimum transfer price equals the incremental cost per unit incurred up to the point of transfer plus the opportunity cost per unit to the supplying division. When the supplying division has idle capacity, its opportunity cost per unit is zero; when the supplying division has no idle capacity, its opportunity cost per unit is positive. Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not. 22-15 Alternative transfer-pricing methods can result in sizable differences in the reported operating income of divisions in different income tax jurisdictions. If these jurisdictions have different tax rates or deductions, the net income of the company as a whole is significantly affected by the choice of the transfer-pricing method.

22-16 (15 min.) Evaluating management control systems, balanced scorecard. 1. Correct answers may include any of the following: Financial perspective – stock price, net income, return on investment, cash flow from operations, cost per visitor, gross margin percentage in retail venues Customer perspective – percentage of repeat visitors, customer satisfaction, ratings by travel organizations, cleanliness ratings Internal-business-process perspective – wait time and number of riders per hour for popular rides, accident-free days, downtime for repairs Learning-and-growth perspective – employee satisfaction, return employees, training hours, absenteeism 2. Each manager would be concerned with management controls related specifically to their level of responsibility. Within the financial perspective, for example, the souvenir shop manager might be concerned with controlling gross margin percentage or inventory turnover, the theme park manager might be concerned with gate proceeds or cash flow from operations, and the CEO might be concerned with stock price or earnings per share. Within the customer perspective, the souvenir shop manager might be concerned with sales per customer, the theme park manager might be concerned with percentage of repeat visitors, and the CEO might be concerned with travel organization ratings across the entire group of parks.


22-17 (25 min.) Cost centers, profit centers, decentralization. 1. The Glass Department sends its product to the Wood and Metal Departments for finishing. The Glass Department does not negotiate internal prices. The Glass, Wood and Metal Departments are cost centers because they are only evaluated on output and cost control (cost variances). 2. The three departments are centralized because upper management dictates their production schedules. 3. A centralized department can be a profit center. Centralization relates to the degree of autonomy that a department has for decision making. This concept is independent of the type of responsibility center used to evaluate performance (for example the Glass Department could be a profit center if upper management chooses a transfer price for the glass transferred from the Glass to the Wood and Metal Departments). A department may be organized as a profit center but it will be centralized if it has little freedom in making decisions. 4. a) With these changes, Fenster will be moving toward a more decentralized environment because each department will have more local decision-making authority, such as the ability to set its own production schedule, buy and sell products in the external market, and negotiate transfer prices. These changes also make all three departments profit centers (rather than cost centers) because the managers of each department are responsible for both costs and revenues. b) I would recommend that upper management evaluate the three departments as profit centers because profits would be a good indicator of the performance of each department.


22-18 (15 min.) Benefits and costs of decentralization. 1. Health Source has a centralized structure. Individual managers have little autonomy in decision-making. 2. Harvest Moon has a decentralized structure. Store managers have significant autonomy. They are able to customize product offerings, negotiate purchases with local farmers, and can even influence store expansion decisions. Benefits of a decentralized structure include: greater responsiveness to local needs and local opportunities, gains from faster decision making, increased motivation and personal commitment of store managers, and freedom of corporate managers to concentrate on strategic planning. Costs of a decentralized structure include: potential for suboptimal decision making, shift of store managers’ focus away from company as a whole, increased cost of information gathering, and duplication of effort. 3. The stores in the Health Source chain would be considered profit centers. Store managers are responsible for store revenues and costs, and as such, would be evaluated based on operating income. Harvest Moon store managers would be considered investment center managers, as they also make, or at least influence, capital investment decisions. They would be evaluated based on return on investment or residual income. 4. Jackson must be attentive to the fact that Harvest Moon managers have enjoyed significant freedom to make decisions about their own stores. Jackson will need to carefully blend the two corporate cultures, and communicate to store managers that their input and efforts are valued. Bonuses and other rewards must be aligned with the corporation’s best interests. Specifically, Jackson should discourage price competition between stores and encourage cooperation among store managers. For example, store managers should be rewarded based on achieving both store-specific and corporate-wide profitability goals.


22-19 (35 min.) Multinational transfer pricing, effect of alternative transfer-pricing methods, global income tax minimization. 1. This is a three-country, three-division transfer-pricing problem with three alternative transfer-pricing methods. Summary data in U.S. dollars are: China Plant Variable costs: Fixed costs: South Korea Plant Variable costs: Fixed costs: U.S. Plant Variable costs: Fixed costs:

900 Yuan ÷ 9 Yuan per $ = $100 per subunit 1,980 Yuan ÷ 9 Yuan per $ = $220 per subunit 350,000 Won ÷ 1,000 Won per $ = $350 per unit 470,000 Won ÷ 1,000 Won per $ = $470 per unit = $125 per unit = $325 per unit

Market prices for private-label sale alternatives: China Plant: 4,500 Yuan ÷ 9 Yuan per $ = $500 per subunit South Korea Plant: 1,340,000 Won ÷ 1,000 Won per $ = $1,340 per unit The transfer prices under each method are: a. Market price • China to South Korea = $500 per subunit • South Korea to U.S. Plant = $1,340 per unit b. 200% of full costs • China to South Korea 2.0 ($100 + $220) = $640 per subunit • South Korea to U.S. Plant 2.0 ($640 + $350 + $470) = $2,920 per unit c. 350% of variable costs • China to South Korea 3.5 $100 = $350 per subunit • South Korea to U.S. Plant 3.5 ($350 + $350) = $2,450 per unit


Method A Internal Transfers at Market Price 1. China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 40% Division net income per unit 2. South Korea Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 20% Division net income per unit 3. United States Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 30% Division net income per unit

2.

Method B Internal Transfers at 200% of Full Costs

Method C Internal Transfers at 350% of Variable Costs

$ 500

$ 640

$ 350

100 220 320 180 72 $ 108

100 220 320 320 128 $ 192

100 220 320 30 12 $ 18

$1,340

$2,920

$2,450

500 350 470 1,320 20 4 $ 16

640 350 470 1,460 1,460 292 $1,168

350 350 470 1,170 1,280 256 $1,024

$3,800

$3,800

$3,800

1,340 125 325 1,790 2,010 603 $1,407

2,920 125 325 3,370 430 129 $ 301

2,450 125 325 2,900 900 270 $ 630

Division net income: Market Price

China Division South Korea Division U.S. Division Tech Friendly Computer, Inc.

$ 108 16 1,407 $1,531

200% of Full Costs $ 192 1,168 301 $1,661

350% of Variable Costs $

18 1,024 630 $1,672

Tech Friendly will maximize its net income by using the third method, 350% of variable costs, as the transfer price. This is because this method sources relatively little income in China, the country with the highest income tax rate. 22-7 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

22-20 (30 min.) Transfer-pricing methods, goal congruence. 1.

Alternative 1: Sell as raw lumber for $200 per 100 board feet: Revenue Variable costs Contribution margin

$200 100 $100 per 100 board feet

Alternative 2: Sell as finished lumber for $275 per 100 board feet: Revenue Variable costs: Raw lumber Finished lumber Contribution margin

$275 $100 125

225 $ 50 per 100 board feet

British Columbia Lumber will maximize its total contribution margin by selling lumber in its raw form. An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, $275 – $200 Incremental costs Incremental loss 2.

$ 75 125 $ (50) per 100 board feet

Transfer price at 110% of variable costs: = $100 + ($100 0.10) = $110 per 100 board feet Sell as Raw Lumber

Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income

Sell as Finished Lumber

$200 100 $100

$110 100 $ 10

$ 0 —

$275 110 125 $ 40

$

0

The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by selling finished lumber, which is contrary to the action preferred by the company as a whole.


3.

Transfer price at market price = $200 per 100 board feet.

Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income

Sell as Raw Lumber

Sell as Finished Lumber

$200 100 $100

$200 100 $100

$

$275 200 125 $ (50)

0 — — $ 0

Since the Raw Lumber Division will be indifferent between selling the lumber in raw or finished form, it would be willing to maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by not further processing raw lumber and this is preferred by the company as a whole. Thus, transfer at market price will result in division actions that are also in the best interest of the company as a whole.


22-21 (30 min.) Effect of alternative transfer-pricing methods on division operating income. Method A Internal Transfers at Market Prices 1. Mining Division Revenues: $90, $661 200,000 units Costs: Division variable costs: $522 200,000 units Division fixed costs: $83 200,000 units Total division costs Division operating income Metals Division Revenues: $150 200,000 units Costs: Transferred-in costs: $90, $66 200,000 units Division variable costs: $364 200,000 units Division fixed costs: $155 200,000 units Total division costs Division operating income


$18,000,000

$13,200,000

10,400,000

10,400,000

1,600,000 12,000,000 $ 6,000,000

1,600,000 12,000,000 $ 1,200,000

$30,000,000

$30,000,000

18,000,000

13,200,000

7,200,000

7,200,000

3,000,000 28,200,000 $ 1,800,000

3,000,000 23,400,000 $ 6,600,000

1

$66 = Full manufacturing cost per unit in the Mining Division, $60 110% Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor + 75% of manufacturing overhead = $12 + $16 + (75% $32) = $52 3 Fixed cost per unit = 25% of manufacturing overhead = 25% $32 = $8 4 Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40% of manufacturing overhead = $6 + $20 + (40% $25) = $36 5 Fixed cost per unit in Metals Division = 60% of manufacturing overhead = 60% $25 = $15 2


2.

Bonus paid to division managers at 1% of division operating income will be as follows: Method A Internal Transfers at Market Prices

Mining Division manager’s bonus (1% $6,000,000; 1% $1,200,000) Metals Division manager’s bonus (1% $1,800,000; 1% $6,600,000)


$60,000

$ 12,000

18,000

66,000

The Mining Division manager will prefer Method A (transfer at market prices) because this method gives $60,000 of bonus rather than $12,000 under Method B (transfers at 110% of full costs). The Metals Division manager will prefer Method B because this method gives $66,000 of bonus rather than $18,000 under Method A.

3. Brian Jones, the manager of the Mining Division, will appeal to the existence of a competitive market to price transfers at market prices. Using market prices for transfers in these conditions leads to goal congruence. Division managers acting in their own best interests make decisions that are also in the best interests of the company as a whole. Jones will further argue that setting transfer prices based on cost will cause Jones to pay no attention to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full costs.


22-22 (30 min.) Transfer pricing, general guideline, goal congruence. 1. Using the general guideline presented in the chapter, the minimum price at which the Airbag Division would sell airbags to the Vivo Division is $90, the incremental costs. The Airbag Division has idle capacity (it is currently working at 80% of capacity). Therefore, its opportunity cost is zero—the Airbag Division does not forgo any external sales and as a result, does not forgo any contribution margin from internal transfers. Transferring airbags at incremental cost achieves goal congruence. 2.

Transferring products internally at incremental cost has the following properties: a. Achieves goal congruence—Yes, as described in requirement 1 above. b. Useful for evaluating division performance—No, because this transfer price does not cover or exceed full costs. By transferring at incremental costs and not covering fixed costs, the Airbag Division will show a loss. This loss, the result of the incremental cost-based transfer price, is not a good measure of the economic performance of the subunit. c. Motivating management effort—Yes, if based on budgeted costs (actual costs can then be compared to budgeted costs). If, however, transfers are based on actual costs, Airbag Division management has little incentive to control costs. d. Preserves division autonomy—No. Because it is rule-based, the Airbag Division has no say in the setting of the transfer price.

3. If the two divisions were to negotiate a transfer price, the range of possible transfer prices will be between $90 and $125 per unit. The Airbag Division has excess capacity that it can use to supply airbags to the Vivo Division. The Airbag Division will be willing to supply the airbags only if the transfer price equals or exceeds $90, its incremental costs of manufacturing the airbags. The Vivo Division will be willing to buy airbags from the Airbag Division only if the price does not exceed $125 per airbag, the price at which the Vivo division can buy airbags in the market from external suppliers. Within the price range of $90 and $125, each division will be willing to transact with the other and maximize overall income of Quest Motors. The exact transfer price between $90 and $125 will depend on the bargaining strengths of the two divisions. The negotiated transfer price has the following properties. a. Achieves goal congruence—Yes, as described above. b. Useful for evaluating division performance—Yes, because the transfer price is the result of direct negotiations between the two divisions. Of course, the transfer prices will be affected by the bargaining strengths of the two divisions. c. Motivating management effort—Yes, because once negotiated, the transfer price is independent of actual costs of the Airbag Division. Airbag Division management has every incentive to manage efficiently to improve profits. d. Preserves subunit autonomy—Yes, because the transfer price is based on direct negotiations between the two divisions and is not specified by headquarters on the basis of some rule (such as Airbag Division’s incremental costs). 4. Since the range of possible transfer prices is between $90 and $125 per unit, a ―split the difference‖ hybrid solution would lead to a transfer price of ($90 + $125)/2 = $107.50.


22-23 (25 min.) Multinational transfer pricing, global tax minimization. 1. Solution Exhibit 22-23 shows the after-tax operating incomes earned by the U.S. and Austrian divisions from transferring 10,000 units of Product 4A36 using (a) full manufacturing cost per unit, and (b) market price of comparable imports as transfer prices.

2. There are many ways to proceed, but the first thing to note is that the transfer price that minimizes the total of company import duties and income taxes will be either the full manufacturing cost or the market price of comparable imports. Consider what happens every time the transfer price is increased by $1 over, say, the full manufacturing cost of $800. This results in the following change for each unit: a. b. c.

an increase in U.S. taxes of 35% $1 an increase in import duties paid in Austria, 15% $1 a decrease in Austrian taxes of 40% $1.15 (the $1 increase in transfer price + $0.15 paid by way of import duty) Net effect is an increase in import duty and tax payments of:

$0.35 0.15

(0.46) $0.04

To verify this solution, note that if the transfer price changes from $800 to $950, the net effect is an increase in import duty and tax payments of ($950 - $800) × $0.04 = $6 per unit. Across 10,000 units, this implies a decrease in total profits of (10,000) × $6 = $60,000, which corresponds exactly to the $60,000 difference in total after-tax operating incomes documented in Solution Exhibit 22-23. Hence, Mornay Company will minimize import duties and income taxes by setting the transfer price at its minimum level of $800, the full manufacturing cost.


SOLUTION EXHIBIT 22-23 Division Incomes of U.S. and Austrian Divisions from Transferring 10,000 Units of Product 4A36 Method A Internal Transfers at Full Manufacturing Cost U.S. Division Revenues: $800, $950 10,000 units Costs: Full manufacturing cost: $800 10,000 units Division operating income Division income taxes at 35% Division after-tax operating income

$

Austrian Division Revenues: $1,150 10,000 units Costs: Transferred-in costs: $800 10,000, $950 10,000 units Import duties at 15% of transferred-in price $120 10,000, $142.50 10,000 units Total division costs Division operating income Division income taxes at 40% Division after-tax operating income Sum of divisional after-tax operating incomes

Method B Internal Transfers at Market Price

$ 8,000,000

$ 9,500,000

8,000,000 0 0 0

8,000,000 1,500,000 525,000 $ 975,000

$11,500,000

$11,500,000

8,000,000

9,500,000

1,200,000 9,200,000 2,300,000 920,000 $ 1,380,000

1,425,000 10,925,000 575,000 230,000 $ 345,000

$ 1,380,000

$ 1,320,000


22-24 (30 min.) Multinational transfer pricing, goal congruence (continuation of 22-23). 1. After-tax operating income if Mornay Company sells all 10,000 units of Product 4A36 in the United States: Revenues, $900 10,000 units $9,000,000 Full manufacturing costs, $800 10,000 units 8,000,000 Operating income 1,000,000 Income taxes at 35% 350,000 After-tax operating income $ 650,000 From Exercise 22-23, requirement 1, Mornay Company’s after-tax operating income if it transfers 10,000 units of Product 4A36 to Austria at full manufacturing cost and sells the units in Austria is $1,380,000. Therefore, Mornay should sell the 10,000 units in Austria. 2. Transferring Product 4A36 at the full manufacturing cost of the U.S. Division minimizes import duties and taxes (Exercise 22-23, requirement 2), but creates zero operating income for the U.S Division. Acting autonomously, the U.S. Division manager would maximize division operating income by selling Product 4A36 in the U.S. market, which results in $650,000 in aftertax division operating income as calculated in requirement 1, rather than by transferring Product 4A36 to the Austrian division at full manufacturing cost. Thus, the transfer price calculated in requirement 2 of Exercise 22-23 will not result in actions that are optimal for Mornay Company as a whole. 3. The minimum transfer price at which the U.S. division manager acting autonomously will agree to transfer Product 4A36 to the Austrian division is $900 per unit. Any transfer price less than $900 will leave the U.S. Division's performance worse than selling directly in the U.S. market. Because the U.S. Division can sell as many units as it makes of Product 4A36 in the U.S. market, there is an opportunity cost of transferring the product internally equal to $350 (selling price $900 variable manufacturing costs, $550). Minimum transfer = price per unit

=

Incremental cost per unit up to the point of transfer $550 + $350 = $900

Opportunity cost per unit to the selling (U. S.) division

This transfer price will result in Mornay Company as a whole paying more import duties and taxes than the answer to Exercise 22-23, requirement 2, as calculated below: U.S. Division Revenues, $900 10,000 units Full manufacturing costs Division operating income Division income taxes at 35% Division after-tax operating income

$

$ 9,000,000 8,000,000 1,000,000 350,000 650,000


Austrian Division Revenues, $1,150 10,000 units` Transferred in costs, $900 10,000 units Import duties at 15% of transferred-in price, $135 10,000 units Division operating income Division income taxes at 40% Division after-tax operating income

$11,500,000 9,000,000

$

1,350,000 1,150,000 460,000 690,000

Total import duties and income taxes at transfer prices of $800 and $900 per unit for 10,000 units of Product 4A36 follow:

(a) (b) (c)

U.S. income taxes Austrian import duties Austrian income taxes

Transfer Price of $800 per Unit (Exercise 22-23, Requirement 2) $ 0 1,200,000 920,000 $2,120,000

Transfer Price of $900 per Unit $ 350,000 1,350,000 460,000 $2,160,000

The minimum transfer price that the U.S. division manager acting autonomously would agree to results in Mornay Company paying $40,000 in additional import duties and income taxes. A student who has done the calculations shown in Exercise 22-23, requirement 2, can calculate the additional taxes from a $900 transfer price more directly, as follows: Every $1 increase in the transfer price per unit over $800 results in additional import duty and taxes of $0.04 per unit So, a $100 increase ($900 – $800) per unit will result in additional import duty and taxes of $0.04 100 = $4.00 For 10,000 units transferred, this equals $4.00 10,000 = $40,000


22-25 (20 min.) Transfer-pricing dispute. This problem is similar to the Problem for Self-Study in the chapter. 1.

Company as a whole will not benefit if Division C purchases from external suppliers: Purchase costs paid to external suppliers, 1,000 units $135 $135,000 Deduct: Savings in variable costs by reducing Division A output, 1,000 units $120 120,000 Net cost (benefit) to company as a whole as a result of purchasing from external suppliers $ 15,000

Any transfer price between $120 and $135 per unit will achieve goal congruence. Division managers acting in their own best interests will take actions that are in the best interests of the company as a whole. 2.

Company as a whole will benefit if Division C purchases from external suppliers: Purchase costs paid to external suppliers, 1,000 units $135 $135,000 Deduct: Savings in variable costs, 1,000 units $120 $120,000 Savings due to A’s equipment and facilities assigned to other operations 18,000 138,000 Net cost (benefit) to company as a whole as a result of purchasing from external suppliers $ (3,000)

Division C should purchase from external suppliers. 3.

Company as a whole will benefit if Division C purchases from external suppliers: Purchase costs paid to external suppliers, 1,000 units $115 $115,000 Deduct: Savings in variable costs by reducing Division A output, 1,000 units $120 120,000 Net cost (benefit) to company as a whole as a result of purchasing from external suppliers $ (5,000)

The three requirements are summarized below (in thousands): Purchase costs paid to external suppliers Relevant costs if purchased from Division A: Incremental (outlay) costs if purchased from Division A Opportunity costs if purchased from Division A Total relevant costs if purchased from Division A Operating income advantage (disadvantage) to company as a result of purchasing from Division A

(1) $135

(2) $135

(3) $115

120 – 120

120 18 138

120 – 120

$ 15

$ (3)

$ (5)

Goal congruence would be achieved if the transfer price is set equal to the total relevant costs of purchasing from Division A.


22-26 (5 min.)

Transfer-pricing problem (continuation of 22-25).

The company as a whole would benefit in this situation if Division C purchased from external suppliers. The $15,000 disadvantage to the company as a whole as a result of purchasing from external suppliers would be more than offset by the $30,000 contribution margin of Division A’s sale of 1,000 units to other customers: Purchase costs paid to external suppliers, 1,000 units $135 Deduct variable cost savings, 1,000 units $120 Net cost to the company as a result of purchasing from external suppliers

$135,000 120,000 $ 15,000

Division A’s sales to other customers, 1,000 units $155 Deduct: Variable manufacturing costs, $120 1,000 units Variable marketing costs, $5 1,000 units Total variable costs Contribution margin from selling units to other customers

$155,000 $120,000 5,000 125,000 $ 30,000


22-27

(20min.) General guideline, transfer pricing.

1. The minimum transfer price that the SD would demand from the AD is the net price it could obtain from selling its screens on the outside market: $100 minus $8 marketing and distribution cost per screen, or $92 per screen. The SD is operating at capacity. The incremental cost of manufacturing each screen is $65. Therefore, the opportunity cost of selling a screen to the AD is the contribution margin the SD would forego by transferring the screen internally instead of selling it on the outside market. Contribution margin per screen = $92 – $65 = $27 Using the general guideline, Incremental cost per Opportunity cost per Minimum transfer screen incurred up to screen to the = + price per screen the point of transfer selling division

= $65 + $27 = $92 2. The maximum transfer price the AD manager would be willing to offer SD is its own total cost for purchasing from outside, $100 plus $7 per screen, or $107 per screen. 3a. If the SD has excess capacity (relative to what the outside market can absorb), the minimum transfer price using the general guideline is: for the first 6,000 units (or 30% of output), $65 per screen because opportunity cost is zero; for the remaining 14,000 units (or 70% of output), $92 per screen because opportunity cost is $27 per screen. 3b. From the point of view of Slate’s management, all of the SD’s output should be transferred to the AD. This would avoid the $7 per screen variable purchasing cost that is incurred by the AD when it purchases screens from the outside market and it would also save the $8 marketing and distribution cost the SD would incur to sell each screen to the outside market. 3c. If the managers of the AD and the SD could negotiate the transfer price, they would settle on a price between the minimum transfer price the SD will accept (from requirement 3a) and $107 per screen (the maximum transfer price the AD would be willing to pay). Any price in this range would be acceptable to both divisions for all of the SD’s output, and would also be optimal from Slate’s point of view. This would obviously apply to the ―split the difference‖ price as well. When the SD has excess capacity, this rule would suggest a price of ($65 + $107)/2 = $86; for the other 70% of output that SD can sell externally, the rule indicates a price of ($92 + $107)/2 = $99.5. From a practical standpoint, note that the latter price also works when SD has excess capacity; as a result, the firm might prefer it as a stable benchmark price, keeping in mind of course that it credits SD with too high a profit even at times of unused capacity.


22-28 (20–30 min.) Pertinent transfer price. This problem explores the ―general transfer-pricing guideline‖ discussed in the chapter. 1. No, transfers should not be made to Division B if there is no unused capacity in Division A. An incremental (outlay) cost approach shows a positive contribution for the company as a whole: Selling price of final product Incremental cost per unit in Division A Incremental cost per unit in Division B Contribution margin per unit

$300 $120 150

270 $ 30

However, if there is no excess capacity in Division A, any transfer will result in diverting products from the market for the intermediate product. Sales in this market result in a greater contribution for the company as a whole. Division B should not assemble the bicycle since the incremental revenue Europa can earn, $100 per unit ($300 from selling the final product – $200 from selling the intermediate product) is less than the incremental cost of $150 to assemble the bicycle in Division B. Alternatively, Europa’s contribution margin from selling the intermediate product exceeds Europa’s contribution margin from selling the final product: Selling price of intermediate product Incremental (outlay) cost per unit in Division A Contribution margin per unit

$200 120 $ 80

Using the general guideline described in the chapter, Minimum,transfer price

=

Additional incremental cos t per unit incurred up to the point of transfer

+

Opportunity cos t per unit to the supplying division = $120 + ($200 – $120) = $200, which is the market price The market price is the transfer price that leads to the correct decision; that is, do not transfer to Division B unless there are extenuating circumstances for continuing to market the final product. Therefore, Division B must either drop the product or reduce the incremental costs of assembly from $150 per bicycle to less than $100 (selling price, $300 – transfer price, $200).


2. If (a) A has excess capacity, (b) there is intermediate external demand for only 800 units at $200, and (c) the $200 price is to be maintained, then the opportunity costs per unit to the supplying division are $0. The general guideline indicates a minimum transfer price of: $120 + $0 = $120, which is the incremental or outlay costs for the first 200 units. B would buy 200 units from A at a transfer price of $120 because B can earn a contribution of $30 per unit [$300 – ($120 + $150)]. In fact, B would be willing to buy units from A at any price up to $150 per unit because any transfers at a price of up to $150 will still yield B a positive contribution margin. Note, however, that if B wants more than 200 units, the minimum transfer price will be $200 as computed in requirement 1 because A will incur an opportunity cost in the form of lost contribution of $80 (market price, $200 – outlay costs of $120) for every unit above 200 units that are transferred to B. The following schedule summarizes the transfer prices for units transferred from A to B: Units 0–200 200–1,000

Transfer Price $120–$150 $200

For an exploration of this situation when imperfect markets exist, see the next problem. 3. Division B would show zero contribution, but the company as a whole would generate a contribution of $30 per unit on the 200 units transferred. Any price between $120 and $150 would induce the transfer that would be desirable for the company as a whole. A motivational problem may arise regarding how to split the $30 contribution between Division A and B. Unless the price is below $150, B would have little incentive to buy. Note: The transfer price that may appear optimal in an economic analysis may, in fact, be totally unacceptable from the viewpoints of (1) preserving autonomy of the managers, and (2) evaluating the performance of the divisions as economic units. For instance, consider the simplest case discussed previously, where there is idle capacity and the $200 intermediate price is to be maintained. To direct that A should sell to B at A’s variable cost of $120 may be desirable from the viewpoint of B and the company as a whole. However, the autonomy (independence) of the manager of A is eroded. Division A will earn nothing, although it could argue that it is contributing to the earning of income on the final product. If the manager of A wants a portion of the total company contribution of $30 per unit, the question is: How is an appropriate amount determined? This is a difficult question in practice. The price can be negotiated upward to somewhere between $120 and $150 so that some ―equitable‖ split is achieved. A dual transfer-pricing scheme has also been suggested, whereby the supplier gets credit for the full intermediate market price and the buyer is charged with only variable or incremental costs. In any event, when there is heavy interdependence between divisions, such as in this case, some system of subsidies may be needed to deal with the three problems of goal congruence, management effort, and subunit autonomy. Of course, where heavy subsidies are needed, a question can be raised as to whether the existing degree of decentralization is optimal.


22-29 (30–40 min.) Pricing in imperfect markets (continuation of 22-28). An alternative presentation, which contains the same numerical answers, can be found at the end of this solution. 1.

Potential contribution from external intermediate sale is 1,000 ($195 – $120) Contribution through keeping price at $200 is 800 $80. Forgone contribution by transferring 200 units

$75,000 64,000 $11,000

Opportunity cost per unit to the supplying division by transferring internally: $11,000 = $55 200

Transfer price = $120 + $55 = $175 An alternative approach to obtaining the same answer is to recognize that the incremental or outlay cost is the same for all 1,000 units in question. Therefore, the total revenue desired by A would be the same for selling outside or inside. Let X equal the transfer price at which Division A is indifferent between selling all units outside versus transferring 200 units inside. 1,000

$195 X

= (800 $200) + 200X = $175

The $175 price will lead to the correct decision. Division B will not buy from Division A because its total costs of $175 + $150 will exceed its prospective selling price of $300. Division A will then sell 1,000 units at $195 to the outside; Division A and the company will have a contribution margin of $75,000. Otherwise, if 800 units were sold at $200 and 200 units were transferred to Division B, the company would have a contribution of $64,000 plus $6,000 (200 units of final product $30), or $70,000. A comparison might be drawn regarding the computation of the appropriate transfer prices between the preceding problem and this problem:


Minimum,transfer price

=

Additional incremental cos t + per unit incurred up to the point of transfer

Opportunity cos t per unit to Division A Perfect markets: = $120 + (Selling price – Outlay costs per unit) = $120 + ($200 – $120) = $200 Imperfect markets: = $120 + Error! = $120 +

$35,000 a $24,000 b = $175 200

aMarginal revenues of Division A from selling 200 units outside rather than transferring to Division B = ($195 1,000) – ($200 800) = $195,000 – $160,000 = $35,000. bIncremental (outlay) costs incurred by Division A to produce 200 units = $120

200 = $24,000.

Therefore, selling price ($195) and marginal revenues per unit ($175 = $35,000 ÷ 200) are not the same. The following discussion is optional. These points should be explored only if there is sufficient class time: Some students may erroneously say that the ―new‖ market price of $195 is the appropriate transfer price. They may claim that the general guideline says that the transfer price should be $120 + ($195 – $120) = $195, the market price. This conclusion assumes a perfect market. However, in this case there are imperfections in the intermediate market. That is, the market price is not a good approximation of alternative revenue. If a division’s sales are heavy enough to reduce market prices, marginal revenue will be less than market price. It is true that either $195 or $175 will lead to the correct decision by B in this case. But suppose that B’s variable costs were $120 instead of $150. Then B would buy at a transfer price of $175 (but not at a price of $195, because then B would earn a negative contribution of $15 per unit [$300 – ($195 + $120)]. Note that if B’s variable costs were $120, transfers would be desirable: Division A contribution is: [800 ($200 – $120)] + [200 ($175 – $120)] Division B contribution is: 200 [$300 – ($175 + $120)] Total contribution

$75,000 1,000 $76,000


Or the same facts can be analyzed for the company as a whole: Sales of intermediate product, 800 ($200 – $120) Sales of final products, 200 [300 – ($120 + $120)] Total contribution

=

$64,000

=

12,000 $76,000

If the transfer price were $195, B would not accept the transfer and would not earn any contribution. As shown above, Division A and the company as a whole will earn a total contribution of $75,000 instead of $76,000. 2.

a. Division A can sell 900 units at $195 to the outside market and 100 units to Division B, or 800 at $200 to the outside market and 200 units to Division B. Note that, under both alternatives, 100 units can be transferred to Division B at no opportunity cost to A. Using the general guideline, the minimum transfer price of the first 100 units [901– 1000] is: TP1 = $120 + 0 = $120 If Division B needs 100 additional units, the opportunity cost to A is not zero, because Division A will then have to sell only 800 units to the outside market for a contribution of 800 ($200 – $120) = $64,000 instead of 900 units for a contribution of 900 ($195 – $120) = $67,500. Each unit sold to B in addition to the first 100 units has an opportunity cost to A of ($67,500 – $64,000) ÷ 100 = $35. Using the general guideline, the minimum transfer price of the next 100 units [801– 900] is: TP2 = $120 + $35 = $155 Alternatively, the computation could be: Increase in contribution from 100 more units, 100 $75 Loss in contribution on 800 units, 800 ($80 $75) Net "marginal revenue"

$7,500 4,000 $3,500 ÷ 100 units = $35

(Minimum) transfer price applicable to first 100 units offered by A is $120 + $0 (Minimum) transfer price applicable to next 100 units offered by A is $120 + ($3,500 ÷ 100) (Minimum) transfer price applicable to next 800 units

= $120 per unit = $155 per unit = $195 per unit


b. The manager of Division B will not want to purchase more than 100 units because the units at $155 would decrease his contribution ($155 + $150 > $300). Because the manager of Division B does not buy more than 100 units, the manager of Division A will have 900 units available for sale to the outside market. The manager of Division A will strive to maximize the contribution by selling them all at $195. This solution maximizes the company's contribution: 900 100

($195 – $120) ($300 – $270)

= =

$67,500 3,000 $70,500

= =

$64,000 6,000 $70,000

which compares favorably to: 800 200

($200 – $120) ($300 – $270)

ALTERNATIVE PRESENTATION (by James Patell) 1.

Company Viewpoint

a: Sell 1,000 units outside at $195 per unit

Price $195 Variable cost per unit 120 Contribution $ 75

1,000 = $75,000

b: Sell 800 units outside at $200 per unit, transfer 200 Transfer price $200 Variable cost per unit 120 Contribution $ 80 800 = $64,000

Total contribution given up if transfer occurs* = $75,000 – $64,000 = $11,000 On a per-unit basis, the relevant costs are: Incremental cost per unit incurred up to + Opportunity cost per unit = Transfer price to Division A the point of transfer

$120 +

$11,000 = $175 200


By formula, costs are:

Increment cost per unit + incurred up to point to transfer

Lost opportunity to sell 200 units at $195 per unit, – for contribution of $75 per unit

= $120 +

Gain when 1st 800 units sell at $200 per unit instead of $195 per unit

200 $75 ($200 $195 ) 800 – 200 200

= $120 + $75 – $20 = $175 *Contribution of $30 per unit by B is not given up if transfer occurs, so it is not relevant here.

2a.

At most, Division A can sell only 900 units and can produce 1,000. Therefore, at least 100 units should be transferred at a transfer price no less than $120. The question is whether or not a second 100 units should be transferred: Company Viewpoint a: Sell 900 units outside at $195 per unit

Transfer price $195 Variable cost per unit 120 Contribution $ 75

b: Sell 800 units outside at $200 per unit, transfer 100

Transfer price $200 Variable cost per unit 120 900 = $67,500 Contribution $ 80

800 = $64,000

Total contribution forgone if transfer of 100 units occurs = $67,500 – $64,000 = $3,500 (or $35 per unit) Incremental cost per unit Opportunity cost per unit = Transfer price incurred up to point of transfer + to Division A

$120 + 2b.

By formula: Incremental cost per unit incurred up to point + of transfer

$35

=

$155

Lost opportunity to sell 100 units at $195 per unit, – for contribution of $75 per unit

Gain when 1st 800 units sell at $200 per unit instead of $195 per unit

100 $75 [($200 $195 ) 800 ] – 100 100 = $120 + $75 – $40 = $155

= $120 +

Transfer Price Schedule (minimum acceptable transfer price): Units 0–100 101–200 201–1,000

Transfer Price $120 $155 $195


22-30 (30–35 min.) Effect of alternative transfer-pricing methods on division operating income. 1. Pounds of cranberries harvested Gallons of juice processed (500 gals per 1,000 lbs.) Revenues (200,000 gals. $2.10 per gal.) Costs Harvesting Division Variable costs (400,000 lbs. $0.10 per lb.) Fixed costs (400,000 lbs. $0.25 per lb.) Total Harvesting Division costs Processing Division Variable costs (200,000 gals. $0.20 per gal.) Fixed costs (200,000 gals. $0.40 per gal.) Total Processing Division costs Total costs Operating income

400,000 200,000 $420,000

$ 40,000 100,000 140,000 $ 40,000 80,000 120,000 260,000 $160,000

2.

Transfer price per pound (($0.10 + $0.25)

2; $0.60)

1. Harvesting Division Revenues (400,000 lbs. $0.70; $0.60) Costs Division variable costs (400,000 lbs. $0.10 per lb.) Division fixed costs (400,000 lbs. $0.25 per lb.) Total division costs Division operating income Harvesting Division manager's bonus (5% of operating income) 2. Processing Division Revenues (200,000 gals. $2.10 per gal.) Costs Transferred-in costs Division variable costs (200,000 gals. $0.20 per gal.) Division fixed costs (200,000 gals. $0.40 per gal.) Total division costs Division operating income Processing Division manager’s bonus (5% of operating income)

200% of Full Costs $0.70

Market Price $0.60

$280,000

$240,000

40,000 100,000 140,000 $140,000 $7,000

40,000 100,000 140,000 $100,000 $5,000

$420,000

$420,000

280,000 40,000 80,000 400,000 $ 20,000 $ 1,000

240,000 40,000 80,000 360,000 $ 60,000 $ 3,000


3. Bonus paid to division managers at 5% of division operating income is computed above and summarized below: Internal Transfers at 200% of Full Costs

Internal Transfers at Market Prices

Harvesting Division manager’s bonus (5% × $140,000; 5% × $100,000)

$7,000

$5,000

Processing Division manager’s bonus (5% × $20,000; 5% × $60,000)

$1,000

$3,000

The Harvesting Division manager will prefer to transfer at 200% of full costs because this method gives a higher bonus. The Processing Division manager will prefer transfer at market price for its higher resulting bonus. Crango may resolve or reduce transfer pricing conflicts by: Basing division managers’ bonuses on overall Crango profits in addition to division operating income. This will motivate each manager to consider what is best for Crango overall and not be concerned with the transfer price alone. Letting the two divisions negotiate the transfer price between themselves. However, this may result in constant re-negotiation between the two managers each accounting period. Using dual transfer prices However, a cost-based transfer price will not motivate cost control by the Harvesting Division manager. It will also insulate that division from the discipline of market prices.


22-31 (25 min.) Goal congruence problems with cost-plus transfer-pricing methods, dual pricing system (continuation of 22-30). 1. Two examples of goal congruence problems that arise if a transfer price of 200% of full costs is mandated and Borges’ decentralization policy is adopted are: a. The Processing Division manager will prefer to buy cranberries from an external supplier at $0.60 per pound, incurring some extra purchasing costs and lowering Crane’s overall operating income. Crango will incur costs of $0.60 per pound and save variable costs of only $0.10 per pound. b. The Harvesting Division manager is forced to sell to an outside purchaser (because the Processing Division prefers to purchase from an external supplier) when it is better for Crango Products to process internally. 2.

Transfer into buying division at market price Harvesting Division to Processing Division = $0.60 per pound of cranberries Transfer out of selling division at 200% of full costs Harvesting Division to Processing Division = 2.0 × ($0.10 + $0.25) = $0.70 per pound of cranberries As calculated in Requirement 2 of 22-30 and also shown below, under the dual transferpricing policy, the Harvesting Division will earn an operating income of $140,000 and the Processing Division will earn an operating income of $60,000. 200% of Full Costs Harvesting Division Revenues (400,000 lbs. $0.70 per lb.) Costs Division variable costs (400,000 lbs. $0.10 per lb.) Division fixed costs (400,000 lbs. $0.25 per lb.) Total division costs Division operating income Processing Division Revenues (200,000 gals. $2.10 per gal.) Costs Transferred in costs (400,000 lbs. $0.60 per lb.) Division variable costs (200,000 gals. $0.20 per gal.) Division fixed costs (200,000 gals. $0.40 per gal.) Total division costs Division operating income

Market Price

$280,000 40,000 100,000 140,000 $140,000

$420,000 240,000 40,000 80,000 360,000 $ 60,000


3.

Under the dual transfer pricing policy, Division Operating Income Harvesting Division Processing Division Crango Products

$140,000 60,000 $200,000

The overall company operating income from harvesting and processing 400,000 pounds of cranberries is $160,000 (see Problem 22-30, requirement 1). A dual transfer-pricing method entails using different transfer prices for transfers into the buying division and transfers out of the supplying division. As a result, the sum of division operating incomes does not equal the total company operating income. 4. Problems which may arise if Crango Products uses the dual transfer-pricing system include: a. b. c.

It may reduce the incentives of the supplying division to control costs since every $1 of cost of the supplying division is transferred out to the buying division at $2.00. A dual transfer-pricing system does not provide clear signals to the individual divisions about the level of decentralization top management seeks. It insulates the Harvesting Division manager from the frictions and the discipline of the marketplace because costs, not market prices, affect the revenues of the supplying division.


22-32 (40 min.) Multinational transfer pricing, global tax minimization. This is a two-country two-division transfer-pricing problem with two alternative transfer-pricing methods. Summary data in U.S. dollars are: South Africa Mining Division Variable costs: 600 ZAR ÷ 6 = $100 per lb. of raw diamonds Fixed costs: 1,200 ZAR ÷ 6 = $200 per lb. of raw diamonds Market price: 3,600 ZAR ÷ 6 = $600 per lb. of raw diamonds U.S. Processing Division Variable costs = $220 per lb. of polished industrial diamonds Fixed costs = $850 per lb. of polished industrial diamonds Market price = $3,500 per lb. of polished industrial diamonds 1.

The transfer prices are: a. 250% of full costs Mining Division to Processing Division = 2.5 × ($100 + $200) = $750 per lb. of raw diamonds b. Market price Mining Division to Processing Division = $600 per lb. of raw diamonds 250% of Full Cost South Africa Mining Division Division revenues, $750, $600 8,000 Costs Division variable costs, $100 8,000 Division fixed costs, $200 8,000 Total division costs Division operating income U.S. Processing Division Division revenues, $3,500 4,000 Costs Transferred-in costs, $750, $600 8,000 Division variable cost, $220 4,000 Division fixed costs, $850 4,000 Total division costs Division operating income

Market Price

$ 6,000,000

$ 4,800,000

800,000 1,600,000 2,400,000 $ 3,600,000

800,000 1,600,000 2,400,000 $ 2,400,000

$14,000,000

$14,000,000

6,000,000 880,000 3,400,000 10,280,000 $ 3,720,000

4,800,000 880,000 3,400,000 9,080,000 $ 4,920,000


2.

250% of Full Cost

Market Price

South Africa Mining Division Division operating income Income tax at 25% Division after-tax operating income

$3,600,000 900,000 $2,700,000

$2,400,000 600,000 $1,800,000

U.S. Processing Division Division operating income Income tax at 40% Division after-tax operating income

$3,720,000 1,488,000 $2,232,000

$4,920,000 1,968,000 $2,952,000

3.

250% of Full Cost South Africa Mining Division: After-tax operating income U.S. Processing Division: After-tax operating income Industrial Diamonds: After-tax operating income

Market Price

$2,700,000

$1,800,000

2,232,000

2,952,000

$4,932,000

$4,752,000

The South Africa Mining Division manager will prefer the higher transfer price of 250% of full cost and the U.S. Processing Division manager will prefer the lower transfer price equal to market price. Industrial Diamonds will maximize companywide net income by using the 250% of full cost transfer-pricing method. This method sources more of the total income in South Africa, the country with the lower income tax rate. 4.

Factors that executives consider important in transfer pricing decisions include: a. Performance evaluation b. Management motivation c. Pricing and product emphasis d. External market recognition

Factors specifically related to multinational transfer pricing include: a. Overall income of the company b. Income or dividend repatriation restrictions c. Competitive position of subsidiaries in their respective markets


22-33

(30–40 min.) International transfer pricing, taxes, goal congruence.

1. The minimum transfer price would be $64 to cover the variable production ($60 per unit) and shipping ($4 per unit) costs, because Calcia would want, at a minimum, zero contribution margin. The opportunity cost is $0 because there are no external customers for IP-2007. The maximum transfer price would be the $75 market price that Argone would need to pay to acquire a product similar to IP-2007 from the external market in the United States. 2. To minimize income taxes, Gemini should use a transfer price of $64. Canada has a higher tax rate so goods coming from Canada should have the lowest transfer price. Calcia would not like a transfer price of $64 because it would report no operating income from the transfer. Argone would like a transfer price of $64 because it is lower than the outside market price of $75. 3a. It is easiest to see the solution to this problem if we assume a selling price for the product that Argone manufactures, for example, $120. (The actual selling price you choose is irrelevant.) Calcia’s after-tax income on each unit from accepting the special order is: Revenue per unit $ 68.00 Variable cost per unit 60.00 Contribution margin per unit 8.00 Income taxes (0.42 × $8) 3.36 Increase in division income per unit after tax $ 4.64 Argone’s after-tax income on each unit if Calcia accepts the special order and Argone buys the substitute product for IP-2007 in the United States for $75 per unit is: Revenue per unit $120.00 Variable cost per unit 75.00 Contribution margin per unit 45.00 Income taxes (0.30 × $45) 13.50 Increase in division income per unit after tax $ 31.50 Gemini’s total net income on each unit from Calcia accepting the special order is therefore $4.64 + $31.50 = $36.14. If Calcia rejects the special order and instead transfers the units internally to Argone at $64 per unit, Calcia’s after-tax income would be: Revenue per unit $ 64 Variable cost per unit 64 Contribution margin per unit 0 Income taxes 0 Increase in division income per unit after tax $ 0 Argone’s after-tax income on each unit is: Revenue per unit Variable cost per unit Contribution margin per unit Income taxes (0.30 × $56) Increase in division income per unit after tax

$120.00 64.00 56.00 16.80 $ 39.20


Gemini’s total net income on each unit as a result of Calcia rejecting the special order and transferring units of IP-2007 to Argone at $64 per unit is therefore $39.20 per unit. Since this is higher than $36.14, accepting the special order does not maximize after-tax operating income. After-tax operating income is maximized by rejecting the special order. 3b. Argone will not want Calcia to accept the special order. It is more costly to buy from the external market than from Calcia. 3c. Calcia will want to accept the special order because Calcia’s income per unit after-tax increases by $4.64 per unit by accepting the special order rather than transferring IP-2007 to Argone at $64 per unit and earning $0 operating income. 3d. Gemini should set the transfer price at $72 per unit. This will result in each division taking actions in its own best interest that is also in the best interest of Gemini as a whole acting as a decentralized organization. The opportunity cost of transferring IP-2007 internally is $8 ($68 – $60) per unit for the first 8,000 units and $0 per unit thereafter. Using the general guideline, Opportunity cost per Minimum transfer Incremental cost per unit inccurred up to unit to the = + price the point of transfer selling subunit So, minimum transfer price

= $64 + $8 = $72 per unit for the first 8,000 units $64 + $0 = $64 per unit for the next 7,000 units

Gemini should use these minimum transfer prices because they are also tax-efficient. At a transfer price of $72 per unit for the first 8,000 units, Calcia is indifferent between accepting the special order or transferring internally. Calcia earns $8 per unit if it accepts the special order. It also earns $8 per unit if it transfers IP-2007 to Argone ($72 – $64 variable cost per unit). Argone will prefer to ―buy‖ IP-2007 from Calcia because the transfer price of $72 is less than the $75 price it would pay to buy a product similar to IP-2007 in the United States. The increase in Gemini’s income will be as follows: From Calcia: Revenue per unit Variable cost per unit Contribution margin per unit Income taxes (0.42 × $8) Increase in division income per unit after tax

$72.00 64.00 8.00 3.36 $ 4.64

From Argone: 22-34 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

Revenue per unit Transfer price per unit Contribution margin per unit Income taxes (0.30 × $48) Increase in division income per unit after tax

$120.00 72.00 48.00 14.40 $ 33.60

Increase in Gemini’s income = $4.64 + $33.60 = $38.24 This net income is greater than the $36.14 net income that Gemini would earn if Calcia accepted the special order. It is less than the $39.20 that Gemini would earn if Calcia had transferred IP-2007 at $64 per unit. Of course, if the transfer price is set at $64 per unit, Calcia would accept the special order, which would lead to a lower net income of $36.14. If Gemini wants to get the benefits of decentralization, it must be willing to suffer the consequences of higher taxes that Calcia would have to pay. Note that Gemini would not want to set the transfer price any higher than $72, the minimum transfer price that would induce Calcia to transfer internally to Argone. Why? Because setting the transfer price any higher would result in exactly the same action (transferring IP-2007 internally) but at a higher cost because of the higher taxes that Calcia would have to pay in Canada. Consider for example a transfer price of $80 per unit. The increase in Gemini’s income will be as follows: From Calcia: Revenue per unit Variable cost per unit Contribution margin per unit Income taxes (0.42 × $16) Increase in division income per unit after tax

$80.00 64.00 16.00 6.72 $ 9.28

From Argone: Revenue per unit Transfer price per unit Contribution margin per unit Income taxes (0.30 × $40) Increase in division income per unit after tax

$120.00 80.00 40.00 12.00 $ 28.00

Increase in Gemini’s income $9.28 + $28.00 = $37.28, which is less than the $38.24 Gemini earns if the transfer price is set at $72 per unit. A transfer price of $72 is the most tax-efficient transfer price consistent with Gemini operating as a decentralized organization. Note also that the transfer price cannot be set above $75 per unit because then Argone would buy a product similar to IP-2007 in the United States rather than from Calcia.


22-34 (35 min.) Transfer pricing, goal congruence. 1. See column (1) of Solution Exhibit 22-34. The net cost of the in-house option is $570,000. 2.

See columns (2a) and (2b) of Solution Exhibit 22-34.

SOLUTION EXHIBIT 22-34 Transfer 20,000 CD players to Assembly. Sell 2,000 in outside market at $45 each (1) Incremental cost of CD Division supplying 20,000 CD players to Assembly Division $30 20,000; 0; 0; 0 Incremental costs of buying 20,000 CD players from Hawei $0; $44 20,000; $51 20,000; $52 20,000 Revenue from selling CD players in outside market $45 2,000; 22,000; 22,000; 22,000 Incremental costs of manufacturing CD players for sale in outside market $30 2,000; 22,000; 22,000; 22,000 Revenue from supplying head mechanism to Hawei $24 0; 20,000; 20,000; 20,000 Incremental costs of supplying head mechanism to Hawei $18 0; 20,000; 20,000; 20,000 Net costs

Buy 20,000 CD Buy 20,000 CD Buy 20,000 CD players from players from players from Hawei at $44. Hawei at $51. Hawei at $52. Sell Sell 22,000 CD Sell 22,000 CD 22,000 CD players in outside players in players in market at $45 outside market outside market at each at $45 each $45 each (2a) (2x) (2b)

$(600,000)

0

$

0

(880,000)

90,000

990,000

(60,000)

(660,000)

0

480,000

0 $(570,000)

(360,000) $(430,000)

$

0

$

0

(1,020,000)

(1,040,000)

990,000

990,000

(660,000)

(660,000)

480,000

480,000

(360,000) $(570,000)

(360,000) $ (590,000)

Comparing columns (1) and (2a), at a price of $44 per CD player from Hawei, the net cost of $430,000 is less than the net cost of $570,000 to Bosh Corporation if it made the CD players in-house. So, Bosh Corporation should outsource to Hawei. Comparing columns (1) and (2b), at a price of $52 per CD player from Hawei, the net cost of $590,000 is $20,000 is greater than the net cost of $570,000 to Bosh Corporation if it made the CD players in-house. Therefore, Bosh Corporation should reject Hawei’s offer. Now consider column (2x) of Solution Exhibit 22-34. It shows that at a price of $51 per CD player from Hawei, the net cost is exactly $570,000, the same as the net cost to Bosh Corporation of manufacturing in-house (column 1). Thus, for prices between $44 and $51, Bosh will prefer to purchase from Hawei. For prices greater than $51 (and up to $52), Bosh will prefer to manufacture in-house.


3. The CD Division can manufacture at most 22,000 CD players and it is currently operating at capacity. The incremental costs of manufacturing a CD player are $30 per unit. The opportunity cost of manufacturing CD players for the Assembly Division is (1) the contribution margin of $15 (selling price, $45 minus incremental costs $30) that the CD Division would forgo by not selling CD players in the outside market plus (2) the contribution margin of $6 (selling price, $24 minus incremental costs, $18) that the CD Division would forgo by not being able to sell the head mechanism to external suppliers of CD players such as Hawei (recall that the CD division can produce as many head mechanisms as demanded by external suppliers, but their demand will fall if the CD Division supplies the Assembly Division with CD players). Thus, the total opportunity cost to the CD Division of supplying CD players to Assembly is $15 + $6 = $21 per unit. Using the general guideline, Minimum transfer price = Incremental cost up to the point of transfer + Opportunity cost = $30 + $21 = $51 Thus, the minimum transfer price that the CD Division will accept for each CD player is $51. Note that at a price of $51, Bosh is indifferent between manufacturing CD players in-house or purchasing them from an external supplier. 4a. The transfer price is set to $51 + $2 = $53 and Hawei is offering the CD players for $52 each. Now, for an outside price per CD player below $53, the Assembly Division would prefer to purchase from outside; above it, the Assembly Division would prefer to purchase from the CD Division. So, the Assembly division will buy from Hawei at $52 each and the CD Division will be forced to sell its output on the outside market. 4b. But for Bosh, as seen from requirements 1 and 2, an outside price of $52, which is greater than the $51 cut-off price, makes inhouse manufacture the optimal choice. So, a mandated transfer price of $53 causes the division managers to make choices that are sub-optimal for Bosh. 4c. When selling prices are uncertain, the transfer price should be set at the minimum acceptable transfer price. It is only if the price charged by the external supplier falls below $51 that Bosh Corporation as a whole is better off purchasing from the outside market. Setting the transfer price at $51 per unit achieves goal congruence. The CD division will be willing to sell to the Assembly Division, and the Assembly Division will be willing to buy in-house and this would be optimal for Bosh, too.


22-35 (20 min.) Transfer pricing, goal congruence, ethics. 1. The transfer price is 110% of the full cost per unit: 1.10 ($0.50 + $2.80 + $1.50) = $5.28 Because $5.00 is below the transfer price of $5.28, the fabrication division manager would choose to purchase the 10,000 pounds from Metalife. 2. The purchase is not in the best interest of Jeremiah Industries because, if produced internally, the additional 10,000 pound would only cost the company $33,000 ($3.30 of variable cost per unit × 10,000 units). Because there is available capacity, fixed costs would be unaffected. If purchased from Metalife, the metal would cost $50,000. The cause of this goal incongruence is two-fold: setting a transfer price based on full cost treats fixed costs as variable, and setting the price above full cost (in this case 110%) artificially inflates the cost to the purchasing division. 3. $5.00 is not a valid market price because it could not be replicated on future orders. $5.50 is a more correct market price. The fabrication manager was not acting ethically in this situation because he or she was withholding pertinent information from both upper management and the recycling division manager, and was even promoting a position they knew to be false. If the transfer price had been changed to $5.00, it would not have affected the company overall, but profit incentive rewards would have been shifted away from the recycling division manager and to the fabrication manager.


22-36 (40 50 min.) Transfer pricing, utilization of capacity. 1. Super-chip Selling price $80 Direct material cost per unit 5 Direct manufacturing labor cost per unit 60 Contribution margin per unit $15 Contribution margin per hour ($15 3; $4 1) $5

Okay-chip $26 2 20 $ 4 $ 4

Because the contribution margin per hour is higher for Super-chip than for Okay-chip, CIC should produce and sell as many Super-chips as it can and use any remaining available capacity to produce Okay-chip. The total demand for Super-chips is 15,000 units, which would take the entire capacity of 45,000 hours (15,000 3 hours per unit). Therefore, CIC should manufacture only Super-chips. Annual contribution margin would be $225,000 ($15 per unit × 15,000 units). 2.

Options for manufacturing process-control unit:

Using Using Circuit Board Super-chip Selling price $132 $145 Direct material cost per unit 70 5 Direct manufacturing labor cost per unit (Super-chip) 0 60 Direct manufacturing labor cost per unit (process-control unit) 45 45 Contribution margin per unit $ 17 $ 35 Overall Company Viewpoint Alternative 1: No Transfer of Super-chips: Sell 15,000 Super-chips at contribution margin per unit of $15 Sell 5,000 Control units at contribution margin per unit of $17 Total contribution margin

$225,000 85,000 $310,000


Alternative 2: Transfer 5,000 Super-chips to Process-Control Division: Sell 10,000 Super-chips at contribution margin per unit of $15 Sell 5,000 Control units at contribution margin per unit of $35 Total contribution margin

$150,000 175,000 $325,000

CIC is better off transferring 5,000 Super-chips to the Process-Control Division. 3. The Semiconductor Division manager would not accept a transfer price below the market price of $80 per unit because the division has willing outside buyers at that price. Any lower price would reduce the division’s operating income. The Process-control Division manager would not pay more than $83 per unit ($70 currently paid for the circuit board, plus the $13 increase in selling price due to using the Super-chip). Therefore, any transfer price between $80 and $83 would ensure goal congruence. 4. If 15,000 additional labor hours were available in the Semiconductor Division, those hours could be used to manufacture 15,000 Okay-chips (at 1 labor hour per chip), or be used to manufacture 5,000 Super-chips (at 3 labor hours per chip) for transfer to the Process-control Division. The Semiconductor Division manager would require a transfer price at least equal to the opportunity cost of the lost sales of Okay-chips. Because the Semiconductor Division could manufacture and sell three Okay-chips at $26 each for every one Super-chip transferred, the minimum required transfer price would be $78 (3 × $26). The maximum price would remain at $83.


CHAPTER 23 PERFORMANCE MEASUREMENT, COMPENSATION, AND MULTINATIONAL CONSIDERATIONS 23-1

Examples of financial and nonfinancial measures of performance are: Financial: ROI, residual income, economic value added, and return on sales. Nonfinancial: Customer perspective: Market share, customer satisfaction. Internal-business-processes perspective: Manufacturing lead time, yield, on-time performance, number of new product launches, and number of new patents filed. Learning-and-growth perspective: employee satisfaction, informationsystem availability.

23-2 1. 2.

The three steps in designing an accounting-based performance measure are: Choose performance measures that align with top management’s financial goals Choose the details of each performance measure in Step 1, including the time horizon and measurement of various aspects of the measure Choose a target level of performance and feedback mechanism for each performance measure in Step 1

3.

23-3 The DuPont method highlights that ROI is increased by any action that increases return on sales or investment turnover. ROI increases with: 1. increases in revenues, 2. decreases in costs, or 3. decreases in investments, while holding the other two factors constant. 23-4 Yes. Residual income (RI) is not identical to return on investment (ROI). ROI is a percentage with investment as the denominator of the computation. RI is an absolute monetary amount which includes an imputed interest charge based on investment. 23-5 Economic value added (EVA) is a specific type of residual income measure that is calculated as follows: Economic value After-tax Weighted-average Total assets minus added (EVA) = operating income – cost of capital current liabilities

23-6 1. 2. 3. 4.

Definitions of investment used in practice when computing ROI are: Total assets available Total assets employed Total assets employed minus current liabilities Stockholders’ equity


23-7 Current cost is the cost of purchasing an asset today identical to the one currently held if an identical asset can currently be purchased; it is the cost of purchasing an asset that provides services like the one currently held if an identical asset cannot be purchased. Historical-costbased measures of ROI compute the asset base as the original purchase cost of an asset minus any accumulated depreciation. Some commentators argue that current cost is oriented to current prices, while historical cost is past-oriented. 23-8 Special problems arise when evaluating the performance of divisions in multinational companies because a. The economic, legal, political, social, and cultural environments differ significantly across countries. b. Governments in some countries may impose controls and limit selling prices of products. c. Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ significantly across countries. d. Divisions operating in different countries keep score of their performance in different currencies. 23-9 In some cases, the subunit’s performance may not be a good indicator of a manager’s performance. For example, companies often put the most skillful division manager in charge of the weakest division in an attempt to improve the performance of the weak division. Such an effort may yield results in years, not months. The division may continue to perform poorly with respect to other divisions of the company. But it would be a mistake to conclude from the poor performance of the division that the manager is performing poorly. A second example of the distinction between the performance of the manager and the performance of the subunit is the use of historical cost-based ROIs to evaluate the manager even though historical cost-based ROIs may be unsatisfactory for evaluating the economic returns earned by the organization subunit. Historical cost-based ROI can be used to evaluate a manager by comparing actual results to budgeted historical cost-based ROIs. 23-10 Moral hazard describes situations in which an employee prefers to exert less effort (or to report distorted information) compared with the effort (or accurate information) desired by the owner because the employee’s effort (or validity of the reported information) cannot be accurately monitored and enforced. 23-11 No, rewarding managers on the basis of their performance measures only, such as ROI, subjects them to uncontrollable risk because managers’ performance measures are also affected by random factors over which they have no control. A manager may put in a great deal of effort but her performance measure may not reflect this effort if it is negatively affected by various random factors. Thus, when managers are compensated on the basis of performance measures, they will need to be compensated for taking on extra risk. Therefore, when performance-based incentives are used, they are generally more costly to the owner. The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager.


23-12 Benchmarking or relative performance evaluation is the process of evaluating a manager’s performance against the performance of other similar operations. The ideal benchmark is another operation that is affected by the same noncontrollable factors that affect the manager’s performance. Benchmarking cancels the effects of the common noncontrollable factors and provides better information about the manager's performance. 23-13 When employees have to perform multiple tasks as part of their jobs, incentive problems can arise when one task is easy to monitor and measure while the other task is more difficult to evaluate. Employers want employees to intelligently allocate time and effort among various tasks. If, however, employees are rewarded on the basis of the task that is more easily measured, they will tend to focus their efforts on that task and ignore the others. 23-14 Disclosures required by the Securities and Exchange Commission are: a. A summary compensation table showing the salary, bonus, stock options, other stock awards, and other compensation earned by the five top officers in the previous three years b. The principles underlying the executive compensation plans, and the performance criteria, such as profitability, sales growth, and market share used in determining compensation c. How well a company’s stock performed relative to the stocks of other companies in the same industry

23-15 The four levers of control in an organization are diagnostic control systems, boundary systems, belief systems and interactive control systems. Diagnostic control systems are the set of critical performance variables that help managers track progress toward the strategic goal. These measures are periodically monitored and action is usually only taken if a measure is outside its acceptable limits. Boundary systems describe standards of behavior and codes of conduct expected of all employees, particularly by defining actions that are off-limits. Boundary systems prevent employees from performing harmful actions. Belief systems articulate the mission, purpose and core values of a company. They describe the accepted norms and patterns of behavior expected of all managers and other employees with respect to each other, shareholders, customers and communities. Interactive control systems are formal information systems that managers use to focus an organization's attention and learning on key strategic issues. They form the basis of ongoing discussion and debate about strategic uncertainties that the business faces and help position the organization for the opportunities and threats of tomorrow.


23-16 (30 min.) ROI, comparisons of three companies. 1. The separate components highlight several features of return on investment not revealed by a single calculation: a. The importance of investment turnover as a key to income is stressed. b. The importance of revenues is explicitly recognized. c. The important components are expressed as ratios or percentages instead of dollar figures. This form of expression often enhances comparability of different divisions, businesses, and time periods. d. The breakdown stresses the possibility of trading off investment turnover for income as a percentage of revenues so as to increase the average ROI at a given level of output. 2.

(Filled-in blanks are in bold face.) Revenue Income Investment Income as a % of revenue Investment turnover Return on investment

Companies in Same Industry A B C $1,000,000 $ 500,000 $10,000,000 $ 100,000 $ 50,000 $ 50,000 $ 500,000 $ 5,000,000 $5,000,000 0.5% 10% 10% 2.0 2.0 0.1 1% 20% 1%

Income and investment alone shed little light on comparative performances because of disparities in size between Company A and the other two companies. Thus, it is impossible to say whether B's low return on investment in comparison with A’s is attributable to its larger investment or to its lower income. Furthermore, the fact that Companies B and C have identical income and investment may suggest that the same conditions underlie the low ROI, but this conclusion is erroneous. B has higher margins but a lower investment turnover. C has very small margins (1/20th of B) but turns over investment 20 times faster. I.M.A. Report No. 35 (page 35) states: ―Introducing revenues to measure level of operations helps to disclose specific areas for more intensive investigation. Company B does as well as Company A in terms of income margin, for both companies earn 10% on revenues. But Company B has a much lower turnover of investment than does Company A. Whereas a dollar of investment in Company A supports two dollars in revenues each period, a dollar investment in Company B supports only ten cents in revenues each period. This suggests that the analyst should look carefully at Company B’s investment. Is the company keeping an inventory larger than necessary for its revenue level? Are receivables being collected promptly? Or did Company A acquire its fixed assets at a price level that was much lower than that at which Company B purchased its plant?‖ ―On the other hand, C’s investment turnover is as high as A’s, but C’s income as a percentage of revenue is much lower. Why? Are its operations inefficient, are its material costs too high, or does its location entail high transportation costs?‖ ―Analysis of ROI raises questions such as the foregoing. When answers are obtained, basic reasons for differences between rates of return may be discovered. For example, in Company B’s case, it is apparent that the emphasis will have to be on increasing turnover by reducing investment or increasing revenues. Clearly, B cannot appreciably increase its ROI simply by increasing its income as a percent of revenue. In contrast, Company C’s management should concentrate on increasing the percent of income on revenue.‖ 23-4 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

23-17

(30 min.) Analysis of return on invested assets, comparison of two divisions, DuPont method.

1.

Test Preparation Division 2011 2012 2013 Language Arts Division 2011 2012 2013 Global Data, Inc. 2011 2012 2013

Operating Income

Operating Revenues

Total Assets

Operating Income Operating Revenues

$720 920 1,140

$9,000 $920 11.5% = $8,000 $1,140 9.5% = $12,000

$1,800 $920 46% = $2,000 $12,000 6 = $2,000

8.0% 11.5% 9.5%

5.0 4.0 6.0

40.0% 46.0% 57.0%

$3,000 3,525 $2,900 1.6 = $4,640

$2,000 2,350 2,900

22.0% 20.0% 12.5%

1.5 1.5 1.6

33.0% 30.0% 20.0%

$12,000 $8,000 + $3,525 = $11,525 $12,000 + $4,640 = $16,640

$3,800 $2,000 + $2,350 = $4,350 $2,000 + $2,900 = $4,900

11.5% 14.1% 10.3%

3.2 2.7 3.4

36.3% 37.4% 35.1%

$3,525 $2,900

$660 20%= $705 20% = $580

$1,380 $920 + $705 = $1,625 $1,140 + $580 = $1,720

Operating Revenues Total Assets

2. Based on revenues, Test Preparation is more than twice the size of Language Arts. In addition, the Test Preparation Division turns over its assets at more than twice the rate of the Language Arts Department (operating revenues as a multiple of total assets). However, Language Arts is twice as profitable in terms of margins (operating income as a percent of operating revenues). The net result is that Test Preparation has a higher ROI, typically in the 40-60% range, while Language Arts has ROI in the 20–35% range. Moreover, the ROI of the Test Preparation Division has been increasing from 2011 to 2013, while the ROI of the Language Arts Department has been falling. Overall, this has resulted in Global Datad showing stable ROI over the past three years.


Operating Income Total Assets

23-18 1.

(10–15 min.) ROI and RI. Operating income = (Contribution margin per unit 150,000 units) – Fixed costs = ($720 – $500) 150,000 – $30,000,000 = $3,000,000 ROI =

2.

Operating income =

Operating income = $3,000,000 ÷ $48,000,000 = 6.25% Investment

ROI

Investment

[No. of pairs sold (Selling price – Var. cost per unit)] – Fixed costs = ROI

Investment

Let $X = minimum selling price per unit to achieve a 25% ROI 150,000 ($X – $500) – $30,000,000 = 25% ($48,000,000) $150,000X = $12,000,000 + $30,000,000 + $75,000,000 X = $780 3.

Let $X = minimum selling price per unit to achieve a 20% rate of return

150,000 ($X – $500) – $30,000,000 = 20% ($48,000,000) $150,000X = $9,600,000 + $30,000,000 + $75,000,000 X = $764


23-19 (20 min.) ROI and RI with manufacturing costs. 1. The operating income is: Sales revenue ($12,000 × 10,000) Less: Direct materials ($3,000 × 10,000) Setup ($1,300 × 6,000) Production ($415 × 175,200) Gross margin Selling and administration Operating income

$120,000,000 $30,000,000 7,800,000 72,708,000

110,508,000 9,492,000 7,340,000 $ 2,152,000

Average invested capital is ($13,500,000 + $13,400,000) ÷ 2 = $13,450,000 ROI =

$ 2,152,000 = 16% $13,450,000

2. Residual income = Operating income − (12% × Invested capital) = $2,152,000 − (12% × $13,450,000) = $2,152,000 − $1,614,000 = $538,000


23-20 (25 min.) Financial and nonfinancial performance measures, goal congruence. 1. Operating income is a good summary measure of short-term financial performance. By itself, however, it does not indicate whether operating income in the short run was earned by taking actions that would lead to long-run competitive advantage. For example, Summit’s divisions might be able to increase short-run operating income by producing more product while ignoring quality or rework. Harrington, however, would like to see division managers increase operating income without sacrificing quality. The new performance measures take a balanced scorecard approach by evaluating and rewarding managers on the basis of direct measures (such as rework costs, on-time delivery performance, and sales returns). This motivates managers to take actions that Harrington believes will increase operating income now and in the future. The nonoperating income measures serve as surrogate measures of future profitability. 2. The semiannual installments and total bonus for the Charter Division are calculated as follows: Charter Division Bonus Calculation For Year Ended December 31, 2012 January 1, 2012 to June 30, 2012 Profitability (0.02 $462,000) Rework (0.02 $462,000) – $11,500 On-time delivery No bonus—under 96% Sales returns [(0.015 $4,200,000) – $84,000] 50% Semiannual installment Semiannual bonus awarded

July 1, 2012 to December 31, 2012 Profitability (0.02 $440,000) Rework (0.02 $440,000) – $11,000 On-time delivery 96% to 98% Sales returns [(0.015 $4,400,000) – $70,000] 50% Semiannual installment Semiannual bonus awarded Total bonus awarded for the year

$

$ 9,240 (2,260) 0 (10,500) $ (3,520) 0

$ 8,800 (2,200) 2,000 (2,000) $ 6,600 $ 6,600 $ 6,600


The semiannual installments and total bonus for the Mesa Division are calculated as follows: Mesa Division Bonus Calculation For Year Ended December 31, 2012 January 1, 2012 to June 30, 2012 Profitability (0.02 $342,000) Rework (0.02 $342,000) – $6,000 On-time delivery Over 98% Sales returns [(0.015 $2,850,000) – $44,750] 50% Semiannual bonus installment Semiannual bonus awarded July 1, 2012 to December 31, 2012 (0.02 $406,000) (0.02 $406,000) – $8,000 No bonus—under 96% [(0.015 $2,900,000) – $42,500] which is greater than zero, yielding a bonus Semiannual bonus installment Semiannual bonus awarded Total bonus awarded for the year Profitability Rework On-time delivery Sales returns

$ 6,840 0 5,000 (1,000) $10,840 $10,840

$ 8,120 0 0 3,000 $11,120 $11,120 $21,960

3. The manager of the Charter Division is likely to be frustrated by the new plan, as the division bonus has fallen by more than $20,000 compared to the bonus of the previous year. However, the new performance measures have begun to have the desired effect––both on-time deliveries and sales returns improved in the second half of the year, while rework costs were relatively even. If the division continues to improve at the same rate, the Charter bonus could approximate or exceed what it was under the old plan. The manager of the Mesa Division should be as satisfied with the new plan as with the old plan, as the bonus is almost equivalent. On-time deliveries declined considerably in the second half of the year and rework costs increased. However, sales returns decreased slightly. Unless the manager institutes better controls, the bonus situation may not be as favorable in the future. This could motivate the manager to improve in the future but currently, at least, the manager has been able to maintain his bonus with showing improvement in only one area targeted by Harrington. Ben Harrington’s revised bonus plan for the Charter Division fostered the following improvements in the second half of the year despite an increase in sales: An increase of 1.9% in on-time deliveries. A $500 reduction in rework costs. A $14,000 reduction in sales returns.


However, operating income as a percent of sales has decreased (11% to 10%). The Mesa Division’s bonus has remained at the status quo as a result of the following effects: An increase of 2.0 % in operating income as a percent of sales (12% to 14%). A decrease of 3.6% in on-time deliveries. A $2,000 increase in rework costs. A $2,250 decrease in sales returns. This would suggest that revisions to the bonus plan are needed. Possible changes include: increasing the weights put on on-time deliveries, rework costs, and sales returns in the performance measures while decreasing the weight put on operating income; a reward structure for rework costs that are below 2% of operating income that would encourage managers to drive costs lower; reviewing the whole year in total. The bonus plan should carry forward the negative amounts for one six-month period into the next six-month period incorporating the entire year when calculating a bonus; and developing benchmarks, and then giving rewards for improvements over prior periods and encouraging continuous improvement.


23-21 (25 min.) Goal incongruence and ROI. 1. Bleefl would be better off if the machine is replaced. Its cost of capital is 6% and the IRR of the investment is 11%, indicating that this is a positive net present value project. 2. The ROIs for the first five years are:

1

Operating income End of year net assets Average net assets ROI 1

Year 1 Year 2 Year 3 Year 4 Year 5 $2,000 $2,000 $2,000 $2,000 $2,000 27,000 24,000 21,000 18,000 15,000 2 28,500 25,500 22,500 19,500 16,500 7.02% 7.84% 8.89% 10.26% 12.12%

Income is cash savings of $5,000 less $3,000 annual depreciation expense.

2

($30,000 + $27,000) ÷ 2 = $28,500 The manager would not want to replace the machine before retiring because the division is currently earning a ROI of 11%, and replacement of the machine will lower the ROI every year until the fifth year, when the manager is long gone. 3. Bleefl could use long term rather than short term ROI, or use ROI and some other long term measures to evaluate the Patio Furniture division to create goal congruence. Evaluating the managers on residual income rather than ROI would also achieve goal congruence. For example, replacing the machine increases residual income in Year 1. Residual income = Operating income − (6% × Average net assets) = $2,000 − (6% × 28,500) = $2,000 − $1,710 = $290


23-22 (25 min.) ROI, RI, EVA®. 1. The required division ROIs using total assets as a measure of investment is shown in the row labeled (1) in Solution Exhibit 23-22. SOLUTION EXHIBIT 23-22

(1)

(2)

(3)

Total assets Current liabilities Operating income Required rate of return Total assets – current liabilities ROI (based on total assets) ($2,475,000 $33,000,000; $2,565,000 $28,500,000) RI (based on total assets – current liabilities) ($2,475,000 – (12% $26,400,000); $2,565,000 – (12% $20,100,000)) RI (based on total assets) ($2,475,000 – (12% $33,000,000); $2,565,000 – (12% $28,500,000))

New Car Division $33,000,000 $6,600,000 $2,475,000 12% $26,400,000

Performance Parts Division $28,500,000 $8,400,000 $2,565,000 12% $20,100,000

7.5%

9.0%

($693,000)

$153,000

($1,485,000)

($855,000)

2. The required division RIs using total assets minus current liabilities as a measure of investment is shown in the row labeled (2) in the table above. 3. The row labeled (3) in the table above shows division RIs using assets as a measure of investment. Even with this new measure that is insensitive to the level of short-term debt, the New Car Division has a relatively worse RI than the Performance Parts Division. Both RIs are negative, indicating that the divisions are not earning the 12% required rate of return on their assets. 4.

After-tax cost of debt financing = (1– 0.4) After-tax cost of equity financing = 15% Weighted average cost of capital =

10% = 6%

($18,000,000 6%) + ($12,000,000 15%) = 9.6% $18,000,000 + $12,000,000

Operating income after tax 0.6 operating income before tax (0.6 $2,475,000; 0.6 $2,565,000) Required return for EVA 9.6% Investment (9.6% $26,400,000; 9.6% $20,100,000) EVA (Optg. inc. after tax – reqd. return)

$ 1,485,000

$1,539,000

2,534,400 1,929,600 $(1,049,400) $ (390,600)

5. Both the residual income and the EVA calculations indicate that the Performance Parts Division is performing nominally better than the New Car Division. The Performance Parts Division has a higher residual income. The negative EVA for both divisions indicates that, on an after-tax basis, the divisions are destroying value––the after-tax economic returns from them are less than the required returns. 23-12 © 2012 Pearson Education, Inc. Publishing as Prentice Hall. SM Cost Accounting 14/e by Horngren

23-23 (25–30 min.) ROI, RI, measurement of assets. The method for computing profitability preferred by each manager follows: Manager of Radnor Easttown Marion

Method Chosen RI based on net book value RI based on gross book value ROI based on either gross or net book value

Supporting Calculations: ROI Calculations Division Radnor Easttown Marion

Operating Income Gross Book Value $142,050 ÷ $1,200,000 = 11.84% (3) $137,550 ÷ $1,140,000 = 12.07% (2) $ 92,100 ÷ $ 750,000 = 12.28% (1)

Operating Income Net Book Value * $142,050 ÷ $555,000 = 25.59% (3) $137,550 ÷ $525,000 = 26.20% (2) $ 92,100 ÷ $330,000 = 27.91% (1)

RI Calculations Division Radnor Easttown Marion

Operating Income – 10% Gross BV $142,050 – $120,000 = $22,050 (2) $137,550 – $114,000 = $23,550 (1) $ 92,100 – $ 75,000 = $17,100 (3)

Operating Income – 10% Net BV1 $142,050 – $55,500 = $86,550 (1) $137,550 – $52,500 = $85,050 (2) $ 92,100 – $33,000 = $59,100 (3)

1Net book value is gross book value minus accumulated depreciation.

The biggest weakness of ROI is the tendency to reject projects that will lower historical ROI even though the prospective ROI exceeds the required ROI. RI achieves goal congruence because subunits will make investments as long as they earn a rate in excess of the required return for investments. The biggest weakness of RI is that it favors larger divisions in ranking performance. The greater the amount of the investment (the size of the division), the more likely that larger divisions will be favored assuming that income grows proportionately. The strength of ROI is that it is a ratio and so does not favor larger divisions. In general, though, achieving goal congruence is very important. Therefore, the RI measure is often preferred to ROI.


23-24 (20 min.) Multinational performance measurement, ROI, RI. 1a.

U.S. Division's ROI in 2012 = Hence, operating income = 9.3%

1b.

Operating income Operating income = = 9.3% $7,500,000 Total assets

$7,500,000 = $697,500.

Norwegian Division's ROI in 2012 (based on kroners) =

6,840,000 kroners = 9.5% 72,000,000 kroners

2. Convert total assets into dollars using the December 31, 2011 exchange rate, the rate prevailing when the assets were acquired (9 kroners = $1):

72,000,000 kroners = $8,000,000 9 kroner per dollar Convert operating income into dollars at the average exchange rate prevailing during 2012 when operating income was earned (9.5 kroners = $1):

6,840,000 kroners 9.5 kroners per dollar

= $720,000

Comparable ROI for Norwegian Division =

$720,000 = 9% $8,000,000

The Norwegian Division’s ROI based on kroners is helped by the inflation that occurred in Norway in 2012 (that caused the Norwegian kroner to weaken against the dollar from 9 kroners = $1 on 12-31-2011 to 10 kroners = $1 on 12-31-2012). Inflation boosts the division's operating income. Since the assets were acquired at the start of the year 2012, the asset values are not increased by the inflation that occurs during the year. The net effect of inflation on ROI calculated in kroners is to use an inflated value for the numerator relative to the denominator. Adjusting for inflationary and currency differences negates the effects of any differences in inflation rates between the two countries on the calculation of ROI. After these adjustments, the U.S. Division earned a higher ROI (9.3%) than the Norwegian Division (9%). 3.

U.S. Division’s RI in 2012 = $697,500 (8% $7,500,000) = $697,500 $600,000 = $97,500 Norwegian Division’s RI in 2012 (in U.S. dollars) is calculated as: $720,000

(8%

$8,000,000) = $720,000

$640,000 = $80,000.

The U.S. Division’s RI also exceeds the Norwegian Division’s RI in 2011 by $17,500.


23-25 (20 min.) ROI, RI, EVA and Performance Evaluation. 1. ROI and residual income:

Operating income after tax Net assets ROI ($600,000 ÷ $3,000,000; $1,600,000 ÷ $10,000,000) RI ($600,000 − 10% × 3,000,000; $1,600,000− 10% × $10,000,000)

Clothing $ 600,000 $3,000,000 20.00% $ 300,000

Cosmetics $ 1,600,000 $10,000,000 16.00% $

600,000

The choice of measure used to evaluate performance will determine which division gets the bonus. If the firm uses ROI, then the Clothing Division will get the bonus. However, the Cosmetics Division has much larger absolute and residual income. If the firm evaluates performance based on residual income, then the Cosmetics Division will get the bonus. The advantages of ROI are that it is easy to calculate and easy to understand. It combines revenue, cost, and investment into a single number, so that managers can clearly see what can be changed to increase returns. But ROI has limitations. Managers who are evaluated based on ROI have incentives to reject investments with ROIs below their divisions’ current average ROI, even when the investments have positive net present values. Residual income has the advantage of goal congruence because any investment that earns more than the required capital charge increases RI, and thereby increases the managers’ performance evaluations. The measure is not subject to the ―cutoff‖ problems that occur when managers compare a new investment’s ROI to the average ROI being earned on existing investments. However, RI is not as easy to measure because it requires the company to determine the amount of capital and the cost of capital for each business unit. 2. Adjusted operating income Net assets less current liabilities Revised ROI ($720,000 ÷ $2,600,000; $1,430,000 ÷ 9,800,000) EVA ($720,000 − 10% × $2,600,000; $1,430,000 − 10% × $9,800,000)

Clothing $ 720,000 $2,600,000

Cosmetics $1,430,000 $9,800,000

27.69%

14.59%

$ 460,000

$ 450,000

Clothing Division will get the bonus because both EVA and ROI (using EVA’s definition of operating income and assets) are higher than those of the Cosmetics Division. 3. Since this is a manufacturing firm, there are a variety of non-financial performance measures such as market share, customer satisfaction, defect rates, and response times that can be used to ensure that managers do not increase short-term operating income, residual income, or EVA at the expense of performance categories that are long-term drivers of company value.


23-26 (20–30 min.) Risk sharing, incentives, benchmarking, multiple tasks. 1. An evaluation of the three proposals to compensate Marks, the general manager of the Dexter Division follows: (i) Paying Marks a flat salary will not subject Marks to any risk, but it will provide no incentives for Marks to undertake extra physical and mental effort. (ii) Rewarding Marks only on the basis of Dexter Division’s ROI would motivate Marks to put in extra effort to increase ROI because Marks’s rewards would increase with increases in ROI. But compensating Marks solely on the basis of ROI subjects Marks to excessive risk because the division’s ROI depends not only on Marks’s effort but also on other random factors over which Marks has no control. For example, Marks may put in a great deal of effort, but, despite this effort, the division's ROI may be low because of adverse factors (such as high interest rates or a recession) which Marks cannot control. To compensate Marks for taking on uncontrollable risk, AMCO must pay him additional amounts within the structure of the ROI-based arrangement. Thus, compensating Marks only on the basis of performance-based incentives will cost AMCO more money, on average, than paying Marks a flat salary. The key question is whether the benefits of motivating additional effort justify the higher costs of performance-based rewards. Furthermore, the objective of maximizing ROI may induce Marks to reject projects that, from the viewpoint of the organization as a whole, should be accepted. This would occur for projects that would reduce Marks’s overall ROI but which would earn a return greater than the required rate of return for that project. (iii) The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager. 2. Marks’s complaint does not appear to be valid. The senior management of AMCO is proposing to benchmark Marks’s performance using a relative performance evaluation (RPE) system. RPE controls for common uncontrollable factors that similarly affect the performance of managers operating in the same environments (for example, the same industry). If business conditions for car battery manufacturers are good, all businesses manufacturing car batteries will probably perform well. A superior indicator of Marks’s performance is how well Marks performed relative to his peers. The goal is to filter out the common noise to get a better understanding of Marks’s performance. Marks’s complaint will be valid only if there are significant differences in investments, assets, and the business environment in which AMCO and Tiara operate. Given the information in the problem, this does not appear to be the case. Of course, using RPE does not eliminate the problem with the ROI measure itself. To keep ROI high, Marks will still prefer to reject projects whose ROI is greater than the required rate of return but lower than the current ROI.


3. Superior performance measures change significantly with the manager's performance and not very much with changes in factors that are beyond the manager’s control. If Marks has no authority for making capital investment decisions, then ROI is not a good measure of Marks’s performance––it varies with the actions taken by others rather than the actions taken by Marks. AMCO may wish to evaluate Marks on the basis of operating income rather than ROI. ROI, however, may be a good measure to evaluate Dexter's economic viability. Senior management at AMCO could use ROI to evaluate if the Dexter Division’s income provides a reasonable return on investment, regardless of who has authority for making capital investment decisions. That is, ROI may be an inappropriate measure of Marks’s performance but a reasonable measure of the economic viability of the Dexter Division. If, for whatever reasons— bad capital investments, weak economic conditions, etc.—the Division shows poor economic performance as computed by ROI, AMCO management may decide to shut down the division even though they may simultaneously conclude that Marks performed well. 4. There are three main concerns with Marks’s plans. First, creating very strong sales incentives imposes excessive risk on the sales force because a salesperson’s performance is affected not only by his or her own effort, but also by random factors (such as a recession in the industry) that are beyond the salesperson's control. If salespersons are risk averse, the firm will have to compensate them for bearing this extra uncontrollable risk. Second, compensating salespersons only on the basis of sales creates strong incentives to sell, but may result in lower levels of customer service and sales support (this was the story at Sears auto repair shops where a change in the contractual terms of mechanics to ―produce‖ more repairs caused unobservable quality to be negatively affected). Where employees perform multiple tasks, it may be important to ―blunt‖ incentives on those aspects of the job that can be measured well (for example, sales) to try and achieve a better balance of the two tasks (for example, sales and customer service and support). In addition, the division should try to better monitor customer service and customer satisfaction through surveys, or through quantifying the amount of repeat business. Finally, setting compensation on the basis of number of units sold, rather than the revenue generated may result in excess discounting by salespersons whose goal is to increase volume without attention to the impact on brand perception or the division’s income from prices that are too low.


23-27 (20 min.)

Residual income and EVA; timing issues.

1. RI =Operating income – (WACC x Assets) = $630,000 – (0.09 x $5,550,000) = $630,000 - $499,500 = $130,500 2. EVA = Adjusted operating income – (WACC x (Total assets – Current liabilities)) Operating income is adjusted as follows: Operating income Add back this period’s advertising expense Less amortized advertising (1/4 of year’s expense) Adjusted operating income

$ 630,000 90,000 (22,500) $ 697,500

Assets are adjusted as follows: Total assets Plus capitalized, unamortized advertising Adjusted total assets

$5,550,000 67,500 $5,617,500

EVA

= $697,500 – (0.09 × ($5,617,500 − $800,000)) = $697,500 − $433,575 = $263,925

3. The differences between the RI and EVA results are due to two factors in this problem: the definition of capital and the treatment of advertising. EVA subtracts current liabilities from total assets when computing capital. Since some types of current liabilities represent sources of ―free‖ short-term funds (e.g., holding off payments to suppliers), they reduce the assets needed to produce income. If short-term liabilities represent a source of funds, EVA more accurately reflects the assets that the company employed to achieve its operating income. Under traditional accounting rules, advertising is a period expense, and the costs and benefits of advertising are not matched if advertising affects revenues over multiple years. Consequently, EVA does a better job matching revenues and costs when the effects of advertising persist over multiple periods and solves the goal incongruence problem that sometimes arises with the RI measures.


23-28 (40–50 min.) ROI performance measures based on historical cost and current cost. 1.

ROI using historical cost measures: Passion Fruit Kiwi Fruit Mango Fruit

$260,000 ÷ $ 680,000 = 38.24% $440,000 ÷ $2,300,000 = 19.13% $760,000 ÷ $3,240,000 = 23.46%

The Passion Fruit Division appears to be considerably more efficient than the Kiwi Fruit and Mango Fruit Divisions. 2. The gross book values (i.e., the original costs of the plants) under historical cost are calculated as the useful life of each plant (12 years) the annual depreciation: Passion Fruit Kiwi Fruit Mango Fruit

12 12 12

$140,000 = $1,680,000 $200,000 = $2,400,000 $240,000 = $2,880,000

Step 1: Restate long-term assets from gross book value at historical cost to gross book value at current cost as of the end of 2011: (Gross book value of long-term assets at historical cost) Construction cost index in year of construction). Passion Fruit Kiwi Fruit Mango Fruit

$1,680,000 $2,400,000 $2,880,000

(Construction cost index in 2011 ÷

(170 ÷ 100) = $2,856,000 (170 ÷ 136) = $3,000,000 (170 ÷ 160) = $3,060,000

Step 2: Derive net book value of long-term assets at current cost as of the end of 2011. (Estimated useful life of each plant is 12 years.) (Gross book value of long-term assets at current cost at the end of 2011) useful life ÷ Estimated total useful life) Passion Fruit Kiwi Fruit Mango Fruit

$2,856,000 $3,000,000 $3,060,000

(Estimated remaining

( 2 ÷ 12) = $ 476,000 ( 9 ÷ 12) = $2,250,000 (11 ÷ 12) = $2,805,000

Step 3: Compute current cost of total assets at the end of 2011. (Assume current assets of each plant are expressed in 2011 dollars.) (Current assets at the end of 2011 [given]) + (Net book value of long-term assets at current cost at the end of 2011 [Step 2]) Passion Fruit Kiwi Fruit Mango Fruit

$400,000 + $ 476,000 = $ 876,000 $500,000 + $2,250,000 = $2,750,000 $600,000 + $2,805,000 = $3,405,000 23-19


Step 4: Compute current-cost depreciation expense in 2011 dollars. Gross book value of long-term assets at current cost at the end of 2011 (from Step 1) ÷ 12 Passion Fruit Kiwi Fruit Mango Fruit

$2,856,000 ÷ 12 = $238,000 $3,000,000 ÷ 12 = $250,000 $3,060,000 ÷ 12 = $255,000

Step 5: Compute 2011 operating income using 2011 current-cost depreciation expense. (Historical-cost operating income – [Current-cost depreciation expense in 2011 dollars (Step 4) – Historical-cost depreciation expense]) Passion Fruit Kiwi Fruit Mango Fruit

$260,000 – ($238,000 – $140,000) = $162,000 $440,000 – ($250,000 – $200,000) = $390,000 $760,000 – ($255,000 – $240,000) = $745,000

Step 6: Compute ROI using current-cost estimates for long-term assets and depreciation expense (Step 5 ÷ Step 3). Passion Fruit Kiwi Fruit Mango Fruit

Passion Fruit Kiwi Fruit Mango Fruit

$162,000 ÷ $ 876,000 = 18.49% $390,000 ÷ $2,750,000 = 14.18% $745,000 ÷ $3,405,000 = 21.88% ROI: Historical Cost 38.24% 19.13 23.46

ROI: Current Cost 18.49% 14.18 21.88

Use of current cost results in the Mango Fruit Division appearing to be the most efficient. The Passion Fruit ROI is reduced substantially when the ten-year-old plant is restated for the 70% increase in construction costs over the 2001 to 2011 period. 3. Use of current costs increases the comparability of ROI measures across divisions’ operating plants built at different construction cost price levels. Use of current cost also will increase the willingness of managers, evaluated on the basis of ROI, to move between divisions with assets purchased many years ago and divisions with assets purchased in recent years.


23-29 (40–50 min.) ROI, measurement alternatives for performance measures (Please alert students that in some printed versions of the book there are two typographical errors in the numbers for Denver. Division revenues are $8,668,000 rather than $8,365,000, and Gross book value of long-term assets should be $4,500,000 and not $4,750,000.) 1. ROI = Operating income ÷ Net book value of total assets Denver ROI

= $723,000 ÷ ($4,500,000 – $3,300,000 + 999,800) = $723,000 ÷ $2,199,800 = 60.25%

Seattle ROI

= $504,000 ÷ ($3,750,000 – $1,750,000 + 768,200) = $504,000 ÷ $2,768,200 = 18.21%

Sacramento ROI

= $466,000 ÷ ($4,050,000–- $1,080,000 + 824,600) = $466,000 ÷ $3,794,600 = 12.28%

2. Step 1:

Denver Seattle Sacramento

÷

Construction cost index in year of construction

=

Gross book value of long-term assets at current cost at end of 2012

÷ ÷ ÷

100) 110) 118)

= = =

$5,490,000 $4,159,091 $4,187,288

×

Estimated remaining useful life

÷

Estimated useful life

× × ×

( 4 ( 8 (11

÷ ÷ ÷

Current assets at end of 2012

+

Long-term assets (from Step 2, above)

=

$999,800 $768,200 $824,600

+ + +

$1,464,000 $2,218,182 $3,070,678

= = =

Gross book value of long-term assets at historical cost

×

Construction cost index in 2012

$4,500,000 $3,750,000 $4,050,000

× × ×

(122 (122 (122

Gross book value of long-term assets at historical cost $5,490,000 $4,159,091 $4,187,288

Step 2:


15) 15) 15)

=

= = =

Net book value of long-term assets at current cost at end of 2012 $1,464,000 $2,218,182 $3,070,678

Step 3:


Current cost of total assets at end of 2012 $2,463,800 $2,986,382 $3,895,278


Step 4:


Gross book value of long-term assets at current cost at end of 2012 $5,490,000 $4,159,091 $4,187,288

+

Estimated total useful life

=

Current-cost depreciation expense in 2012 collars

+ + +

15 15 15

= = =

$366,000 $277,273 $279,153

Step 5:


Historical-cost operating income $723,000 $504,000 $466,000

–

Current-cost depreciation expense in 2012 dollars

– – –

$366,000 ($277,273 ($279,153

–

Historicalcost depreciation expense

=

– – –

$300,000) $250,000) $270,000)

= = =

Operating income for 2012 using current-cost depreciation expense in 2012 dollars $657,000 $476,727 $456,847

Step 6: Operating income for 2012 using current-cost depreciation expense in 2012 dollars Denver Seattle Sacramento

$657,000 $476,727 $456,847

÷

Current cost of total assets at end of 2012

=

+ + +

$2,463,800 $2,986,382 $3,895,278

= = =

ROI using current-cost estimate

26.67% 15.96% 11.73%

3. Adjusting assets to recognize current costs negates differences in the investment base caused solely by differences in construction-price levels. Compared with historical-cost ROI, current cost ROI better measures the current economic returns from the investment. Because the Denver assets are older, there is a more significant difference between historical cost and current cost.


23-30 (20 min.) ROI, RI, and multinational firms. 1. Calculation of ROI and RI before currency translation:

Investment in assets Income for current year ROI ($681,250 ÷ $5,450,000; 486,400 eu ÷ 3,800,000 eu ) RI ($681,250 − (0.12 × $5,450,000); 486,400 eu − (0.12 × 3,800,000 eu))

United States $5,450,000 $ 681,250 12.5% $

27,250

Investment in assets

United States $5,450,000

Income for current year

$ 681,250

ROI ($681,250 ÷ $5,450,000; $680,960 ÷ $4,940,000 ) RI ($681,250 − (0.12 × $5,450,000); $680,960 − (0.12 × $4,940,000))

France 3,800,000 eu 486,400 eu 12.8% 30, 400 eu

France $4,940,000 (3,800,000 eu × $1.30) $ 680,960 (486,400 eu ×$1.40)

12.5% $

27,250

13.8% $

88,160

Without currency translation, the ROIs in the United States and France are similar, but after currency translation the ROI of France is substantially higher. Residual income is not comparable before currency translation given the different currencies used by the units. After translation, RI is higher in France. Together with the higher ROI, the RI results suggest that performance was better in France than in the United States. 2. Adjusting for differences in currency values makes the comparison of performance between foreign countries more meaningful since the accounting measures being examined are more comparable. However, changes in relative currency values can lead to misleading performance evaluations if interdependencies exist across units in different countries.


23-31 (30-40 min.)

Multinational firms, differing risk, comparison of profit, ROI, and RI.

1. Comparisons of after-tax operating income using translated values: US

Germany

NZ

Operating revenues ($13,362,940; 5,250,000 eu × $1.40; 4,718,750 NZD × $0.64) $13,362,940 $7,350,000 $3,020,000 Operating expenses ($8,520,000; 3,200,000 eu × $1.40; 3,250,000 NZD × $0.64) 8,520,000 4,480,000 2,080,000 Operating income 4,842,940 2,870,000 940,000 Income tax at 40%; 35%; 25% 1,937,176 1,004,500 235,000 After-tax operating income

$ 2,905,764 $1,865,500 $ 705,000

In terms of after-tax operating income, the US division is doing best, with Germany second. However, the New Zealand division is far behind the other two in terms of operating income. 2. Comparison of ROI for each division. 1. After-tax operating income 2. Long-term assets ($23,246,112; 11,939,200 eu × $1.25; 9,400,000 NZD × $0.60) 3. ROI (Row 1 ÷ Row 2)

US $ 2,905,764

Germany $ 1,865,500

$23,246,112 12.5%

$14,924,000 12.5%

NZ $ 705,000

$5,640,000 12.5%

Because of differences in the value of assets employed in each division, they have identical returns on investment despite the differences in after-tax operating income. 3. After-tax operating income Long-term assets Cost of capital (given) Imputed cost of assets (cost of capital times long-term assets Residual income (After-tax operating income less imputed cost of assets)

US $ 2,905,764 $23,246,112 8%

Germany $ 1,865,500 $14,924,000 12%

NZ $ 705,000 $5,640,000 14%

$ 1,859,689

$ 1,790,880

$ 789,600

$ 1,046,075

$

$

74,620

(84,600)

In contrast to the same ROIs found in each division, the US division is performing the best on the basis of residual income since its return substantially exceeded its cost of capital of 8%. Germany has a small positive residual income, while New Zealand’s residual income is negative. These differences are due to differences in the cost of capital across countries. Both Germany and New Zealand achieved the same 12.5% ROI, but the required rate of return in Germany was just 12%, while that in New Zealand was much higher, at 14%.


4. Comparison of ROI using pre-tax operating income: US 1. Operating income (from requirement 1) 2. Long-term assets 3. ROI (Row 1 ÷ Row 2)

Germany

$ 4,842,940 $23,246,112 20.83%

$ 2,870,000 $14,924,000 19.23%

NZ $ 940,000 $5,640,000 16.67%

The ROI computed using pre-tax operating income is much higher than the 12.5% ROI for all divisions using after-tax income. The differences arise from the different tax rates imposed on each division. The divisions should be compared on after-tax dollars because selling prices and costs in each country reflect different expectations regarding income taxes. For instance, selling prices are likely to be higher in the US division, which has the highest tax rate.


23-32 (30–40 min.) ROI, RI, DuPont method, investment decisions, balanced scorecard. 1.

2012 Print Internet

Revenue Total Assets 0.85 ($20,400 2.50 ($30,000

Operating Income Revenues

$24,000) $12,000)

0.300 ($6,120 ÷ $20,400) 0.026 ($ 780 ÷ $30,000)

=

ROI = Operating Income Total Assets 0.255 ($6,120 $24,000) 0.065 ($ 780 $12,000)

The Print Division has a relatively high ROI because of its high income margin relative to Internet. The Internet Division has a low ROI despite a high investment turnover because of its very low income margin. 2. Although the proposed investment is small, relative to the total assets invested, it earns less than the 2012 return on investment (0.255) (All dollar numbers in millions): 2012 ROI (before proposal) =

$6,120 $24, 000

= 0.255

Investment proposal ROI

=

$144 $960

= 0.150

2012 ROI (with proposal)

=

$6,120 $144 = 0.251 $24, 000 $960

Given the existing bonus plan, any proposal that reduces the ROI is unattractive. So, Mays would not wish to take on the new investment, which drops the Print division’s ROI from 25.5% to 25.1%. 3a.

Residual income for 2012 (before proposal, in millions): Operating Income

Print Internet 3b.

Imputed Interest Charge

$6,120 – 780 –

$2,880 (0.12 1440 (0.12

Division Residual Income

$24,000) = $12,000) =

$3,240 (660)

Residual income for proposal (in millions): Operating Income $144

Imputed Interest Charge –

$115.2 (0.12

$960) =

Residual Income $28.8

Investing in the fast-speed printing press will increase the Print Division’s residual income by $28.8 million. As a result, if Mays is evaluated using a residual income measure, Mays would be favorably inclined to adopt the computerized reporting and printing system.


4. As discussed in requirement 3b, Moreno could consider using RI. The use of RI motivates managers to accept any project that makes a positive contribution to net income after the cost of the invested capital is taken into account. Making such investments will have a positive effect on Global Event Group’s customers. Moreno may also want to consider nonfinancial measures such as newspaper subscription levels, internet audience size, repeat purchase patterns, and market share. These measures will require managers to invest in areas that have favorable long-run effects on Global Event Group’s customers. 23-33 (20–30 min.) Division manager’s compensation, levers of control. 1

Consider each of the three proposals that Moreno is considering:

a.

Compensate managers on the basis of division RI. The benefit of this arrangement is that managers would be motivated to put in extra effort to increase RI because managers’ rewards would increase with increases in RI. But compensating managers largely on the basis of RI subjects the managers to excessive risk, because each division’s RI depends not only on the manager’s effort but also on random factors over which the manager has no control. A manager may put in a great deal of effort, but the division’s RI may be low because of adverse factors (high interest, recession) that the manager cannot control. To compensate managers for taking on uncontrollable risk, Moreno must pay them additional amounts within the structure of the RI-based arrangement. Thus, using mainly performance-based incentives will cost Moreno more money, on average, than paying a flat salary. The key question is whether the benefits of motivating additional effort justify the higher costs of performance-based rewards. The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager. Finally, rewarding a manager only on the basis of division RI will induce managers to maximize the division’s RI even if taking such actions are not in the best interests of the company as a whole. b.

Compensate managers on the basis of companywide RI. Rewarding managers on the basis of companywide RI will motivate managers to take actions that are in the best interests of the company rather than actions that maximize a division’s RI. A negative feature of this arrangement is that each division manager’s compensation will now depend not only on the performance of that division manager but also on the performance of the other division managers. For example, the compensation of Mays, the manager of the Print Division, will depend on how well the manager of Internet performs, even though Mays herself may have little influence over the performance of these divisions. Therefore, compensating managers on the basis of companywide RI will impose extra risk on each division manager, and will raise the cost of compensating them, on average. Compensate managers using the other division’s RI as a benchmark. The benefit of benchmarking or relative performance evaluation is to cancel out the effects of common noncontrollable factors that affect a performance measure. Taking out the c.


effects of these factors provides better information about a manager’s performance. What is critical, however, for benchmarking and relative performance evaluation to be effective is that similar noncontrollable factors affect each division. It is not clear that the same noncontrollable factors that affect the performance of the Print Division (cost of newsprint paper, for example) also affect the performance of the Internet division. If the noncontrollable factors are not the same, then comparing the RI of one division to the RI of the other division will not provide useful information for relative performance evaluation. A second factor for Moreno to consider is the impact that benchmarking and relative performance evaluation will have on the incentives for the division managers of the Print and Internet Divisions to cooperate with one another. Benchmarking one division against another means that a division manager will look good by improving his or her own performance, or by making the performance of the other division manager look bad. 2. Using measures like RI and ROI—diagnostic levers of control—can cause managers to cut corners and take other actions that boost short-run performance but harm the company in the long run. Moreno can guard against such problems by introducing and upholding strong boundary and belief systems of control within the company. Strict codes of conduct should govern what employees cannot do. Moreno should also foster a culture where employees have a deep belief in the value of the company’s journalistic mission. 3. Another potential problem of an excessive focus on diagnostic measures is a myopic disregard for emerging threats and opportunities. Interactive control systems, based on debate and discussion and regular review of strategic uncertainties and the competitive landscape can help overcome this problem. Moreno should not only ask for regular reports on ROI, RI, etc., he should meet regularly with division managers, discuss 5- and 10-year strategic plans, and obtain their field-based inputs. Such regular dialogues will help surface emerging threats and opportunities, and the action plans that need to be taken in response.


23-34 (20 min.) Executive compensation, balanced scorecard. The percentage changes in net income and customer satisfaction in the three business units between 2011 and 2012 are:

Percentage change in net income ($2,912,000 − $2,600,000) ÷ $2,600,000; ($2,940,000 − $2,800,000) ÷ $2,800,000; ($2,499,000 − $2,550,000) ÷ $2,550,000 Percentage change in customer satisfaction (75.48 − 74) ÷ 74; (75.9 − 69) ÷ 69; (78.88 − 68) ÷ 68

Retail Banking

Business Banking

Credit Cards

12%

5%

(2%)

2%

10%

16%

1. The bonus formula indicates that the executives of the three units will receive the following 2012 bonuses as a percent of salary: Retail Banking: 12% + 2% = 14% of salary Business Banking: 5% + 10% = 15% of salary Credit Cards: 0% + 16% = 16% of salary 2. The results show an inverse relation between changes in net income and changes in customer satisfaction. When changes in net income are higher, changes in customer satisfaction are lower, and vice versa. Some units may be over-investing in customer satisfaction initiatives, causing overall financial performance to decline. However, increases in customer satisfaction are not likely to pay off as immediately as increases in net income, which suggests that some units may be making investments in customer satisfaction to increase long-term financial performance, even though these investments cause short-term net income to decline. The company needs to examine whether one or both of these explanations is true. 3. The board of directors can set targets for changes in both net income and customer satisfaction. This would allow the company to take differences in the units, their competitive environments, and their customers into account when assessing performance. Target setting would also allow the company to reward managers when desirable investments in one dimension lead to short-term declines in the other. In addition, the board can improve the bonus plan by determining the relative importance of short-term changes in net income and customer satisfaction. Currently, a 1% change in either measure receives the same weight in the bonus formula, and declines have no effect on bonus payouts. However, a 1% increase in one measure may be more valuable than a 1% increase in the other, and declines in either measure may have a bigger effect on long-term value than increases. The payment formula can be modified by putting appropriate (and different) weights on each of these factors.


23-35 (25 min.) Ethics, manager’s performance evaluation (A. Spero, adapted). 1a.

Variable manufacturing cost per unit = $3 Fixed manufacturing cost per unit = $8,000,000 400,000 = $20 Total manufacturing cost per unit = $3 + $20 = $23 Revenues, $25 400,000 Variable manufacturing costs, $3 400,000 Fixed manufacturing costs, $20 400,000 Fixed marketing costs Total costs Operating loss Ending inventory: $0

1b.

$10,000,000 1,200,000 8,000,000 900,000 10,100,000 $ (100,000)

Variable manufacturing cost per unit = $3 Fixed manufacturing cost per unit = $8,000,000 500,000 = $16 Total manufacturing cost per unit = $3 + $16 = $19 Revenues, $25 400,000 Variable manufacturing costs, $3 400,000 Fixed manufacturing costs, $16 400,000 Fixed marketing costs Total costs Operating income Ending inventory = $19 per unit 100,000 units = $1,900,000

$10,000,000 1,200,000 6,400,000 900,000 8,500,000 $ 1,500,000

2. It would not be ethical for Jones to produce more units just to show better operating results. Professional managers are expected to take operating actions that are in the best interests of their shareholders. Jones’s action would benefit him at the cost of shareholders. Jones’s actions would be equivalent to ―cooking the books,‖ even though he may achieve this by producing more inventory than was needed, rather than through fictitious accounting. Some students might argue that Jones's behavior is not unethical––he simply took advantage of the faulty contract the board of directors had given him when he was hired. 3. Asking distributors to take more products than they need is also equivalent to ―cooking the books.‖ In effect, distributors are being coerced into taking more product. This is a particular problem if distributors will take less product in the following year or alternatively return the excess inventory next year. Some students might argue that Jones’s behavior is not unethical—it is up to the distributors to decide whether to take more inventory or not. So long as Jones is not forcing the product on the distributors, it is not unethical for Jones to push sales this year even if the excess product will sit in the distributors’ inventory.


23-36 (15 min.) Ethics, levers of control. 1. If Frank Jessup ―turns a blind eye‖ toward what he has just observed at the Dallas distribution center, he will be violating the competence, integrity, and objectivity standards for management accountants. Competence Perform professional duties in accordance with technical standards Integrity Abstain from engaging in or supporting any activity that would discredit the profession Credibility Communicate information fairly and objectively Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations. Jessup should: a. Follow established company policies to bring the issue to the attention of Monroe management through regular channels; then, if necessary, b. Discuss the problem with the immediate superior who is not involved in the overstatement of material yield. c. Clarify relevant ethical issues with an objective advisor, preferably a professional person outside Monroe. d. If all the above channels fail to lead to a correction in the organization, he may have to resign and become a ―whistle-blower‖ to bring Monroe to justice. 2. Monroe is clearly emphasizing profit, driving managers to find ways to keep profits strong and increasing. This is a diagnostic measure, and over-emphasis on diagnostic measures can cause employees to do whatever is necessary—including unethical actions—to keep the measures in the acceptable range, not attract negative senior management attention and possibly improve compensation and job reviews. To avoid problems like this in the future, Monroe needs to establish some strong boundary systems and codes of conduct. There should be a clear message from upper management that unethical behavior will not be tolerated. Monroe management needs to pay close attention to inspecting inventory for quality when the year-end inventory count is conducted. They should also investigate unusual changes, such as the increase in the Dallas center yield. Monroe needs to articulate a belief system of core values. The goal is to inspire managers and employees to do their best, exercise greater responsibility, take pride in their work, and do things the right away.


23-37 (45 minutes) RI, EVA, Measurement alternatives, Goal congruence. 1. Operating Income

Spa

–

$1,220,000 – 1,190,000 – 1,295,000 –

Ft. Meyers Scottsdale Monterey

Required Rate of Return

×

(11% (11% (11%

× × ×

Investment

=

Residual Income

6,155,000) = 6,312,000) = 7,435,000) =

$542,950 495,680 477,150

The residual income from the new saunas would be: $22,000 operating income - ($225,000 investment ×11% required rate) = ($2,750) Because the RI of the project is negative, the rate of return on the project is less than the required rate of 11%, and the Ft. Meyers manager would reject the project. Other managers would also reject the project because they all face a required rate of return of 11%. 2. Renewal Resorts may want to use EVA instead of RI because EVA explicitly takes into consideration both the weighted-average cost of capital and the effect of income taxes. EVA also uses long-term assets and working capital in its calculation as opposed to the use of total assets in the RI calculation. When performance is evaluated using EVA, managers must either earn more after-tax operating income with the same capital, use less capital to earn the same after-tax operating income, or invest capital in high-return projects. EVA is considered a stricter standard by which to gauge performance. 3. WACC =

8% (1 35%) $15,300,000 (14% $7,650,000) $15,300,000 $7,650,000

$1,866,600 8.13% $22,950,000

4. EVA = After-tax operating income – [WACC × (Total assets – current liabilities)] Using net book value of assets: Ft. Meyers EVA

= ($1,220,000 × 65%) – [8.13% × ($6,155,000 - $330,000)] = $793,000 - $ 473,572.50 = $ 319,427.50

Scottsdale EVA

= ($1,190,000 × 65%) – [8.13% × ($6,312,000 - $265,000)] = $773,500 - $ 491,621.10 = $281,878.90

Monterey EVA

= ($1,295,000 × 65%) – [8.13% × ($7,435,000 - $84,000)] = $841,750 - $597,636.30 = $244,113.70


Using gross book value of assets: Ft. Meyers EVA

= ($1,220,000 × 65%) – [8.13% × ($8,355,000a - $330,000)] = $793,000 - $654,058.50 = $140,567.50

Scottsdale EVA

= ($1,190,000 × 65%) – [8.13% × ($7,822,000a - $265,000)] = $773,500 - $614,384.10 = $159,115.90

Monterey EVA

= ($1,295,000 × 65%) – [8.13% × ($7,655,000a - $84,000)] = $841,750 - $615,522.30 = $226,227.70

a

Total assets + Accumulated depreciation

Using net book value of assets, Ft. Meyers, the oldest spa, shows the highest EVA, and Monterey shows the lowest. This is understandable, as the Ft. Meyers assets have been more fully depreciated. This technique, however, can lead management to make false assumptions about the earning power of the Ft. Meyers spa. Using the gross book value method, Monterey shows the highest EVA, while Ft. Meyers shows the lowest. This method unmasks the decline in earning power of older spa assets. 5. If Renewal Resorts chooses to use gross book value of assets in its EVA calculation, it may achieve greater goal congruence, as spa managers will be less reluctant to invest in newer assets that will produce higher future revenue. If a company measures assets using net book value, a manager will reject replacing older, fully depreciated, less profitable assets with newer ones because the initial effect will be lower EVA, even though the replacement may have positive long-term effects for the company.


Solution Manual of Cost Accounting A Managerial Emphasis by Horngren, Datar & Rajan 14th Edition

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